International Paper Down to Neutral (IP) (MWV) (UFS) (UPMKY)

We have recently downgraded our recommendation on International Paper Co. (IP) from Outperform to Neutral based on pension headwinds, increased raw material costs and high debt levels. Currently, the stock retains a Zacks #3 Rank, implying a short-term Hold rating.

Mergers and acquisitions remain International Paper’s key strategy to strengthen its businesses over the long term. The acquisition of Texas-based Temple-Inland is the largest since it acquired Weyerhaeuser Co.’s (WY) corrugated-packaging business for $6 billion in August 2008. The company has achieved its initial $300 million synergy target a year ahead of schedule, and expects an additional $100 million before the integration is complete. The transaction is expected to be accretive to EPS within one year of closing and incrementally beyond 2013. Moreover, the combination will strengthen the packaging business of North America by increasing its share in the corrugated packaging market to 34% from the current level of 27%.

International Paper has several ongoing strategic and cost-saving projects and initiatives in Russia, China and Brazil. The International Paper-Ilim joint venture in Russia is working on two major projects – a pulp mill in Bratska and a new paper machine at Koryazhma mill in Russia. These represent a combined investment of $1 billion and International Paper expects to generate over 20% in returns. In China, the International Paper- Sun joint venture has set up a new consumer paperboard line. The company is targeting more than 12% return on the $330 million investment.

The company has recently entered into a joint venture with Grupo Orsa, a leading corrugated packaging producer in Brazil and signed a supply agreement with Fibria to extend the option to build a second uncoated freesheet machine at its Tres Lagoas mill between 2016 and 2018, in order to meet the increase in demand. Going forward, these initiatives will contribute to both earnings and cash flow immensely.

International Paper is working toward transforming and improving the profitability of its distribution business, Xpedx. Improvements are expected in procurement, replenishment of orders, reduced stock keeping units (SKU) and supply chain (including fewer/larger warehouses). We believe that these initiatives will boost results and be accretive to EPS going forward.

International Paper recently hiked its annual dividend by 14% to $1.20 per share from the previous payout of $1.05. International Paper had earlier hiked its dividend by 40% to $1.05 per share in March last year from the previous dividend payout of 75 cents.

Through two dividend hikes, in April 2010 and subsequently in January 2011, the company substantially raised its dividend payout from 10 cents to 75 cents – a positive development for the shareholders, since the company had slashed its dividend by 90% to 10 cents in March 2009, in order to preserve cash to counter the economic downturn.

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

On the flipside, rising energy, chemical and old corrugated containers costs remain headwinds. Further, margins in the fourth quarter will be affected by the startup costs from the aforementioned investments in Ilim and Sun projects, higher interest expense related to the debt issued for Temple Inland acquisition and increase in maintenance expense and higher pension expense. For 2013, management expects pension expense to increase by $250-300 million in 2013.

Even though International Paper is making efforts to repay its debts, its debt levels still remain high. It was further aggravated by the issue of debt to fund the Temple Inland acquisition. The debt-to-capitalization ratio remains high at 59.9% as of September 30, 2012.

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 Domtar Corporation (UFS), MeadWestvaco Corporation (MWV) and UPM-Kymmene Oyj (UPMKY).