International Paper Co /New/ Q3 FY2021 Earnings Call

Thank you, Anjay. Good morning and thank you for joining International Paper's third quarter 2021 earnings call. Our speakers this morning are Mark Sutton, Chairman and Chief Executive Officer, and Tim Nicholls, Senior Vice President and Chief Financial Officer. There is important information at the beginning of our presentation on Slide 2, including certain legal disclaimers. For example, during today's call, we will make forward-looking statements that are subject to risks and uncertainties. We will also present certain non-U.S. GAAP financial information. A reconciliation of those figures to U.S. GAAP financial measures is available on our website. Our website also contains copies of the third quarter 2021 earnings press release and today's presentation slides. Lastly, relative to the Ilim joint venture, Slide 2 provides context around the joint venture's financial information and statistical measures. I will now turn the call over to Mark Sutton.

Thank you, Guillermo, and good morning, everyone. We will begin our discussion on Slide 3. In the third quarter, International Paper grew revenue, earnings, and margins. We continue to generate strong cash from operations. We continue to see strong demand for corrugated packaging and solid demand for absorbent products. We're making strong progress on price realization from our prior increases. Having said that, the supply chain and input cost environment remain very challenging. It impacted our results much more than we anticipated. The widespread supply chain constraints limited our ability to capture the full opportunity that comes with the strong level of demand that we're seeing. Our mills performed well; however, stretched supply chains impacted volume in our industrial packaging and global cellulose fibers businesses. Container board inventories in our packaging network improved in the latter part of the third quarter, and we are in a much better position as we enter the seasonally strong fourth quarter. Input costs in the third quarter rose by about $230 million or $0.46 per share, which was more than twice what we had anticipated, with cost pressure in just about every category. Our Ilim joint venture delivered another strong performance, with equity earnings of $95 million. On capital allocation, we continue to make significant progress strengthening our balance sheet. In the third quarter, we reduced debt by $235 million. I would also highlight that our pension plan is fully funded. This is a significant milestone that further strengthens the company. In the third quarter, we also returned $411 million to our shareholders, including $212 million of share repurchases. On October 1st, we completed the spin-off of the Printing Papers business. IP received a $1.4 billion payment from Sovamo, and we retained a 19.9% interest in the new company, which we intend to monetize within one year. The teams did an outstanding job executing the transaction in a very challenging environment. The Printing Papers business delivered a strong performance in the third quarter, and we wish Sovamo all the best as they move forward as a standalone company. We're laser-focused on strengthening the company and building a better IP for all of our stakeholders. Tim and I will share more about the progress we're making during today's discussion. Turning now to Slide 4, we delivered EBITDA of $938 million and free cash flow of $519 million in the third quarter, which brings our free cash flow to nearly $1.6 billion year-to-date. Revenue increased by nearly $600 million or 12% when compared to last year. If we exclude the Printing Papers business, third quarter revenue grew by 14% as compared to last year. We also expanded our margins in the third quarter with realization of our prior price increases. We expect continued margin expansion in the fourth quarter. I will now turn it over to Tim to cover our business performance and our fourth quarter outlook.

