Putting It Down on Paper

Putting It Down on Paper
By KOPIN TAN
Barron's, August 7, 2006

INVESTORS STOPPED BUYING PAPER STOCKS A LOT sooner than consumers stopped buying paper. Today, the average American still uses 675 pounds of paper every year and, despite conscientious recycling, discards enough to make the stuff the single biggest component of landfills. And while U.S. usage has been stable, demand is booming in emerging markets like China and India.

All this ought to be good news for International Paper, the world's largest paper-products maker. But the global economic expansion that sent commodity-related stocks soaring seemed to have bypassed Memphis, Tenn., where IP is based. At about 34, the shares (ticker: IP) have barely budged over the past year -- in fact, they have gone nowhere in six years. Even an ongoing restructuring, which could eventually boost per-share earnings by $3 or more, has failed to lift the stock.

Investors' aversion to IP is understandable (if regrettable). Not only has the electronic age raised the prospect of a world that never puts pen to paper, but the underlying business of paper-making is notoriously price-competitive and capital-intensive. The soaring cost of raw materials -- oil, chemicals, timber -- further threaten to slice margins that already are, well, paper- thin. Meanwhile, every data point suggesting a potentially slowing economy sends IP shares aflutter. Even staunch value investors have adopted a "show me" stance toward IP.

But the pervasive skepticism is also the reason IP shares are undervalued -- and poised to improve as an ambitious financial restructuring begins to pay off. At recent levels, IP stock is trading at 16.9 times expected 2007 earnings and 13.1 times 2008 estimates, compared with 17.6 and 14.4, respectively, for the sector. Any upside potential will be further enhanced by an upswing in the paper cycle that has quietly begun this year, could accelerate over the next few years and could help drive the shares toward 40.

"Short of a severe global recession, we believe there is very limited downside risk to the stock at this price," says Phyllis Thomas, a portfolio manager at NWQ Investment Management, which owns about 10.9 million shares, or 2.2% of outstanding IP stock. "In fact, we think there is a strong probability of upside earnings surprises in the future."

IP gave a glimpse of its potential last week when it reported its strongest second-quarter sales in six years. Earnings from continuing operations rose 32%, to 41 cents a share, handily beating the 33 cents forecast, and revenue of $6.3 billion topped the $5.9 billion of a year ago.

Higher raw-material and freight costs did eat into profits, but results were particularly encouraging in printing papers and industrial packaging -- two areas of emphasis for IP, which now devotes 75% of its production capacity to these paper grades. Operating profits for printing papers (what the industry calls "uncoated free sheets") jumped 98%, to $254 million from the first quarter, while those for industrial packaging rose to $100 million from $38 million. (IP's other units include consumer packaging, distribution and forest products).

Company executives, who declined to be interviewed by Barron's, told analysts that they expect stronger profits this quarter. But the earnings power should persist well beyond that.

Already, management, led by CEO John Faraci, has demonstrated it can deliver more than promised. One of the largest landowners in the U.S., IP last year began selling millions of acres of forestland as it abandoned logging to focus on becoming a more nimble paper and packaging producer. Last month, it said that the sale is going better than expected and could raise more than $11 billion, up from $8 billion-to-$10 billion initially forecast.

The strong sale means IP can set aside $3 billion to buy back nearly 20% of its outstanding shares, the top end of the previously forecast range; reduce its debt by $6 billion to $7 billion, compared with the initial expectation of $3.2 billion to $5 billion; and reinvest another $2 billion to $4 billion in as yet unspecified corporate projects, versus a previous estimate of $1.6 billion to $2.5 billion.

"Investors are not giving IP enough credit for [these] structural changes," says Morgan Stanley analyst Edings Thibault.

As IP shrinks its share base and whittles down interest expense, speculation has increased that it might raise its 3% annual dividend. What's more, included in its debt repayment is the $500 million-to-$1 billion IP is plunking down for its U.S. pension fund. With pension costs projected to peak in 2007 at about $400 million, JPMorgan analyst Claudia Shank estimates that the cash contribution will wipe out 2007 pension expense and add 40 cents to 50 cents to per-share profit projections.

Analysts expect IP to earn $1.38 a share this year, $2.01 in 2007 and $2.60 in 2008. In time, those projections could be revised upward. Citigroup analyst Chip Dillon, for one, believes "Street estimates are too low and likely will rise," in part to "reflect IP's cash-redeployment plans" and better-than-expected paper prices. He reckons that International Paper will earn $1.55 a share this year and $2.25 next year, with shares worth about 38.

