Risky Yield: An International Paper Case Study

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About: International Paper Co. (IP)
by: Growth Stock Prospector
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Summary

Stocks with high dividend yields have been relentlessly driven up by the market.

Investors often mistakenly park cash in these stocks because they think they are safe.

International Paper illustrates how there is significant downside risk in these types of names.

Individuals need to be ultra-cautious when searching for value investments at all-time market highs. The reason is that many of the traditional value plays are trading at rich multiples that the fundamentals cannot support. For example, the utilities industry is trading at a ttm P/E multiple of 29.51 despite expecting annual profit growth of only 6.36% over the next five years. This article will attempt to illustrate how expensive some common value plays are by walking through a case study of International Paper (NYSE: IP).

International Paper is a packaging and containers company in the consumer goods sector that employs 56,000 people worldwide. They derive 65% of revenue from the industrial packaging sector, 13% from consumer packaging, and 22% from paper and pulp. International Paper's business focuses on North America with a large majority of sales coming from this continent, but they are actively growing businesses in Latin America, EMEA, Asia, and India. International Paper pays investors a 3.47% dividend at the time of this writing. In short, International Paper is the kind of steady, well managed, consistent company that many people presume they can safely park cash in during a volatile and expensive period in the equity markets.

The problem with this type of thinking is that the low interest rate environment investors have suffered through over the past decade has led stocks like this to become tremendously overvalued. The hunt for yield has resulted in investors driving up the valuation of any stock that has a significant dividend yield. With respect to International Paper the market has awarded a market cap of 23B dollars to the company's equity as of this writing. A simple discounted cash flow analysis will demonstrate that the company's equity is worth as little as 8.2B, or $23.79/share, which would represent a decline of over 50% from the company's most recent closing price of $55.93/share. Let's get into the nuts and bolts of the DCF analysis.

The following chart outlines critical assumptions for the international paper discounted cash flow analysis.

5 Year FCF Growth Rate

3.86%

WACC

10.84%

EV

35,200

D/V

35%

E/V

65%

tax rate

33%

Rfr

2.41%

Beta

1.72

mrkt rate

7%

Ce

14.45%

Cd

6%

tax shield

67%

For simplicity sake let's take the 5 Year FCF Growth Rate and use that to extrapolate cash flows over the next ten years.

2011

1516

2012

1584

2013

1830

2014

1711

2015

1093

2016(e)

1551

2017(e)

1611

2018(e)

1674

2019(e)

1739

2020(e)

1807

2021(e)

1877

2022(e)

1951

2023(e)

2027

2024(e)

2106

2025(e)

2188

2026(e)

2273

Terminal Value

26226.92

The terminal value was calculated presuming a perpetual fcf growth rate of 2%.

Present valuing these free cash flow figures using the weighted average cost of capital paints an ugly picture. The following chart displays present value for each of the future years expected free cash flow.

2016(e)

1551

2017(e)

1454

2018(e)

1363

2019(e)

1277

2020(e)

1197

2021(e)

1122

2022(e)

1052

2023(e)

987

2024(e)

925

2025(e)

867

2026(e)

813

Terminal Value

9,375

Adding up these free cash flows generates a present day company value of 21.982B dollars. Once the market value of the debt (12.2B) is subtracted the value of the equity is 9.782B dollars. With 411.21M shares outstanding this gives us an intrinsic value per share of $23.79. Bear in mind that this model is somewhat favorable to the company given that it uses a WACC of 10.84% compared to the GururFocus wacc of 12.87%.

It's an interesting academic exercise to change the inputs of the model in an attempt to justify the current stock price. What would the company have to achieve in order to be worth $55.93/share today? Using the WACC of 10.84% the company would have to grow free cash flow by 10% annually for ten years before leveling out to 2% in order to legitimize this valuation. If the model assumes the 12.87% WACC the company would have to grow fcf at about 12.5% per year for ten years, then 2% per year forever in order to legitimize the current stock price. There is nothing in the company's recent history to suggest management is capable of executing to this degree.

The purpose of this analysis is to illustrate that many "safe" places to put money aren't so safe. Any investor who thinks they can park cash in boring or basic businesses and collect a great dividend without much risk while waiting for the market to correct is fooling themselves. Some of the most overvalued companies out there today are firms that pay significant dividends. Investors should instead do deep dive research into companies that aren't yet paying dividends but will more likely than not introduce a dividend over the next few years as results improve. These firms have not yet been driven up in price by the relentless reach for yield that has occurred due to zero interest rate policy from the Federal Reserve. For investors that insist on purchasing firms with high dividend yields it could be worth considering hedging by buying downside protection in the form of puts on the relevant benchmark index. The reason is that if the individual dividend paying companies an investor owns were to collapse en masse then it is likely that the index containing them would be down significantly as well. Some of the losses from the individual names would be made up as the value of the put options increase with the index's decline.

It's a dangerous time in the markets. Investors must be cautious that they don't pay too much for yield. Many of the traditionally safe spaces to park cash are radically overvalued. Investors can't presume anything is safe and must perform significant due diligence before investing at all-time market highs.

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.