Paper heavyweight International Paper (click ticker for report: ) continues to restructure its business, generating value for shareholders. The firm is trading 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 7-10% range. For firms as small as Boise (click ticker for report: ) and Clearwater Paper (click ticker for report: ) and as large as International Paper and MeadWestvaco (click ticker for report: ), 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 gross domestic product (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 firm 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 as a result of planned outages, we think additional capacity will help the company capture long-term growth, specifically in Asia and emerging markets. However, we suspect Rock-Tenn (click ticker for report: ) and other competitors will follow suit with capacity additions, absorbing outsize economic profits.
We prefer firms 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) and there is meaningful valuation upside from today’s levels based on our fair value estimate, we’d prefer if the firm pulls back even more from today’s levels (below our fair value range).
And while International Paper’s annual dividend yield of nearly 3% at current prices is attractive, we don’t think the firm’s 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). However, there is little excess capacity for future dividend increases based on our current projections of the firm’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 over $10 billion in long-term debt versus 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 fall 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, we think 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’d 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.
Please click the following link for our Dividend Report on International Paper: