This Industry Giant’s Stock Could Gain 25%
After a less-than-stellar performance for the S&P 500 in 2011, investors continue to scratch their heads as they try to figure out where to allocate capital for the New Year. Treasuries? Sure, if you want to pay too much, then take on more downside risk than you think and get paid next to nothing. The truth is, too many areas of the marketare stretched out like the cotton sweater I got from Target eight years ago that everyone in the house seems to borrow.
But we can still find value out there. And one of my favorite stocks is pretty well known: a little fly-by-night outfit called International Paper (NYSE: IP).
#-ad_banner-#Why would I invest in a paper company in the face of a collapsing Europe, the Iranians threatening to close the Straits of Hormuz, and the exponential shrinkage of paper usage thanks to e-mail and the tidal wave of smartphone and tablet growth?
Yes, there’s risk in everything, but International Paper possesses all of the qualities I like to see in a stock if I’m considering deploying new money: a well-run, high-quality name with a strong market position, a forward price-to-earnings (P/E) ratio well below that of the S&P 500 and exceptional dividend yield. In fact, International Paper passes all these tests with flying colors.
With an $11.8 billion market cap, International Paper is one of the world’s largest producers of uncoated free sheet (UCFS) paper, the type of paper you put in the copier or the printer at the office. It also consumer and industrial packaging such as to-go coffee cups, frozen-dinner packages, cardboard boxes, and pulp.
But as the U.S. economy recovers slowly and Europe tries to hold its economy together with the band aid du jour, global demand for UCFS paper is expected to decline further. This compounds the secular decline the paper market grapples with as manufacturing continues its march into the digital age.
Just like ice hockey great Wayne Gretzky, who famously said that he just went to “where the puck is going to be,” International Paper didn’t get to where it is by accident — they knew where the puck was going. The company has narrowed its product focus, and while free sheet paper is still an important part of the business (25% market share), International Paper has chosen to invest more in the packaging operation.
Growth by and global reach
You can either build a business or buy one. International Paper has decided to buy.
In 2008, it gobbled up rival Weyerhaeuser in a deal that improved the company’s revenue by a muscular 10%. Last year, International Paper returned to the hunt with a rocky courtship and eventual engagement to acquire corrugated packaging provider Temple Inland (NYSE: TIN), and then made a trip to India to buy paper maker Andhra Pradesh.
It’s easy to note that emerging-market expansion has become a cornerstone of International Paper’s growth strategy. It has invested substantially in Brazil, a market that contributed nearly 22% to the company’s 2011 EBITDA; and Eastern Europe — primarily Russia and Poland — which makes up for 18% of the company’s EBITDA. And thanks to the Andhra Pradesh acquisition, India now contributes 1%, with volume from that segment projected to grow 5%. That’s a huge amount if you consider the business brings in more than $26 billion in annual revenue.
In addition, the Temple Inland merger is expected to be a net positive for the company. Once completed, International Paper’s containerboard business is projected to go from 40% to 55% of total sales, while its North American containerboard market share will likely jump from 26% to 37%. This is another sign of the company transitioning away from the shrinking UCFS paper market and stepping into more solid ventures.
The merger should also be a boost to the company’s earnings per share (EPS). Standalone estimates for International Paper’s 2012 EPS called for $2.42. Factoring in Temple Inland’s contribution, pro forma EPS for 2012 would be $2.72: a 12.39% increase, which would be similar to the value added by the Weyerhaeuser acquisition.
Historically, the company is well known for its operational discipline. International Paper has done a great job of lowering costs and maximizing efficiencies. It doesn’t hesitate to shut down a nonperforming mill or get rid of a subpar manager, either. This discipline has resulted in strong operating margins: in 2011 they are expected to come in at 9.2%, up 13.5% from 2010. A 13.5% margin increase is pretty substantial when you consider the size and scale of International Paper’s business.
Risks to consider: IP’s ability to realize the synergies associated with the Temple Inland merger will be a decisive factor in the company’s performance. In addition, International Paper recently shuffled its top-tier management, which adds risk to the company’s ability to execute the transaction successfully. Another significant risk to the balance sheet is its underfunded pension, the scourge of most big U.S. companies. IP ended 2010 with a pension deficit of $1.5 billion. Although it has announced a voluntary contribution of $300 million, the plan’s underperformance and low rates will continue to compound the problem. The macro risks IP faces are the usual suspects: a challenging global economy, commodity price inflation and fundamental, secular shifts in key product areas.
Action to Take — > International Paper shares currently trade around $30.81 with a forward P/E of 10 times 2012 projected EPS of $3.10. If the company can successfully implement of the Temple Inland merger, then the realized synergies should help boost the forward P/E by 12%. This would imply at 12-month price target of $37.20. Combined with the 3.4% dividend yield, the result would be a total return of nearly 24% — not bad for such a big company in a tough environment.