International Paper Downgraded - Analyst Blog


We have recently downgraded our recommendation on International Paper Company ( IP ) from Outperform to Neutral due to the integration risks associated with the Temple-Inland merger, margin headwinds and high debt levels.

Mergers and acquisitions continue to be International Paper's key strategy to strengthen its business for the long term. The company's recent acquisition of Texas-based Temple-Inland will be its largest since the August 2008 acquisition of Weyerhaeuser Co.'s corrugated-packaging business for $6 billion. The transaction is expected to be accretive to EPS within 12 months of closing and highly accretive beyond 2013.

The combination would yield synergies of $140 million in the first 12 months of closing and $300 million within two years. Moreover, the combination will fortify the packaging business of North America by increasing its share in the corrugated packaging market to 34% from the current 27%.

The company also completed the acquisition of a majority stake in leading Indian paper company Andhra Pradesh Paper Mills Limited. This transaction made International Paper the first global paper and packaging company to have a significant presence in India's growing paper and packaging industries.

The International Paper-Ilim joint venture in Russia has been growing rapidly; International Paper's initial investment in Ilim was $600 million. The Ilim joint venture is working on two major projects: a pulp mill in Bratsk and a new paper machine at the Koryazhma mill in Russia. International Paper expects the $1 billion in investment in these two ventures to yield more than 20% returns.

In China, the International Paper-Sun joint venture is building a new consumer paperboard line that should come online late in 2012. The company is targeting more than12% return on the $330 million investment. These initiatives will contribute to both earnings and cash flow going forward.

International Paper has twice hiked the quarterly dividend on its common stock in the past one year. This is impressive given that the company was bound to cut the dividend by 90% in 2009 in order to preserve cash in an economic downturn.

International Paper has more than doubled its free cash flow from 2000-2004 levels. We expect International Paper to continue utilizing its sound cash flow by investing in capital projects, indulging acquisitions, reducing its total debt and returning a greater proportion of cash to shareholders through an increased dividend.

International Paper is re-focusing its attention on Xpedx, its distribution business. Improvements are expected in areas like procurement, replenishment of orders, reduced stock keeping units (SKU), and supply chain improvements (including fewer/larger warehouses). Businesses not doing so well, like printing, are expected to be mitigated by up-and-coming ones, like packaging.

The company is working to integrate the entire platform into a single operating system. All these initiatives are expected to double profits. The segment reported an operating profit of $86 million in 2011. Initiated in 2011, the company is only about six months into this multi-year initiative. We believe these initiatives will boost results and be accretive to EPS going forward.

So far we've been enumerating the many positives of International Paper. However, given the magnitude of the imminent merger between International Paper and Temple Inland, the risk of integration runs high. If International Paper is not successful in realizing the expected synergies from the acquisition, the company's earnings would come under intense pressure.

Furthermore, under its consent decree with the Department of Justice, International Paper has to divest 970,000 tons of container board capacity. International Paper has agreed to divest Temple-Inland's mills in Ontario, California and New Johnsonville, Tennessee, and its existing mill in Hueneme, California. Even if the acquisition goes as planned -- realizing the synergies to be derived from it, the shedding of a good many mills from its armor -- would definitely tarnish returns and aid competitors.

Besides, the company depends heavily on raw materials, such as wood fiber, purchased in the form of pulpwood, wood chips and old corrugated containers ( OCC ), and certain chemicals, including caustic soda and starch, and energy sources, principally natural gas, coal and fuel oil. Rising energy, chemical and OCC costs create headwinds.

Further, margins will be affected by startup costs from the aforementioned investments in Ilim and Sun projects, higher interest expense due to debt issued for the Temple-Inland acquisition, increasing maintenance expense, higher pension expense and tax rate.

Even though International Paper is making efforts to repay its debts, they still remain stubbornly high. The debt-to-capitalization ratio increased to 59.9% as of December 31, 2011 from 53.3% as of September 30, 2011.

All said, we downgrade our recommendation from Outperform to Neutral on International Paper.

Memphis, Tennessee-based International Paper is a global paper and packaging company with operations in North America, Europe, Latin America, Russia, Asia and North Africa. International Paper conducts its businesses through five segments: Printing Papers, Industrial Packaging, Consumer Packaging, Distribution (Xpedx) and Forest Products. International Paper competes with  MeadWestvaco Corporation  ( MWV ) and  Weyerhaeuser Co . ( WY ).

INTL PAPER ( IP ): Free Stock Analysis Report
MEADWESTVACO CP ( MWV ): Free Stock Analysis Report

WEYERHAEUSER CO ( WY ): Free Stock Analysis Report
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: Investing , Business , Stocks

Referenced Stocks: IP , MWV , OCC , WY

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