Earnings Call Transcript - IP Q3 2022

Operator, Operator

Ladies and gentlemen, good morning and thank you for standing by. Welcome to today's International Paper Third Quarter 2022 Earnings Call. All lines have been placed on mute to prevent background noise. After the speakers' remarks, you'll have an opportunity to ask questions. As a reminder today's conference is being recorded. I'd now like to turn the conference over to Mark Nelson, Vice President Investor Relations. Please go ahead.

Mark Nelson, Vice President Investor Relations

Thank you, Paul. Good morning and thank you for joining International Paper's third quarter 2022 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 this call, we will make forward-looking statements that are subject to risks and uncertainties. We will also present certain non-US GAAP financial information. A reconciliation of those figures to US GAAP financial measures is available on our website. Our website also contains copies of our third quarter earnings press release and today's presentation slides. I will now turn the call over to Mark Sutton.

Mark Sutton, Chairman and CEO

Thank you, Mark, and good morning, everyone. We'll begin our discussion on Slide 3. The third quarter was a very dynamic and challenging environment, which had a significant impact on our earnings. We experienced a sharp decline in demand in our Industrial Packaging segment and significantly higher cost headwinds from higher energy and distribution costs. On a more positive note, I'm very pleased with the progress our Global Cellulose Fibers team is making to improve performance in that business. They are successfully advancing their commercial strategy and achieved cost of capital returns in the third quarter. In both businesses, we also delivered strong price realization. And for the year, we expect to exceed our $225 million target related to our Building a Better IP initiatives. Now back to the demand environment. As we enter the third quarter, we recognized there were macroeconomic uncertainties ahead of us and that our businesses are not immune to these risks. However, these macro trends shifted drastically midway through the quarter, creating stronger headwinds than expected versus our previous outlook, particularly in our Industrial Packaging business. Based on feedback from our customers and after observing order patterns across our various channels and end user segments, we believe inflationary pressures weighed heavily on the consumer, resulting in lower demand for goods. This had a large impact on demand for Packaging, as consumer priorities shifted towards nondiscretionary goods and services in the quarter. In addition, our customers and the broader retail channel continued to work through elevated inventories of their products, which further reduced Packaging demand in the quarter. In response to these trends, we quickly aligned our production with our customer demand, which resulted in significant economic downtime in the quarter for our Containerboard system. Also, our significantly lower export position versus prior years contributed to a higher level of downtime, all of which suboptimized our system from a cost standpoint in the quarter. I would point out that our mill system continued to operate very well before being constrained by lower demand. The work we did in the last several quarters to improve reliability is paying dividends. As we enter the fourth quarter, Packaging demand appears to be stabilizing at these lower levels. And finally on capital allocation, we returned $434 million to shareholders in the third quarter including $269 million of share repurchases. As a result, we've returned approximately $1.6 billion of cash to shareholders so far this year. If we turn to the third quarter in particular on slide 4, revenue increased by 10% year-over-year driven by strong price realization across our two business segments. Operating earnings and margins were lower than prior periods due to the significant macro headwinds I discussed earlier. However, our free cash flow generation was stable in the quarter. I would also like to take this opportunity to mention that we are making good progress regarding Ilim. As I've mentioned before, the complexity of the situation and our joint venture structure impact the pace of reaching a resolution, but we feel good about the progress we're making and we'll provide another update when there is more information to share. I'll now turn to slide 5, which is one that we shared with you last quarter as we recognized that there were a lot of macro uncertainties ahead of us. Our outlook for the fourth quarter, which Tim will share with you shortly assumes our earnings will remain under pressure in the near term. However, I want to reinforce my confidence in the resiliency of IP and our ability to navigate through these dynamic environments. Our teams at International Paper know what it takes to successfully manage through a business cycle. And given the rapid change in demand, it will take some time to realign and optimize our system to the current environment. We have a wide range of options and capabilities across our large system of mills, box plants, and supply chain. And we know how to leverage them while taking care of our customers. Also, later in the presentation Tim is going to share some specific actions that our teams are taking to shift production to our lowest-cost operations and shed high-margin costs across the system. We're also continuing to invest in projects to drive structural cost reduction through efficiency improvements. And finally, we have built a very strong balance sheet, which we will preserve because we believe it's ensuring our financial stability and optionality and is foundational to our company, especially in softer economic environments. This allows us to continue investing in our businesses and to return cash to shareholders in a meaningful way by maintaining our dividend and through opportunistic share repurchases. I'm now going to turn it over to Tim who will cover our business performance and outlook. Tim?

