I first looked at International Paper (IP) when I was researching Clearwater Paper (CLW), an interesting spin-off from a timberland operation. In a comparative analysis, I realized that both companies were trading at a similar free cash flow multiple of around 2x because they will need to partially recapitalize in the near future, CLW as part of the spin-off agreement, and IP as a result of a poorly-timed, highly leveraged acquisition. Both of these companies are trading at a significant discount to the paper industry, and appear to be extremely undervalued. Since September 9th, 2005 (date chosen because that’s how far back Google tracks the paper goods industry), the S&P has fallen by 37%, the paper goods industry by 46%, and IP by 80%.
Industry dynamics have been unfavorable in recent years. Manufacturing costs are a function of three main inputs: pulp, energy, and chemicals. Pulp is a euphemistic term for sawdust and scrap wood produced mostly as a byproduct of lumber production. Therefore, the price of pulp increases as the production of lumber decreases as a result of low housing starts, which has put a significant strain on paper manufacturers. The cost of energy is also an important input especially as pulp prices rise and paper manufacturers look further away to find cheap sources. The production process itself is energy intensive and many mills hedge the risk of fluctuating energy prices in the futures market, which has caused a lag in relief from falling oil prices. The price of chemicals has reportedly gone up over the past year as well. In general, 2008 seems to have benefited from increasing volume and sales prices, but suffered from the increase in raw materials costs, resulting in lower total profits. Demand is expected to vary as a function of GDP and white-collar employment even though demand seems to have held up in the most recent quarter.
The reason for IP’s share price collapse (beyond that of the industry as a whole) is the highly leveraged purchase of Weyerhaeuser’s Containerboard, Packaging and Recycling (CBPR) business in mid 2008. The most major short-term psychological risk to shareholders is a downgrade from the present S&P rating of BBB with a negative outlook to junk. Traded debt is already yielding 9-11% YTM, more similar to BB rated debt than BBB. Earnings for IP have been littered with one-time charges in recent years, so I think it pays to look at interest coverage ratios from both an adjusted earnings and a cash flow point of view. To do this, I use a free cash flow to the firm measurement (FCFF) that adds the after-tax cost of interest back to the CFO-CapEx FCF equation. Interest coverage ratios for IP based off FCFF appear healthy at around 4.1x in the last twelve months. However, this does not take into account the increase in interest expense in the most recent two quarters. Doubling the most recent half-year’s interest expense gives us $660 million going forward. FCFF/$660 yields a coverage ratio of 3.1x.
The EBIT based interest coverage ratio for IP is a useless negative number unless we add back some one-time charges. The major non-recurring charges include $370 million for restructuring, $1,777 million for impairment of goodwill, and a $261 gain on the sale of mineral rights, and a $106 loss on the sale of a business. If we add back only the impairment of goodwill charge, we get 1.7x interest coverage ratio. Including the net effect of all non-recurring transactions (an additional add-back of $215) yields a coverage ratio of 2.0x. If we use analyst expectations for 2009 EBIT of $969 we get 1.4x interest coverage. Cash flow has traditionally been greater than earnings, although not by as much as was experienced in the LTM.
Also important is the coming maturity of long-term debt listed below. When we include these liabilities in our analysis, earnings for 2010 seem unlikely to fully cover interest and short-term debt repayment. Cash flow still has some wiggle room to cover these expenses, but it is possible that IP will have to raise money in other ways to meet these obligations. Aside from failure to pay, covenants include the maintenance of a minimum net worth of $9 billion and a debt to capital ratio of less than 60%. In 2008, net worth was $11.2 billion, and the debt to capital ratio was 51.9%. Unused credit includes a $1.5 billion revolver that expires in March 2011 and $1 billion of available receivables securitization that expires in January 2010.
Year 2009 2010 2011 2012 2013
Bonds Maturing $828 $1,344 $1,389 $967 $1,504
The most enticing factor in the IP equation is the historic dividend yield of $1/share, which was recently reduced to $0.10/share. In the most recent conference call, an analyst from Barclays asked about IP’s priorities regarding the use of cash in general and the dividend specifically. The CFO responded by saying that reducing the debt burden is currently the most important priority, but then was evasive on the dividend part of the question. Later in the call another analyst asked if IP would consider selling shares to repay debt. The CEO was equally evasive saying things like “I wouldn’t want to, at this point in time, speculate on what we might do down the road”. With debt at BBB yielding 10% and equity yielding a 15% dividend at $1/share plus the obvious potential for growth and a recent history of share repurchases as the stock price has languished, equity seems like the undervalued asset class here. I don’t know what the optimal capitalization is, but I’m pretty sure that selling shares for $6 to repay debt would be a complete destruction of value unless it’s a last ditch effort to avoid bankruptcy. But if IP repays debt faster than necessary by sacrificing dividend payments, and this brings IP’s capitalization in line with what the market deems optimal, it might benefit equity holders just as much as a 15% dividend yield by raising total market valuation. IP’s share price has already recovered from a low around $4 to over $7 since the dividend has been reduced.
In any scenario, as long as IP avoids a bankruptcy, there’s room for significant return to equity holders. At a share price of $7.25, investors are only paying 1.8x FCF. The historic dividend signals a clear intent and the capability to return value directly to shareholders without requiring any growth assumptions. A paper from Moody’s Investors Service published in January 2000 indicates that companies with IP’s current debt rating have a less than 5% chance of default within 5 years based on data from 1920 to 1999. I don’t see how the default risk or the weak macroeconomic factors affecting the paper industry justify the current valuation.
EV/ EV/ MC/ MC/
Ticker Price Market Cap. Enterprise Value Revenue EBIT NI FCF
CLW 7.30 82.83 182.82 0.1x 4.9x 5.2x 1.6x
IP 7.26 3,105.58 14,035.58 0.6x -21.2x -2.4x 1.8x
KMB 46.87 19,392.93 5,109.93 1.3x 9.7x 11.2x 11.7x
MWV 10.39 1,774.74 1,739.74 0.2x 1.9x 7.0x 14.7x
RKT 25.42 972.75 2,293.05 0.8x 10.6x 11.9x 6.2x
NP 3.70 4.00 419.28 0.4x 6.6x -0.5x -2.8x
Margins Interest Coverage Price/ Bloomberg Fiscal ‘09
Ticker EBIT NI EBIT FCF Book Earnings Multiple
CLW 3.0% 1.3% 2.9x 4.5x 0.3x NA
IP -2.7% -5.1% -1.3x 4.1x 0.6x 9.8x
KMB 13.2% 8.8% 8.5x 6.1x 3.9x 10.1x
MWV 12.7% 3.5% 5.0x 1.3x 0.5x 16.0x
RKT 7.6% 2.9% 2.4x 2.4x 1.5x 6.4x
NP 6.3% -11.3% 2.5x -0.1x 0.2x 5.5x
