International Paper Co (NYSE: IP ) is a tremendous long-term success story. The common shares look to be taking a breather, providing patient investors with a chance to score some good gains.
A transformation journey
Dynamic CEO John Faraci has been leading the world's largest paper and packaging company on a transformational journey going back to 2006. Prior to that time, investors rode this highly cyclical stock like a roller coaster. Now, Faraci has nearly completed his vision to change the enterprise into a more stable powerhouse.
The company has long sold off its forestry, wood products, and chemicals divisions. Instead, International Paper has focused on its core business: manufacturing industrial and consumer packaging. Printing papers have retained a prominent place in the corporate portfolio, still generating about 30% of sales. However, senior leadership recognizes that this segment is in secular decline, and it's being repositioned.
Management has also emphasized increased international exposure, directly and via joint ventures. Since 2006, new operations in Russia, China, Brazil, and India have placed the company into position to serve many of the faster-growing developing markets.
Strategically, perhaps the biggest coup was the 2012 Temple-Inland acquisition. T-I was one of International Paper's biggest competitors. The merger eliminated a tough peer, and paved the way for management to sop up excess manufacturing capacity, a problem that had dogged the industry for years.
MeadWestvaco Corp (NYSE: MVA ) is now I-P's primary global competitor. However, this company is only a third of the market cap, while sporting lower returns on equity, assets, and net investment. Gross margins are lower. MeadWestvaco's cash dividend yield is less, clocking in at 2.5%. In the commodity materials business, size matters.
International Paper runs for cash
Most noteworthy for investors, Faraci and his team have promised the company will emphasize free cash flow -- cash generated by operations less routine capital expenditures. Senior management has also stated that 30%-40% of this free cash flow will be targeted for cash dividends. The current $1.40 annualized payout yields a solid 3% on a recent closing share price. It's increased 44% since 2011, with another boost likely by 4Q this year.
The company expects the mid-cycle dividend will reach $1.80 per share. That would push the yield to 4% on shares purchased today.
Stock price has stalled... a pause that refreshes
For nearly a year, the price per share has flatlined in the mid-to-high $40s. Some see this as a temporary pause while the company digests the $4.3 billion Temple-Inland acquisition. During the transition, International Paper has continued to grow operating earnings, cash flow, and, of course, the dividend. Management has only missed one quarterly earnings expectation of the past 13, while besting Wall Street expectations nine times.
Make no mistake: despite the near-term share stall, International Paper stock has been no shrinking violet. The five-year total return (2009-2013 with dividends reinvested) is 33% versus the S&P500 total return of 17%.
International Paper is concentrating efforts on fully integrating Temple-Inland, ensuring the balance sheet remains strong by paying down resulting debt, ensuring the Russia-based Ilam JV begins to spin off cash dividends to its owners, and restructuring Xpedex, a paper and packaging distribution arm that targets smaller businesses. CEO Faraci and his team have a clear track record of "getting results," and investors should expect nothing less on the current set of initiatives.
Materials sector stocks, like International Paper, are sensitive to global economics. They tend to do best during the mid-cycle phase of economic recoveries. Risks include departure from today's steady, slow-growth expansion.
How about the shares?
The fundamentals are strong and sound. EBITDA margins have climbed steadily, and the debt-to-EBITDA ratio is less than the corporate 3x benchmark that the rating agencies wanted to see. For 2014, free cash flow is forecast to be ~$2 billion, which would be up 11% versus last year, thereby allowing company directors to bump the dividend to $1.60 per share. That's the midpoint of the 30%-40% FCF/dividend target. A $1.5 billion share repurchase plan has also been announced.
I submit the fair value for the shares may be best based upon a multiple of operating cash flow. For all of 2013, International Paper generated $6.74 operating cash flow per share. Management expects to grow that by ~10% a year under the premise of modest global economic expansion. If so, a conservative seven times estimated 2015 OCF yields a $56 price target. That's roughly a 20% uplift versus the recent closing price, without counting the dividend.
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