Tim Nicholls, Senior Vice President and CFO

Thank you, Mark. Good morning, everyone. I'm on slide 6, which shows our sequential earnings bridge. Third quarter operating earnings per share were $1.01 as compared to $1.24 in the second quarter. Price and mix improved by $151 million or $0.31 per share with strong price realization across both segments. Volume is lower in Industrial Packaging as a result of the softer demand across all channels. Global Cellulose Fibers demand was stable. However, pulp shipments were higher due to improved supply chain velocity. Operations and costs were impacted by the non-repeat of favorable one-time items in the second quarter, significant economic downtime in our Industrial Packaging business and higher distribution costs and other inflation across all businesses. As you may recall, our operations and costs in the second quarter benefited from $96 million or $0.19 per share of favorable one-time items related to insurance recovery for our Prattville mill as well as lower employee benefit costs, medical claims, and workers' compensation expenses. Maintenance outages were lower in the third quarter as planned, improving earnings by $0.13. Input costs continue to be a headwind and were $75 million or $0.15 per share higher in the third quarter driven by higher energy and chemicals, partially offset by lower OCC costs. On slide 34 of the appendix, we provide details on our consumption of key inputs including natural gas, which was a significant cost headwind in the quarter for our businesses in North America and Europe. Corporate and other items include benefits from lower tax expense and a lower share count. Lastly, equity earnings were below the quarter prior primarily due to the lower sales price and FX related to Ilim. So turning to the segments and starting with Industrial Packaging on slide 7. We had very strong price and mix improvement in the quarter as we successfully completed implementation of our March price increase while also benefiting from higher average export prices and commercial initiatives focused on margin improvement. As Mark mentioned earlier, the challenging macro environment resulted in much lower volumes and unfavorable costs in our North American and European Packaging businesses. Demand for Packaging weakened significantly mid-quarter across all channels and segments from lower consumer demand and retailer inventory destocking. This large decline in volume impacted operations and costs in the quarter as we adjusted our system to align our production with our customers' demand. These actions resulted in approximately 400,000 tons of economic downtime across the system, resulting in higher unabsorbed fixed cost and a sub-optimized system. This represented approximately one-third of the higher cost and ops quarter-over-quarter. In addition, when not constrained our mills ran very well, which increased the amount of economic downtime needed to match the reduced level of demand. Sequentially, operations and costs were also impacted by significantly higher distribution costs, inflation on materials and services, and the non-repeat of favorable one-time items we discussed in the second quarter. It also includes some additional spending on recovery boilers and bark boilers across our mills to make our own energy given the significant increases in natural gas prices. Input costs were another significant headwind in the quarter and much higher than we expected, primarily due to higher energy costs that were only partially offset by lower OCC cost. These cost headwinds are even more significant for our packaging business in Europe where natural gas prices doubled since the second quarter and averaged about nine times the normal level. Turning to slide 8. We thought it would be helpful if we share some additional perspective on underlying segment trends for our corrugated packaging business. As shown on the previous slide, our US box shipments were down 5.4% year-over-year and our overall US channel was down 5.9%. As a reminder, our US channel includes the US box system as well as our open market containerboard customers and our equity partnerships with strategic sheet feeders. In the third quarter, we saw demand decline across all end-use segments. The yellow indicators represent segments where the demand decline was less than our overall average of 5.4%, and the red indicators represent declines that were worse than our overall average. Segments including beverage, durables, and non-durables, which are more discretionary in nature, came under the most pressure as consumers had to make choices while dealing with high inflation. In addition, retailer inventory destocking has exacerbated the demand decline for most segments in the near term. Based on feedback from our customers and our performance in October, demand appears to be stabilizing at these lower levels, as companies continue to work through their inventories in the fourth quarter. Despite these near-term headwinds, we understand the critical role of corrugated packaging plays in bringing essential products to consumers and believe that IP is well positioned to grow with our customers over the long-term. Turning to Slide 9. As Mark mentioned earlier, in the softer demand environment where we are able to run our systems at full capacity, we have the ability to shed high marginal costs due to a wide range of options and capabilities across our large system of mills, box plants, and supply chain. For example, we are shifting between fiber options based on the marginal cost of wood versus OCC. In this case, our mill teams consider the total cost to process the fiber including the benefits from own-make energy when consuming wood versus the cost of natural gas used to process OCC. Another example would be in the supply chain area. Our teams are reducing premium freight through mode optimization and increased availability of lowest-cost carriers. At mills, we're working to lower our planned maintenance outage costs by reducing overtime and premium pay that is traditionally associated with the shorter schedule. We are also continuing to invest in our operations to drive structural cost reduction from efficiency improvements in the areas of fiber and energy consumption. Ultimately, we are focused on restoring margins to historical levels by aligning our production with customer demand while optimizing our cost structure. Turning to Cellulose Fibers on Slide 10. I'll start with an update on the demand environment and supply chain. Demand for fluff pulp remains stable across all regions. Feedback from customers continues to indicate that fluff pulp inventories are near historical lows. We are experiencing moderate improvement in supply chain efficiencies. However, they continue to remain stretched driven by ongoing port congestion and vessel delays. We believe fluff pulp will