Thanks, Mark. Moving to the Quarter-Over-Quarter earnings bridge on Slide 5, Third quarter operating earnings per share were $1.35, as compared to $1.06 in the second quarter. Price and mix improved by $0.43 per share, a strong price realization across the three businesses. Volume decreased sequentially. Supply chain constraints limited our ability to capture the full benefit of the strong demand backdrop. We replenished our container board inventories in the latter part of the third quarter, which positions us well entering the seasonally strong fourth quarter. Our Cellulose Fibers business demand for absorbent pulp remains solid. Our pulp shipments were constrained due to significant port congestion, and our backlogs remain stretched. Our mills performed well. Operating costs benefited from about $35 million of one-time items, including the sale of nitrogen credits and insurance recovery related to the winter storm earlier this year. Supply chains are stretched, and transportation costs are elevated for both inbound materials and outbound shipments. Every mode of transportation is tight, and we expect this to remain tight for the foreseeable future. Maintenance costs decreased as expected. Input costs rose by $0.46 per share, or about $230 million, which is more than double what we had anticipated for the quarter. Higher fiber and energy costs accounted for about 80% of this increase. Corporate expenses were essentially flat, tax expense was lower by $0.04 per share in the third quarter, with an effective tax rate of 18% as compared to 21% in the second quarter. Most of this was related to adjustments to our federal tax provision after finalizing our 2020 tax return in the third quarter. Equity earnings were lower sequentially following the final monetization of our stake in GPK in the second quarter. Turning to the segments, I'll start with Industrial Packaging on Slide 6. We see strong demand across all channels, including boxes, sheets, and containerboard. Third quarter shipment across our U.S. channels improved by 1.3% year-over-year. However, box shipments were hampered by low containerboard inventories and stretched supply chains. We successfully replenished inventories across our box system in the latter part of the third quarter, which puts us in a much better inventory position as we enter the seasonally strong fourth quarter. We expect supply chains to remain stretched for the foreseeable future, which requires us to carry more inventory, given the slower velocity across our network. To put the velocity in context, our mill-to-box plant container board supply chain is currently running 3 to 4 days longer than our normalized flow, and in some lanes, even longer. Taking a look at third quarter performance, price and mix was strong. Our March increases were essentially fully implemented, with $128 million of price realization in the third quarter. Volume was lower by $45 million. Box shipments in North America were impacted by low containerboard inventory, especially in the first half of the quarter. Volume and EMEA were seasonally slower as expected, representing about $10 million of a sequential decrease. Operations and costs were essentially flat sequentially. Our mill system performed at 100%, providing much-needed inventory relief to our box system. In the third quarter, we also received insurance proceeds of about $15 million related to the winter storm. These benefits were largely offset by unplanned maintenance costs. We're not seeing any relief on supply chain costs, and we're managing risk associated with transportation capacity and congestion across the rail and truck networks. Input costs increased by nearly $190 million in the quarter. OCC and Woodfibre accounted for $120 million of that total. Energy accounted for another $45 million, primarily in our recycled containerboard mills and our box plants. Taking a closer look at fiber, our North American packaging fiber mix is around 65% virgin wood and 35% OCC. Wood fiber cost increased sharply in the third quarter due to continued wet conditions across the Southern and Eastern regions, as well as inbound transportation constraints. Wood inventories are below our control limits, and we expect difficult operating conditions again in the fourth quarter. We expect demand for OCC to remain strong with no cost relief, even as generation gradually improves. As a reminder, we consume about 4.5 million tons annually in the U.S. and nearly 0.5 million tons in EMEA. Moving to Global Cellulose Fibers on Slide 7, the business delivered earnings of $96 million. Third quarter segment earnings included $13 million from the Sovamo subsidiary and Kwidzyn mill, which are no longer part of our operations in the fourth quarter. Looking at our sequential earnings, price and mix improved by $59 million. Volume improved by $11 million sequentially, with solid demand for fluff pulp, which represents about 75% of our mix. Our shipments continue to be negatively impacted by unprecedented port congestion and vessel delays. Keep in mind, we export about 90% of our volume in this business, and the majority of this is fluff pulp that ships in containers. The congestion at ports is especially challenging. We have systems in place to manage through this environment, but vessel delays and higher supply chain costs are expected to continue for the foreseeable future. Our mills performed well. We also benefited from about $20 million in one-time items related to the sale of nitrogen credits and lower corporate costs in the quarter. These benefits were largely offset by $50 million of higher supply chain costs for export operations. In this segment, costs decreased sequentially, while input costs were a significant headwind in the third quarter, driven primarily by higher wood and chemical costs. Turning to Printing Papers on Slide 8, the business delivered earnings of $106 million in the third quarter, with strong momentum ahead of the spin-off. Third quarter results included the Kwidzyn mill until the sale on August 6. Performance in the third quarter was strong, with continued demand recovery globally and price realization outpacing rising input costs. Now that the spin-off is complete, the historical results of the business will be treated as a discontinued operation with a full recast of previous periods. Going forward, activity pertaining to the Printing Papers off-take agreement for Riverdale or Georgedale will be included in our Packaging and Global Cellulose Fiber segment earnings. I do want to echo Mark Sutton's comments and thank our teams for successfully executing the spin in a very challenging environment. Looking at the Ilim results on Slide 9, the joint venture delivered another quarter of strong performance with equity earnings of $95 million and an EBITDA margin of 44%. Solid price realization for pulp and containerboard were partially offset by lower volume due to high planned maintenance outages in the quarter as expected. Volume in the fourth quarter is expected to improve. However, shipping capacity remains tight and supply chains to China are stretched. So now we'll turn to the fourth quarter outlook on Slide 10. In industrial packaging, we expect price and mix to improve by $70 million, mostly on the realization of our August 2021 price increase. That includes a negative mix impact as we start to recover some export backlogs. Volume is expected to improve by $65 million sequentially, on strong seasonal demand, even as we have set down three shipping days. Operations and costs are expected to improve by $5 million, with the North American system benefiting from improved containerboard inventory levels, partly offset by one-time benefits in the third quarter. Staying with industrial packaging, maintenance outage expense is expected to increase by $3 million. Input costs are expected to increase by $50 million, mostly on the flow-through of higher third quarter input costs for fiber and energy. In Global Cellulose Fibers, we expect price and mix to be stable. Volume is expected to decrease by $5 million. Operations and costs are expected to decrease earnings by $25 million, due to the non-repeat of one-time benefits in the third quarter. Maintenance outage expense is expected to increase by $37 million, and input costs are expected to increase by $15 million due to higher wood and energy costs. On our outlook slide, we include the sequential earnings adjustment associated with the Printing Papers spin and Kwidzyn sale for a total of $134 million across the three segments. With regard to cash flow, I would note that our cash from operations in the second half of 2021 includes cash taxes of about $450 million associated with the various monetization transactions from earlier this year. Remember that the proceeds for these transactions are not captured in our free cash flow. However, the resulting cash taxes are included in free cash flow, and the majority will be paid in the fourth quarter.

