Description

International Paper (IP) has been an industrial darling for the past 5+ years largely driven by industry consolidation (supply discipline), perception that the US is an “island” (exporter of high-quality virgin product) and a savvy management team (market at times believes they can walk on water).  The real underlying story over the past 5-years has been around (1) global S/D: limited new supply additions and improving demand environment as well as (2) a steep cost curve: US low-cost and ROW high-cost.  This virtuous cycle has resulted in improved unit economics for US containerboard companies and has duped investors into believing that the US containerboard industry is a resilient acyclical specialty packaging biz (instead of viewing as it is, a global commodity).  Fast forward to today, IP generates super-normal margins and ROIC: margin expectations are for ~12% EBIT versus 6-year historical of ~7.5% … and ROIC expectations are for close to ~20% pre-tax versus a 6-year average of ~13%.  The set-up is for smooth sailing ahead: market assumes the good times roll both on its earnings power (~50% above norm) and multiple (~1-standard deviation above 5-yr normal on EV/sales, EV/EBITDA, EV/EBIT and ~2-standard deviation above on P/B).

Divergence from the market: Despite the market assuming smooth-sailing, containerboard prices are one the cusp of falling meaningfully lower for three reasons: (1) inducement economics for new and converted supply are too good to pass up and as a result, Europe and China have brought on additional supply which will negatively impact trade flows (Europe big net importer and China net exporter), (2) additional low-cost pulp supply coming on-line in the n-term (~6MM+ tons over next 24-mths equates to >8% per annum; pulp and OCC and containerboard prices are highly correlated, (2) strengthening USD putting US lower on the cost curve, (3) US prices are incentivizing supply to enter the US market and there is heightened evidence of US producers facing resistance to export product (>20% of IP US volumes) coupled w/ greater import pressure.  Ultimately, these 3 dynamics will negatively impact containerboard profits for IP (~75% of profits) especially because of its financial leverage (~2.25 – 2.5x) and operating leverage (containerboard companies are akin to aircraft carriers).  Additionally, the other 25% of IP's biz is also exposed to the pulp curve flattening dynamic (think uncoated freesheet, paperboard operations - BUT the market frankly only cares about the industrial packaging segment thus the focus of the thesis). 

Quantification: Containerboard pricing is falling and will likely compress to levels that are more consistent w/ Mexican prices (typically a leading indicator of US prices).  US prices have dropped by approx -15 / ton YTD and the market is pxing in stabilization and improvement in the 2H of 2015 but my expectation is for at least another -20 / ton (Mexican prices have already dropped by -40 / ton YTD to help put in relative context).  The reason is 4-fold: (1) input prices are lower (pulp / OCC tied at the hip) - this is flattening the cost curve putting the US at a disadvantage, (2) US exports are being hampered by the strong USD (exports down -7% since peak to Europe) + US is facing additional imports (>7.6% in 15 vs 14), (3) European export prices have fallen by -100 / ton (additionally, Turkey represents ~5% of US export capacity and has recently put tariffs on US production effectively shutting down this valve), (4) US producer ROIC’s are still at close to peak levels and the 6-year historical average EBIT / ton for IP is ~75 / ton versus its 2015 level of ~110 / ton equating to a ~35 / ton compression back to normalized levels.  Assuming a -35 / ton haircut to IP’s industrial packaging segment, this implies a roughly -20% to -25% haircut to EBIT for IP. 

New reality: As earnings power compresses, a corresponding compression in the multiple is likely (history around both European and US containerboard cos supports this assertion).  Applying a 6x EBITDA multiple to base case estimates (compares to 10-yr historical of 6.4x and 5-yr of 6.1x), this equates to a ~26 – 27 / share FV (versus ~41 current) or -35% upside to the trade.  The base case FV equates to ~2.8x BV multiple relative to IP's 10-year average 2.3x and 5-yr of 2.8x … and ~15% pre-tax ROIC (versus ~13% normalized).  An added downside kicker is IP’s (a) ~1.8MM tons of pulp and (b) ~1.5MM tons of paperboard – both are arguably in a more challenged position versus containerboard given global over-supply and import pressure. 

Catalyst: Update on containerboard prices comes out this evening (posted by RISI).  The stock is pricing in smooth sailing but the industry cracks are too large to ignore

Risks: USD weakens (cost curve steepens), US containerboard cos remove supply (helps encourage the “island” bull case), demand surprises to the upside (supply is not as far out of whack w/ demand)

Catalyst

Update on containerboard prices comes out this evening (posted by RISI).  The stock is pricing in smooth sailing but the industry cracks are too large to ignore