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International Paper's Spin-Off of xpedx Gains the Firm a Narrow Moat

We're confident that the firm can generate consistent economic profits over the next decade thanks to the low-cost production advantage in its legacy mills.

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Since 2005,  International Paper Co. (IP) has transformed from a business with 12 operating units to one with just three operating units today (excluding the distribution business that's scheduled to be spun off in mid-2014). Over the past eight years, it has shed more than $11 billion worth of timberland and noncore businesses and strengthened its position in industrial packaging by acquiring  Weyerhaeuser's (WY) packaging division in early 2008 and Temple-Inland in 2012. These acquisitions have resulted in IP having an approximate one-third share of the North American containerboard industry, compared with 19% for its closest competitor,  Rock-Tenn (RKT).

We recently increased our economic moat rating for International Paper to narrow after considering the impact of the forthcoming tax-free spin-off of the struggling xpedx distribution business. In 2013, xpedx accounted for about 20% of group revenue, and it has been a drag on IP's ability to generate economic profits over the past decade. Though the xpedx division is a relatively small piece of IP's operations, the spin-off provides us with additional confidence that the firm can generate consistent economic profits over the next decade as a result of a low-cost production advantage in its legacy mills, which serve the legacy industrial and consumer packaging and printing papers segments.

IP's massive corporate restructuring has been bold and expensive, but given the old business model's inability to sustainably generate returns above its cost of capital, we think such a move was necessary and believe the new model will increase shareholder value. IP has done a fantastic job integrating the Temple-Inland acquisition, with realized synergies well ahead of expectations, and its industry-leading EBITDA margins speak to the company's ability to efficiently run a large mill network.

In addition to industrial packaging, the other half of IP's business, which includes legacy printing papers and consumer packaging, requires more of management's attention, as each segment has a unique set of challenges. While more than three fourths of IP's revenue comes from the United States, the company also has paper operations or investments in each of the BRIC countries and in Eastern Europe. The jewel of IP's emerging-market investments is its joint venture with Ilim, the largest pulp and paper company in Russia. Ilim has two pulp mills in Siberia that provide daily rail deliveries into China, the country with the world's biggest fiber deficit. Despite the strong uncoated free sheet, or UFS, paper demand in emerging markets, we believe those regions will also increasingly adopt digital forms of communication. This is likely to shorten the emerging-market UFS growth phase, though that growth phase could nevertheless continue for another five or more years.

Our Fair Value Estimate is $49 per Share
We recently increased our fair value estimate to $49 per share from $46 per share to reflect our confidence that IP can generate economic profits further into the future than we had originally thought. Our fair value estimate represents a 2014 price/adjusted earnings multiple near 14 times and an enterprise value/EBITDA multiple near 6.5 times. Our model assumes an 8.8% weighted average cost of capital.

Industrial Packaging's Low-Cost Production Advantage Helps Create a Moat for IP
Once the xpedx distribution business is spun off, IP's industrial packaging division will account for about two thirds of annual revenue and operating profit. We believe this business benefits from a low-cost production advantage, with 95% of its production capacity falling in the first and second quartiles of the global cost curve. This advantage can be seen in IP's North American industrial packaging EBITDA margins, which are higher than those of its primary competitors in the region, Packaging Corporation of America and Rock-Tenn.

IP's other legacy operations, printing papers and consumer packaging, will account for the remaining third of revenue and operating profit. The vast majority of IP's paper and paperboard mills also fall in the lower half of the cost curve, but the difference between producers in the first and fourth quartiles isn't as wide as it is in containerboard. Additionally, margins are not quite as attractive in these businesses owing to the secular headwinds facing printing papers and tepid volume growth in consumer packaging in recent years.

We believe IP's low-cost production advantage stems from a number of factors including mill locations in close proximity to wood baskets that were part of the once vertically integrated company. When IP sold its forest holdings during its transformation period, it also locked in long-term fiber supply agreements with the new landowners, which should ensure that IP's proximity advantage persists for at least another 10 years. Further, IP's virgin fiber mills are effectively irreplaceable from a cost standpoint given the environmental regulations and capital requirements to build a greenfield virgin fiber mill in the U.S. Finally, the company has invested heavily in energy reduction projects at its mills, which has further reduced production costs relative to some of its peers.

We continue to believe, however, that the efficient-scale moat source is not present in the North American containerboard industry. That's because containerboard supply can be added through mill conversions and brownfield investments when conditions are particularly strong. Conversions, in particular, can be added relatively inexpensively and quickly. That said, converted mills tend to sit higher on the industry cost curve. As such, if more are added in the coming years, they wouldn't likely diminish IP's low cost production advantage.

Containerboard Price Increases Have Been a Tailwind but Won't Likely Persist
Despite the successful containerboard and box price increases instituted over the past two years, we are maintaining our stable moat trend for IP. We think that the fall 2012 price hike was motivated by the industry's need to make up for a lack of price increases in the previous two years, but that the most recent increase was an aggressive attempt by industry participants to capitalize on more favorable near-term industry dynamics. We do not consider the most recent increase to have been an appropriate action by a rational oligopoly and believe the improved industry profit margins that will come from the higher prices will encourage new capacity to enter the containerboard market over the next three to five years, via idle paper machine conversions and even large brownfield investments. We also do not expect IP's relative position on the industrial packaging cost curve to change much in the coming years as both IP and its major competitors invest in capital projects (such as biomass boilers) to lower their cost structures.

We expect that the secular decline in domestic UFS demand will prompt additional industry consolidation and mill closures. This should help maintain disciplined industry pricing and allow the larger players like IP to generate substantial levels of cash from UFS assets in the medium term.

Shareholder Capital Is in Good Hands With the IP Team
We assign International Paper an Exemplary stewardship rating, supported by the company's tremendously successful transformation over the past decade. Our stewardship rating focuses on how well management teams have played the hands they were dealt, and we believe IP worked a minor miracle given the secular headwinds faced by the domestic paper industry in the past two decades. Between 2002 and 2006, for example, IP's returns on invested capital averaged a little below 8% on average and its quarterly dividend had been held at $0.25 per share from 1995 to 2009. During this period, the company was simply stretched across too many business lines, and operations were largely inefficient.

Since 2006, however, IP has turned things around by selling timberland and noncore business lines, and acquiring packaging assets such as Weyerhaeuser and Temple-Inland. As a result of these moves, IP's returns on invested capital improved to about 18% by 2012, and despite needing to slash its dividend during the financial crisis, the payout has more than fully rebounded and is well above its pre-financial-crisis levels. Though we expect increased competitive pressure in the North American containerboard market over the next few years, we believe IP is on much better footing as a result of management's wise decisions and strong operational execution in recent years.

John Faraci has been chairman and CEO since 2003 and is largely responsible for the company's significant transformation. Faraci joined IP in 1974 and served as CFO for three years before becoming CEO. CFO Carol Roberts has been with the company since 1981 and assumed her current role in 2011. IP has a deep bench of executive talent with decades of experience, so we would anticipate future leadership changes to promote internal candidates and transitions to be relatively smooth. IP executives' bonuses are tied to free cash flow, return on investment, and total shareholder return metrics, which we consider appropriate, and we're encouraged that 87% of the CEO's target compensation is at risk.

Todd Wenning does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.