How International Paper Stacks Up

 | Sep 11, 2012 | 10:30 AM EDT
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Paper heavyweight International Paper (IP) continues to restructure its business, generating value for shareholders. The stock trades at the low end of our fair value range and boasts a relatively high dividend yield. Should investors be interested?

As with other highly cyclical industries, the paper products sector is prone to bouts of under-utilization and overcapacity. The sector's operating margins vary based on product mix, but most companies that specialize in paper and packaging achieve operating margins in the 7% to 10% range. For companies as small as Boise (BZ) and Clearwater Paper (CLW) and as large as International Paper and MeadWestvaco (MWV), a small change in operating margins can meaningfully affect operating income and free cash flow generation. Market demand in developed regions is primarily a product of GDP growth, as paper consumption per person continues to face pressure due to innovations in cloud storage and electronic communications (driving a secular decline in newsprint).

Though International Paper will certainly feel the impact of a decline in physical goods distribution, as well as a decline in print consumption during economic troughs, the company has a nice position as a leader in the consumer packaging business. It makes different types of packaging for food and beverages that cannot be displaced by digital distribution and consumption. Although the business is down year-to-date due to planned outages, additional capacity will help the company capture long-term growth, specifically in Asia and emerging markets. Rock-Tenn (RKT) and other competitors, however, may follow suit with capacity additions, absorbing outsize economic profits.

We prefer companies trading below the low end of our fair value range, as our margin-of-safety bands insulate us from risks related to the future volatility of a company's business fundamentals and cash flow. Though International Paper trades at the low end of our fair value range (and not below it), we prefer if the company pulls back even more from current levels (below $33 per share).

While International Paper's annual dividend yield of nearly 3% at current prices is attractive, we don't think its dividend growth potential is that great over the long haul. International Paper registers a 1.1 on our Valuentum Dividend Cushion measure, which suggests the company can cover its dividend payments with future cash flow based on its capital structure (any score above 1 indicates this). There is, however, little excess capacity for future dividend increases based on our current projections of International Paper's free cash flow generation and its existing capital structure. Though International Paper doesn't have any short-term liquidity issues, the company does have more than $10 billion in long-term debt vs. a cash position of just $1.2 billion. The result is heavy interest obligations that will make any material dividend increases hard to stomach. And while we stop short of saying the company's dividend is in meaningful jeopardy of being cut, we have little interest in adding the name to our Dividend Growth Newsletter portfolio at this time based on the dividend's limited growth prospects.

Ultimately, the paper giant has a few very nice businesses, but it operates in a highly cyclical and extremely competitive business. For us to get excited about adding a position to our actively managed portfolios, it would take a larger pullback in the share price and better-than-expected future free cash flow generation that would reveal dividend payments are safe over the long haul.



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