International Paper: A Solid And Attractive Dividend

|
About: International Paper Co. (IP), Includes: CLW, KS, PKG, UFS, WRK
by: Frank Isaksen, CFA
Summary

High and sustainable dividend.

Attractive valuation.

Possibly oversold conditions.

Investment thesis
International Paper (NYSE: IP) is the world's largest pulp and paper maker. Pulp and paper is a mature industry with relatively low growth. However, International Paper and the other big producers seem to be faring somewhat better than the overall market. Some of the other big producers are WestRock (NYSE: WRK), Packaging Corporation of America (NYSE: PKG), KapStone (NYSE: KS), Clearwater (NYSE: CLW), Domtar (NYSE: UFS), and Georgia-Pacific (subsidiary of Koch Industries). In general the small producers seems to be losing market share.

International Paper has a management team with good track record. The company has a solid balance sheet. They are gradually increasing the cash return to shareholders through dividends and share buybacks. My analysis shows that even with a somewhat lower future EBITDA margins, the company seems to have no problem with maintaining the consensus forecasted dividend. The share buyback will be an additional cash return to shareholders. In a previous article Valuentum has also analyzed the probability of expected future dividends being paid.

It ma
y take some time, but my thesis is that investors will want to buy a solid dividend company like International Paper.

International Paper
The slides below are from international Paper.
Sources: Second Quarter 2015 Earnings, Investor Roadshow 2Q 2015

The column chart below shows the historical EBITDA margins for the different business areas. The pie chart shows the EBITDA composition for the whole company. The company gets most of its earnings from North America and from Industrial Packaging.

The chart below shows the operating business earnings per share history. The company has an impressive track record.

The chart below shows the historical free cash flow generation. The free cash flow generation potential for the next 2 years seems to be averaging between $400 million and $550 million per quarter.

The chart below shows the historical annualized dividend.

The slide below gives an overview of the use of cash.

The charts below give an indication of the market share, and market share development, in some of the key businesses that International Paper operates in. It seems like the big gets bigger at the expense of the smaller players.

The chart below shows the global cost curve for industrial packaging, the most important sector for International Paper. International Paper has a roughly equal cost position in their other sectors as well. The chart depicting this can be found in the Investor Roadshow 2Q 2015.

Share price
The chart below from Yahoo Finance shows the International Paper share price development for the last 5 years.

Source: YahooFinance

The chart below shows the historical share price for the last 315 trading days (the last year) and estimated possible share price development for the next 63 trading days (3 months). The estimated possible share price development is based on historical simulation for the share price for the last 5 years.

Source: SimulationFinance, Portfolio Model

Consensus
Source: 4-traders.com

Forecast
I have used the Equity Analysis Model from SimulationFinance.com to generate all the financial forecasts in this analysis. I have simply created an International Paper analysis by selecting the auto-generated analysis on SimulationFinance.com (short tutorial).

This auto-generated analysis contains historical financial data from Google Finance, and forecast assumptions based on consensus forecast from 4-traders.com. The complete analysis is available on SimulationFinance.com.

The below image from the Equity Analysis model shows the auto-generated assumption. The image shows that from the second quarter of 2015, the start of the explicit forecast period, to the end of the explicit forecast period, Price (revenues) is expected to have a quarterly growth of 0.53%. COGS (costs) is expected to have a quarterly growth of 0.23%. The default valuation method is the discounted cash flow method, and the default weighted average cost of capital and perpetual growth is 10% and 4% respectively. I will test other assumptions further below in the analysis.

The standard deviation for Price (5%) and COGS (4.36%) are calculated automatically from the historical reported revenues and EBITDA.

Confidence analysis
All the charts below are from the analysis made in the Equity Analysis Model on simulationfinance.com. The chart below shows the calculated possible quarterly revenues development with included risk assumptions.

The black whole line shows the historical quarterly revenues. The black dotted line shows the base case quarterly revenues forecast. The darkest blue area shows the range that contains 75% of the calculated outcomes. The second darkest blue area, together with the darkest blue area, contains 90% of the calculated outcomes. The total blue area contains 95% of the calculated outcomes. 2.5% of the calculated outcomes are above the blue area and 2.5% of the calculated outcomes are below the blue area. The quarterly revenues in 2018 are calculated to be between $5.2 billion and $7 billion.

The chart below shows the calculated possible quarterly EBITDA development.

The chart below shows the calculated possible quarterly EBITDA margin development.

The chart below shows the calculated possible quarterly development in earnings per share.

The chart below shows the Price/Earnings and Price/Cash earnings for 2016 and 2017.

Dividend probability and dividend capacity
International Paper is a relatively solid company with a good free cash flow generation. Both the management and consensus expect the EBITDA margin to continue to increase the next years. However, assuming the EBITDA margin (and thereby earnings and cash flow) is decreasing, will International Paper still be able to pay the forecast dividends?