continue to grow over the long term and are confident in the essential role of absorbent personal care products in meeting consumer needs. Taking a look at the second quarter performance, price and mix improved by $62 million due to the successful execution of previously announced price increases with solid momentum as we enter the fourth quarter. Volume in the quarter was higher due to some improvement in supply chain velocity. However, I would note that backlogs remain above normalized levels due to ongoing logistics challenges. Our mills continue to run well. Operations and costs were unfavorable in the quarter due to higher distribution costs and non-repeat favorable one-time items in the second quarter. Planned maintenance outages were lower by $26 million sequentially while input costs were higher by $12 million. Turning to Slide 11. Our Global Cellulose Fibers business continues to make significant progress towards growing earnings and delivering cost of capital returns in the third quarter. And the business remains well positioned to sustain this level of performance in the fourth quarter. Our team successfully deployed a commercial strategy focused on building strategic relationships with key global and regional customers and aligning with the most attractive regions and segments. We are focused on creating value for our customers by delivering products that meet their stringent product safety standards and deliver innovative value. In addition, we are driving structural margin improvement by ensuring we get paid for the value we provide. To date, we have made solid progress in our fluff pulp contract negotiations which will provide additional commercial benefits as we move into 2023. We are committed to building on this momentum and delivering value-creating returns over the business cycle. I would also note that this is a key part of building a better IP initiative in the category of strategy acceleration. Turning to Slide 12, I would like to update you on Building a Better IP set of initiatives. We're making solid progress in delivering $70 million of earnings in the third quarter for a total of $175 million year-to-date and we're on track to exceed the high end of our full-year target. About half of the benefits to date are from our lean effectiveness initiative by rapidly streamlining our corporate and staff functions to realign with a more simplified portfolio. We have already offset 100% of the dis-synergies from the Printing Papers spin-off. Although most of these benefits have been achieved, we will continue to pursue additional opportunities. The process optimization initiative has the potential to significantly reduce costs across areas such as maintenance and reliability, distribution and logistics, and sourcing as we leverage advanced technology and data analytics. These initiatives will deliver meaningful benefits in 2023 as we finish implementing new capabilities across our businesses. And finally, strategy acceleration is about delivering profitable growth through commercial and investment excellence. Getting our Global Cellulose Fiber business to deliver value-creating returns is one example of this. We are also focused on profitably growing our Industrial Packaging business by improving margins and investing for organic growth. Turning to Slide 13 and a look at the fourth quarter outlook. As Mark mentioned, our earnings will remain under pressure in the near term given the current demand environment. With that I'll start with Industrial Packaging. We expect price and mix in the export channel to be lower by $10 million, volume is expected to decrease by $30 million with four less days sequentially in North America and the traditional seasonal pickup from holiday demand is not expected to be as strong this year. This will be partially offset by seasonally higher produce volume and EMEA packaging. Operations and costs are expected to decrease earnings by $120 million. A little more than half of this is from the higher unabsorbed fixed costs resulting from lower volumes, as well as seasonally higher costs primarily from energy consumption and labor benefits. The remainder includes such items as inflation on materials and services, and the timing of spending. Maintenance outage expense is generally flat. And lastly, input costs are expected to decrease by $80 million from lower fiber and energy costs. In Global Cellulose Fibers, we expect price and mix to improve by $20 million on the realization of prior increases. Volume is expected to decrease by $10 million based on timing of shipments through the supply chain. Operations and costs are expected to increase by $5 million due to seasonality while maintenance outage expense is expected to increase by $34 million. Lastly, input costs are expected to increase by $5 million, primarily related to energy costs at our converting operations in Poland. Turning to Slide 14, I'll take a moment to update you on our capital allocation actions in the third quarter. As Mark mentioned earlier, we have a very strong balance sheet, which we will preserve because we believe it is core to our capital allocation framework. Our 2021 year-end leverage was 2.3 times on a Moody's basis, which is below our target range of 2.5 to 2.8 times. Looking ahead, we have limited medium-term maturities with about $1.3 billion due over the next 10 years. And finally, even in this environment, the risk mitigation strategies we've taken to ensure our pension plan remains fully funded are in place and are delivering. Returning cash to shareholders is a meaningful part of our capital allocation framework. In the third quarter, we returned $434 million to shareholders including $269 million through share repurchases, which represents 6.4 million shares or about 1.8% of shares outstanding. As a result, we've returned approximately $1.6 billion of cash to shareholders so far this year. In October, our Board of Directors authorized an additional $1.5 billion of share repurchases, which brings our total authorization to approximately $3.4 billion. Going forward, we are committed to returning cash through maintaining our dividend and through opportunistic share repurchases. Investment excellence is essential to growing earnings and cash generation. We are targeting between $900 million to $1 billion, which includes the funding cost for cost reduction projects with attractive returns for strategic projects to build out capabilities and capacity in our box system to support future profitable growth. We will continue to be disciplined and selective on assessing M&A opportunities that may supplement our goal of accelerating profitable growth. You can expect M&A focus primarily on bolt-on opportunities in our packaging businesses in North America and Europe. Any potential opportunity we pursue must create compelling long-term value for our shareholders.