Others are even more bullish. Mark Wilde, Deutsche Bank's veteran paper analyst, values IP using various metrics that take into account both cycle peaks and averages. Most of his projected ratios value IP slightly above the industry, its historical premium based on size and earnings consistency. He expects the stock to trade at about twice book, or accounting, value, and 5.9 times peak, or 10.7 times normalized, earnings. Using these and other measures Wilde has set his target at 40, 18% above the current stock price.

PREDICTIONS OF PAPER'S DEMISE date back to the 1960s when the computer's potential was first widely recognized and long before the world went onto the World Wide Web. But while computers have radically changed the way paper is used, they haven't much curbed the quantities needed. Today, survey after survey shows paper use increasing in offices after e-mail systems are introduced -- chiefly because workers print out documents to read or keep. Online bill-paying, to cite another example, has cut demand for envelopes and forms. But rapidly proliferating home offices have spawned a whole new market. "Electronic substitution may be one factor why the paper industry is slow-growing, but it hasn't resulted in declining demand," says Paul Rogers, a partner and paper expert at Deloitte & Touche USA.

In fact, paper manufacturers have been able to raise prices by about $50 a ton several times this year. Why? Because they've shuttered less-efficient mills and shrunk the overcapacity that curtailed previous paper booms. The result: Supply and demand are "in balance," says Standard & Poor's. And the newfound pricing power could grow -- since there has been disciplined capital spending in recent years and, compared with prior decades, less of a rush to build mills whenever paper prices creep up.

As Thibault notes, printing-paper inventories are now below the industry's five-year average while demand continues to rise. Containerboard inventory, too, is running low, all of which improves the odds that recent price hikes will stick. Meanwhile, speculation that Weyerhaeuser (WY) might sell its printing paper business -- possibly to Boise Cascade (BCC) or Domtar (DTC) -- could remove more capacity from the segment, which augurs well for IP's pricing.

That said, demand for printing paper and packaging will rise and fall with the economy. But while U.S. GDP is expected to slow in the second half, global economic growth remains robust. Living up to the adjective in its name, IP derives a fifth of its revenue from outside North America and runs profitable mills in emerging markets, including Poland and Russia. It also continues to broach joint ventures everywhere from Brazil to China.

At the same time, International Paper has streamlined its business to become less reliant on the cycle and to maximize profits even when the cycle matures. By slashing its head count to 68,700 from about 112,900 six years ago, it's boosted revenue per employee 37%, to $342,000. The return on capital, near a middling industry average of 4.1% last year, is projected to improve to 6.5% this year and 9.5% in 2008, says Morgan Stanley.

INVESTORS HAVE SUFFERED paper cuts from IP before and are right to be a little wary about its sudden trove of cash. With $2 billion to $4 billion earmarked "for reinvestment," the prospect of a big, feckless IP acquisition has some money managers quaking in their Bruno Maglis. It overpaid in 2000 when it shelled out $9.5 billion for rival Champion International.

But CEO Faraci has won fans with his unrelenting focus on cost, and for reserving his enthusiasm for deals that can promptly earn back the cost of capital. People familiar with his thinking say they expect only small, add-on transactions that quickly boost earnings.

A deal now under way in Brazil may offer a preview. There, IP is negotiating to sell its Tres Lagoas timberland to a joint-venture partner that will then construct a pulp mill, with IP using the proceeds to build two new machines on site that can each produce 200,000 tons of paper. "We never thought IP could gain 400,000 tons of low-cost Latin American uncoated free- sheet capacity at little or no capital cost," notes Citigroup's Dillon. Earnings may be smaller than those generated by a pulp mill, "but the returns on what little capital is invested would likely be higher," he says.

There also are concerns that IP might merit a lower valuation once it sells off its land. Lenders and value managers are partial to a patch of forest on a paper company's balance sheet, since it diversifies assets and requires little encouragement to grow -- and increase in value -- if left alone.

"But the feeding frenzy for timberland among timber investment-management and private-equity firms may have reached a point where the smarter business decision is to sell and capitalize on current high prices," says NWQ's Thomas. By streamlining, IP is inoculating itself against any potential downturn -- and positioning itself to cash in on the latest upswing. The paperless society seems a very long way off.