Turning to Slide 11, I will take a moment to update you on our capital allocation actions in the third quarter, and what you can expect from International Paper following the recent papers spin-off. We will maintain a strong balance sheet. As we previously said, we're comfortable taking our leverage below the stated target of 2.5 to 2.8 times debt EBITDA on a Moody's basis. In the third quarter, we reduced debt by $235 million, which brings our year-to-date debt reduction to $1.1 billion. We will also complete an additional $800 million of debt repayment by the end of this month. Taking a look at pension, we're very pleased with the performance of our plan this year. Our qualified pension plan is fully funded, and we feel really good about the actions we've taken to improve performance and de-risk the plan. Returning cash to shareholders is a meaningful part of our capital allocation framework. In the third quarter, we returned $411 million to shareholders through dividends and share repurchases. Share repurchases were $212 million, which represented about 3.6 million shares at an average price of $59.13. Also earlier this month, the Board of Directors approved an additional $2 billion share repurchase program, which raises our total available authorizations to $3.3 billion. We will continue to execute on that authorization in a manner that maximizes value for shareholders over time. With regard to the dividend, our policy does not change. We're committed to a competitive and sustainable dividend with a payout of 40% to 50% of free cash flow, which we will continue to review annually as earnings and cash flow grow. Earlier this month, we decreased our dividend by 9.8% to $1.85 per share annually following the spin-off of the Papers business. This adjustment is well below the 15% to 20% proportion of cash previously generated by the Papers business, as we outlined from when we announced the spin last year. Investment excellence is essential to growing earnings and cash generation. We expect capex in 2021 to be around $600 million, which is less than our original plan, primarily due to the timing of equipment delivery and a more challenging contract labor environment. We will continue to proactively manage capex and have the ability to increase or pull back if circumstances warrant. You can expect strategic capital to be deployed mostly to our packaging business to build up capability and capacity needs to drive profitable growth. We will continue to assess disciplined and selective M&A opportunities to supplement our goal of accelerating profitable growth. We can expect M&A to focus primarily on bolt-on opportunities in our packaging business, both in North America and Europe. Any potential opportunity we pursue must be compelling value for our shareholders. And with that, I will turn it back over to Mark. Thanks, Tim, for all the details. I on slide 12 now. Let's talk about the future and how we're going to accelerate value creation for IP and our shareholders. We are building a better IP. At the recent spin-off of the Papers business, IP is really a corrugated packaging-focused company. We're significantly less complex with a much narrower geographic footprint. In addition, we have strengthened the company's financial footing, as Tim has described significantly over the past few years. Our focused profile and financial strength will further enable us to make sustainable, profitable growth and accelerate value creation. As I said earlier in the process, we've been actively working on multiple streams of earnings initiatives over the past year. We established a dedicated team that's been working closely with our businesses and external partners over the past year to identify, develop, and pilot a wide range of highly attractive opportunities, which are now moving to scaled implementation. Let's turn to Slide 13 to see how our earnings drivers ramp up over the next few years. We will deliver $200 to $225 million of gross incremental earnings in 2022. That represents more than twice the dis-synergies resulting from the spin-off. Our value drivers ramp up in '23 and 2024 with net incremental earnings of $350 to $400 million in 2024. These include around $300 million in cost reduction initiatives and at least $50 million through commercial and investment initiatives. Our earnings catalysts are front-loaded with significant benefits coming in 2022 from streamlining and simplifying the company and scaling a wide range of process optimization initiatives. Streamlining and simplifying is all about agility and effectiveness; the organization is being designed to support a packaging-focused company with a more focused footprint. We are aligning our talent to accelerate performance. We've also examined our processes to increase efficiency and reduce costs. We are implementing and scaling new approaches for areas such as sourcing, supply chain, and operations by leveraging technology and data analytics. Let me give you a few examples of these value drivers for 2022. We redesigned our sourcing process for our 200 converting facilities. We're using data analytics and third-party partners to deploy an automated catalog of sourcing options for operating and repair materials in our box plants. This program will deliver meaningful value in 2022. We're also using data analytics to unlock capacity in our converting facilities by improving our planning and order execution process. This includes, for example, how we aggregate and plan smaller orders and how we can optimize our manufacturing mix in each plant and each network of plants. We have also developed a new application to further optimize containerboard replenishment to our box plants. A system anticipates potential raw inventory stockouts, which had been a big issue for us this year and recommends the lowest cost replenishment option to reduce premium freight. There are many initiatives that contribute to our value drivers and the savings. We have really good line of sight on the expected benefits in 2022, and the ramp-up as we move forward. Our 2022 value drivers not only deliver meaningful benefits in the near term, but they are also setting the foundation for IP going forward to accelerate commercial and investment excellence to drive profitable growth. So with that, we're ready to take your questions.