Mark Sutton, Chairman and CEO

Thanks, Tim for all the details. Look, this is clearly a very dynamic environment with a lot of moving parts. As I look back across our company, I'm really proud of the improvement we've made in customer service over the last several quarters considering where we were in the middle of last year with Containerboard inventory issues and box plant availability for our customers. The reliability improvements we've made in our mill system both in Global Cellulose Fibers and in Containerboard, I feel really good about because we're running very, very well in some cases at levels – productivity levels that are the best we've ever run. I also feel good about the progress our Global Cellulose Fibers team is making and the trajectory of the profitability earnings and the business model changes we've made that Tim described a bit earlier. At the same time, I'm not at all satisfied with the level of our profitability, which has been impacted by supply chain disruptions, inflation, and falling demand in the second half of this year. But I am certain, we will make improvements in this area. I'm also very certain about the resiliency of International Paper. During the past few years, we have significantly enhanced our financial strength and flexibility and taken a lot of risk out of the company. This strong foundation makes IP well positioned for success across a wide spectrum of economic environments. So with that operator, we're ready to take questions.

Operator, Operator

Our first question comes from Bank of America and the line of George Staphos. Please go ahead.

George Staphos, Analyst

Hi. Thanks very much. Hi, everyone. Good morning. Thanks for all the details, Mark and Tim. First question broadly on containerboard and the second one on pulp. So in containerboard, can you talk to us about what benefit you expect to get from the optimization efforts on a run rate basis, what the horizon would be in terms of when you expect to be at a more optimized level that you're targeting? And how do current box shipments and trends play into your optimization? And what are you seeing early in the quarter?

