International Paper - Thin Dividend Safety

| About: International Paper (IP)


International Paper recently agreed to purchase Weyerhaeuser's Pulp business for $2.2 billion, which is expected to result in $175 million in annual synergies by the end of 2018.

We're not fond of International Paper's balance sheet, which will likely worsen in the near term due to the Weyerhaeuser deal.

Though its free cash flow generation has been strong historically, it has been inconsistent as of late. We don't like the volatility.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

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By The Valuentum Team

Paper giant International Paper's (NYSE:IP) global scale is a key advantage complemented by an extensive distribution system, and we love the resiliency embedded in its history that dates back to the end of the 19th century. The firm recently agreed to purchase Weyerhaeuser's (NYSE:WY) Pulp business for $2.2 billion, which will impact its balance sheet but is expected to result in $175 million in annual synergies by the end of 2018.

As International Paper's dividend cut in 2009 indicates, its business is not without risks, and we have a difficult time getting excited about any company so tied to the future of paper. We're not fond of the firm's balance sheet, which will likely worsen in the near term due to the Weyerhaeuser deal, as net debt stood at ~$7.9 billion at the end of the first quarter of 2016. The company's scale is not enough to help it avoid industry overcapacity during economic troughs, and returns can dip below its cost of capital at times.

Though its free cash flow generation has been strong historically, it has been inconsistent as of late, falling to under $1.1 billion in 2015 from over $1.8 billion in 2013. Free cash flow generation has averaged more than $1.5 billion annually from 2013-2015 and has been more than sufficient in covering average annual cash dividend obligations of just under $620 million. Though the firm cut its dividend in 2009, management has not been shy about increasing the payout since then, as its yield indicates (~3.8%). More safe income ideas are available, in our opinion, as International Paper's Dividend Cushion ratio of 0.5 indicates.

Image Source: Valuentum, International Paper's stock landing page

International Paper's Investment Considerations

Investment Highlights

• International Paper's global paper and packaging operations are complemented by an extensive distribution system. That doesn't insulate it from the threat of industry overcapacity during the troughs of the economic cycle, however. Returns can dip below its cost of capital at times. The company was founded in 1898 and is headquartered in Memphis, Tennessee.

• Though we like International Paper's fundamentals, particularly its free cash flow generating ability, it is hard to get excited about the long-term prospects of a company so dependent on the future of paper. The firm recently agreed to buy Weyerhaeuser's Pulp business for $2.4 billion.

• International Paper's intermediate-term targets are for EBITDA to exceed $5.1 billion on margins of 15%, as it pulls in more than $2.2 billion in annual free cash flow on yearly returns on invested capital of ~12%. We're expecting the firm to hit these targets by mid-late decade, and we especially like the company's focus on ROIC.

• International Paper's focus areas for the near term include continuing to improve its North American Packaging business and the optimization of its North American Paper commercial opportunities. The recent expansion of its Foodservice business enables profitable cup growth.

• International Paper has a dominant position in corrugated packaging, coated paperboard, and distribution in North America and a solid platform for uncoated papers in Brazil and paper, pulp and packaging in Russia. It has a track record of success.

Business Quality

Economic Profit Analysis

In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.

The gap or difference between ROIC and WACC is called the firm's economic profit spread. International Paper's 3-year historical return on invested capital (without goodwill) is 15.3%, which is above the estimate of its cost of capital of 9.7%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.

In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. International Paper's free cash flow margin has averaged about 6.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At International Paper, cash flow from operations decreased about 14% from levels registered two years ago, while capital expenditures expanded about 24% over the same time period.

Valuation Analysis

We think International Paper is worth $51 per share with a fair value range of $41-$61.

The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 0.5% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -7%.

Our model reflects a 5-year projected average operating margin of 12.3%, which is above International Paper's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.7% for the next 15 years and 3% in perpetuity. For International Paper, we use a 9.7% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $51 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Intl Paper. We think the firm is attractive below $41 per share (the green line), but quite expensive above $61 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate International Paper's fair value at this point in time to be about $51 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of International Paper's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $62 per share in Year 3 represents our existing fair value per share of $51 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.