We'll take a moment to gather the Q&A list. Your first question comes from Phil Ng with Jefferies.

Hey guys. It's been a challenging few quarters in the industrial sector. A pretty healthy demand backdrop, so with inventory normalizing for you guys and pricing flowing through, when do you actually expect EBITDA margins and dollar EBITDA to be up year-over-year in Industrial? Now that you have inventory at a more respectable level, do you expect your box inventory to track more in line with the broad industry in the fourth quarter?

That's a great question, Phil. What we talked about in our second quarter was that we thought it would take at least till the end of the year to get the inventory situation where it wasn't constrained. I think we made a little more progress than we expected in the third quarter. And most importantly, September was a lot better than July. but we still have some spotty issues depending on the grade and the type of end-use box. As we enter the fourth quarter, the progress we made in the third quarter puts us close to our ability from a board supply to really track our own box shipments with the market. We will continue to see EBITDA margin and absolute EBITDA improvement as we move forward. As you know, and as we outlined, Tim talked about, we underestimated a number of our cost initiatives, in our outlook for the third quarter. That obviously took a bite out of our EBITDA margins. We really expected to see EBITDA margins in the 20%-ish range in the third quarter, and we didn't get there, primarily because some costs were twice as high as we anticipated. Costs like OCC have varied due to our estimates about supply, demand, and generation, affecting where we're going to buy it from and what transportation will cost. But I'm encouraged that we're making progress. The price flow-through is going well, and we expect to see our margins expand further. We are positioning the company for growth in our other channels, which we have had a lot of success with. Our own box plants have faced challenges primarily due to our ability to get the right containerboard into the right plant at the right time.

Got it, Mark. That's helpful. As a school of thought, many believe four weeks of inventory maintains balance, but considering the industry's challenges from a supply chain standpoint, what is your view on that balance?

Hey, Phil, it's Tim. Right now, as we mentioned in the comments, we're 3 to 4 days longer or slower in terms of velocity, which is affecting shipment from the mill to the box plants compared to a more normalized type of environment.