The below chart shows the calculated possible quarterly development in financial leverage (measured with net debt/EBITDA) assuming consensus forecast.

The chart shows that the net debt/EBITDA is expected to decrease, and that there is a relatively small likelihood that the net debt/EBITDA is going above 2.5 the next years.

The chart below shows the calculated possible quarterly development in indicative rating assuming consensus forecast.

The 2 charts above indicate that based on consensus forecast, International Paper should not have any problems paying the consensus forecast dividends, and in addition, keep buying back shares.

If the EBITDA margin moves towards the lowest level seen in the last 5 quarters, then the dividend payout ratio must be increased from 43.5% to about 60% to be able to pay the consensus forecast dividends. The lowest EBITDA margin the last 5 quarters is 15.7%. The below chart shows the calculated possible quarterly development in net debt/EBITDA assuming this worsening EBITDA margin case.

The chart below shows the calculated possible quarterly development in indicative rating assuming this worsening EBITDA margin case.

The 2 charts above indicates that if the EBITDA margin moves towards the lowest level seen in the last 5 quarters, then International Paper should be able to keep up the dividend, but would have less ability to buy back shares. Based on the current share price, the dividend yield is expected to move from currently about 4% to about 4.7% in 2017.

Valuation
Based on the discounted cash flow, assuming a weighted cost of capital of 10% and perpetual growth of 4%.

Alternative 1: Assuming consensus forecast.

The distribution chart shows the distribution of valuations per share based on all the assumptions made. The horizontal axis shows the distribution of calculated fair value per share, and the vertical axis shows the calculated probability of each outcome. The percentage shown on each bar is the accumulated probability, starting from the left. The chart shows that there is an estimated about 36.8% probability that the fair value per share is below $47.1. It is therefore also a 63.2% probability that the fair value is above $47.1. Current share price is about $40.7. Based on the above assumptions, the share seems to offer a good risk-reward.

The valuation is highly sensitive with regards to the assumptions used for both weighted cost of capital and perpetual growth. The below chart shows the valuation with the different weighted cost of capital assumptions. E.g., the column to the left says that fair value per share based on the assumption made in this analysis is estimated to be $92 per share if weighted average cost of capital is lowered by 2 percentage points, that is, from 10% to 8%. The estimated fair value when keeping the weighted cost of capital at 10% is $53.

Alternative 2. Assuming the EBITDA margin moves towards the average EBITDA margin the last 5 quarters. The average EBITDA margin the last 5 quarters is 17%.

The chart shows that there is an estimated about 50.4% probability that the fair value per share is below $40.3. It is therefore also a 49.6% probability that the fair value is above $40.3. The current share price is about $40.7. Based on the above assumptions, the shares seem to be fairly priced.

The chart below shows the valuation with different weighted cost of capital assumptions.

Alternative 3. Assuming the EBITDA margin move towards the lowest EBITDA margin the last 5 quarters. The lowest EBITDA margin the last 5 quarters is 15.7%.

The chart shows that there is an estimated about 56.8% probability that the fair value per share is below $36.4. It is therefore also a 43.2% probability that the fair value is above $36.4. The current share price is about $40.7. Based on the above assumptions, the shares seem relatively expensive.

Alternative 4: Testing the upside potential. Assuming consensus forecast and maximum cash return to shareholders with the restraint that net debt shall be relatively stable.

The chart below shows the calculated possible quarterly development in net debt assuming a dividend payout ratio of 90%. The net debt level goes only slightly down from about $8.3 billion in 2015 to about $8.1 billion in 2018.

The chart below shows the calculated possible quarterly development in net debt/EBITDA assuming a dividend payout ratio of 90%.

The chart below shows the calculated possible quarterly development in indicative rating assuming this 90% dividend payout ratio case.

The charts above indicate that if the consensus forecast materializes, then International Paper theoretically could return almost 90% of their profit as cash to their shareholders.

The chart below shows the estimated fair value per share range in this scenarios. Assuming the dividend growth model, weighted cost of capital still at 10% and perpetual growth still at 4%. Main case fair value per share in this theoretical scenario is about $65 per share.

Conclusion
International Paper is a solid company with a good track record. The current expected dividend yield of between 4% and 4.7% the next years seems possible even in a somewhat adverse scenario. In addition, the company seems to be able to continue its share buybacks. A major risk for International Paper and its competitors is the price pressure in the market. The price pressure is reducing margins and profitability. However, with its size, diversification and balance sheet, International Paper seems to be one of the companies in the industry that can best handle a margin squeeze. The increasingly high cash return to shareholders and its relatively solid balance sheet makes International Paper an attractive investment. It is a good alternative for income- and dividend-oriented investors.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in IP over 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.