To reinforce Tim's comments, we are unsure if that 3-4 day lag will extend to 5. It depends on the velocity through trucking and rail, while port issues are primarily affecting Cellulose Fibers. Therefore, we plan accordingly one, two, and three months out is what we're doing now. I think you're going to see for IP that inventory above our normal history is a good investment right now because it leads almost automatically to a sale of a box.

Got it. That's helpful. Just one last one for me. You are generating a lot of cash; you've announced a sizable buyback program and have about $3 billion available. Any color on the pace and will you look to use vehicles like KSR and broadly how you plan on deploying some of that excess cash on your balance sheet in the near-term?

Great question. The summary would be we’ve not changed our capital allocation and deployment framework. We've worked hard to de-risk our company through our balance sheet and pension. As I mentioned, our qualified plans are now fully funded. Reducing leverage is something we've been pointing to for over a year now. Regarding share repurchases, we now have the authorization to work with. We'll continuously look at how our stock is trading relative to our intrinsic value and adjust accordingly.

In addition to Tim's comments on capital allocation, we've never been in a better position to maintain cash flow consistent relative to our balance sheet. We're committed to the dividend, which I think everyone knows. Share repurchases have been sporadic, but we are now in a strong position to execute consistently based on our view of intrinsic value. Investment in our own business will focus on enhancing cash flow and cost reductions, as well as smart growth which typically involves bolt-on opportunities. We're now positioned to execute that effectively.

That's great color; great to have all this optionality. Really appreciate it. Thank you.

Your next question comes from the line of Anthony Pettinari with Citigroup.

Good morning.

Morning.

The detail on the value-creation initiatives is really helpful. There's a reference on the slide to meaningful improvement in Global Cellulose Fibers performance. I'm just wondering if you can talk broadly about the drivers to improve that performance and how you ensure those benefits don't get competed away?

Our plan is to maintain our competitive advantage. Some initiatives are unique to our scale and footprint. We expect steady quarter-by-quarter improvements in the performance of the cellulose fibers business. We're observing improvements despite unforeseen supply-chain issues, which won't be permanent. Our commercial strategies are aligned to facilitate better pricing for customers moving forward. I believe the supply chain will normalize, possibly in the second half of next year, but our shift in customer relations will enable long-term improvement.

That's very helpful. About the dual control policy in China, can you remind us of the percentage of your Cellulose Fibers sales that is going to China? What's your take on the impact of this policy on that market?

About one-third of our fluff goes to China, and that majority comprises premium customers and converters. We haven't seen a major impact from these issues, as the disruptions primarily affect smaller companies without multiple global value sources. Our strong relationships with multinational customers allow us to navigate these challenges efficiently.

Your next question comes from the line of Mark Wilde with Bank of Montreal.

Good morning, Mark, good morning, Tim.

Hi Mark.

Can you help us unpack the cost pressures in Industrial Packaging, especially between North America and Europe? Your costs in Industrial Packaging have been up about $100 per ton over the last four quarters. Any additional detail would be appreciated.

Between the U.S. or North America and Europe, most of it is in North America due to higher exposure to OCC, energy, and chemicals. The recent pressure has predominantly been caused by rising OCC and energy costs, particularly natural gas, which has moved rapidly.

How much of that cost increase would you say is at the converting level? I'm curious about the impact of labor and transportation inputs as well.

We don't break it down that way, but there's certainly an impact. A lot of costs stem from the mills, though unique converting materials like wax can drive prices higher. Moreover, labor costs have increased across all our businesses, affecting converting as well.

Regarding labor in converting, our employees have shown tremendous commitment throughout the pandemic. In regions where plants typically operated 5 days a week, they successfully ramped up production while we work to hire permanent staff under challenging conditions leaving overtime on the table. As we products are sold, it justifies labor expenditures. Transportation has likewise been a significant concern, particularly regionally.

A bit of a change in topic, but can you offer any insight on the ownership structure of Ilim moving forward?

We like our current 50-50 joint venture structure with Ilim, considering the geopolitics and risk profiles. We continually seek ways to maximize the value from that 50% ownership. Our partnerships are strong, and the management team is performing exceptionally.

Your next question comes from the line of George Staphos with Bank of America.

Thanks. Everyone, good morning. Mark and Tim, I want to go back to Slide 6. There's been this narrative from a lot of people in the industry that labor shortages and supply chain issues have not only increased costs but also prevented converters integrated companies from hitting demand. Is it fair to say that some of the 1.7% box shipment trend that you saw in the third quarter was largely constrained by these constraints, and what impact do you see on recaptured volume versus potential permanent loss?

The primary reason for the shortfall involved severe containerboard shortages in our box system, and we had a heavy order intake but couldn't take many orders. Importantly, most of the demand we're not fulfilling isn’t lost, but rather new business that we cannot accept as new customers continue wanting us in their supply base.

Based on that perspective, while some demand may have been foregone, do you believe you can recapture that going into the fourth quarter?

Yes, that's the gist of it. There has been a lot of improvement in our inventory positions, and even though July faced immense challenges, August and September were much better. So we enter the fourth quarter feeling quite optimistic. Labor remains an issue for our customers and while unique boards may still be tight, we're in a better position overall.

One question on pulp and then, can you remind us what EBITDA return you see as reasonable and how you see the potential impact from the dual control policy in China affecting your business?

The Cellulose Fibers business is value-creating around EBITDA margins just north of 20%. We believe as the cost structures normalize, we should return to that range, and various strategies should improve our positioning. Regarding pulp markets in China, our exposure is managed primarily with premium customers, which minimizes potential fallout from the dual control policy.

Your next question comes from the line of Mark Weintraub with Seaport Global.

Thanks, Mark and Tim. Just two follow-up questions. Can you share your thoughts on how supply chain challenges may have affected overall box demand, particularly considering the industry's recent performance?

Third-quarter and fourth-quarter comps are tougher due to last year’s performances. Supply chain issues affect all segments, and it’s not just isolated to us.

So, while the industry has been facing these supply chain challenges, is it fair to say labor and customer-level issues vary greatly?

Yes, we face our constraints, but many of our customers are also struggling with their own labor and production capabilities, which also affects us.

Demand remains strong despite ongoing issues related to supply chains, labor, and production. It appears that, generally speaking, the overall money people have to spend has built up in anticipation of demand, so the underlying demand should remain.

Understood. Would you similarly agree that for both the fourth quarter and the next year it is difficult to predict box demand given current uncertainties?

Yes, it remains complicated, but recent growth trends show an uptick in our October volumes between 4% and 5%. Thus, we are taking business on a month-by-month basis.

Just one last quick point. You mentioned three to four days more cycle time. What does that compare to a normal cycle time for containerboard movement?

It's tough to quantify in weeks, but it represents a significant increase in cycle time, with some lanes reporting more than four days.

Thanks, Tim.

You're welcome.

Your next question comes from the line of Adam Josephson with KeyBanc Capital.

Thanks. Mark and Tim, good morning. Hope you're well.

Hi, Adam.

Tim, can you talk about your initial expectations regarding the dividend reduction in December, which you projected at 15% to 20%? Why was it reduced only by 10% ultimately?

At the time, we considered the historical performance of the Papers business’s contribution to earnings and cash flow performance. While we faced constraints earlier in the year, we felt strong about our cash flow position and subsequent performance. Returning cash to shareholders remains paramount, so we adjusted the reduction to reflect that stronger positioning.

I appreciate that insight. On guidance for next year, given the uncertainty, how comfortable are you in giving full-year guidance now that the papers spin-off is completed?

There are many events yet to unfold by January when we report the fourth quarter. It’s important we begin normalizing issues in the supply chain to project full-year guidance accurately. However, we feel good about our position for 2022 preparations.

That makes sense. Just one last question regarding box demand. Considering the surprises from the third quarter, how are you setting expectations for the fourth quarter in light of potential supply chain issues?

We’ve observed October growth and are optimistic about demand trends. While the environment remains challenging, supply stability from improved containerboard inventories gives us confidence in maintaining a solid outlook for the fourth quarter performance. As we wrap up, I want to express that we are committed to overcome the challenges we face today. Our team is doing exceptional work, and we expect our margins to recover further as we move through the fourth quarter and into 2022 with significant momentum. Thank you for your investment in International Paper, and we look forward to our next conversation.

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