Mark Sutton, Chairman and CEO

So early in the quarter, we are observing, as Tim mentioned, that box shipments are still stabilizing from their exit in the third quarter, which is down about 6% from where the quarter worsened slightly. The issue we're addressing regarding cost structure optimization is somewhat unique at this moment compared to previous periods. We are experiencing a significant number of production slowdowns in a relatively short timeframe, especially as most of our maintenance outages are behind us. In prior periods when we adjusted output to align with demand, those adjustments were more evenly distributed. Some adjustments occurred in the first half of the year alongside maintenance outages. In the third quarter, much of the adjustment happened in the last two months. The fourth quarter adjustments are spread more evenly but are still an attempt to anticipate demand while remaining flexible to increase production if demand rises. Therefore, I believe the fourth quarter will be a transitional period. The last meaningful economic downtime in our containerboard system was in 2019, and if we compare the variable cost per unit of production from that time, we're actually performing a bit better now. However, what is different this time is that we are operating in a high inflationary environment. The prices of many of our inputs remain persistently elevated. We expect some relief in the fourth quarter, but it hasn’t fully materialized yet. In 2019, we weren’t contending with that aspect of costs, but our teams are well-prepared to handle it. Additionally, we didn't have such high energy costs back then. Our current objective is to maximize our self-generated energy, which is something anyone in any industry that produces their own energy would strive for now. However, this goal must align with the actual production output required, which in turn influences how we operate our pulp mill. I anticipate that we will see ongoing improvements in controlling those marginal costs throughout the fourth quarter.

George Staphos, Analyst

Thanks Mark. My other question on pulp. So you said, I believe, demand for GCF was stable yet your customers' inventories are still relatively low. You've seen some improvement, but not a lot, I'm paraphrasing there in the supply chain. So with inventories low, did customers pick up their purchases relative to where they otherwise would have been because they could access more material, because the supply chain has improved? And as we look out over the next couple of quarters presumably the supply chain improves, do you think that will lead customers to purchase more and improve their inventory position, or now that it will be much more hand-to-mouth, because supply chain has improved and so the need to have inventory will diminish somewhat? Thanks guys. Good luck in the quarter.

Mark Sutton, Chairman and CEO

I think the low levels of inventory for this particular type of product given it's not easily substitutable in the short term given the qualifications, the low levels of inventory make the value chain very nervous. And so I think customers will work to get to some level of comfort that they're used to. I don't think anyone will trust the supply chain for quite a while to be the answer to, I can run with a lot lower inventories. Some of our shipments as Tim mentioned, or alluded to, we shipped a little more than we expected partly because the supply chain velocity improved a little bit as you paraphrased. We don't know for sure if that's permanent or if that was just in the third quarter, we hope it's going to get better because it will help us lower our cost. But we still have the issues in the market. For example, China's market is still semi-closed with some of the lockdowns. We think the inventory situation is going to remain strained meaning low finished products throughout the value chain for the coming several quarters. And so we think that the demand is stable. It could improve if China figures out their vaccine strategy and maybe opens the economy a little more. But right now, what we see is stable demand going forward a lot of commercial improvements that will flow into 2023, and the ability with a little bit better supply chain to really start to take cost out of our system that we get to keep.

George Staphos, Analyst

Thank you, Mark.

Mark Sutton, Chairman and CEO

Thanks, George.

Operator, Operator

Thank you. Our next question comes from Citi and the line of Anthony Pettinari. Please go ahead.

Anthony Pettinari, Analyst

Good morning. Just following up on inventories maybe on the Containerboard side, how would you characterize customer inventories here in October as well as your own inventories? And to the extent that there's maybe an overhang still in the channel? Like how long do you think it might take to work through that?

Mark Sutton, Chairman and CEO

So I think there's – if you go back to the slide Tim showed, Anthony, with the yellow and red segment descriptors. Those that were – the demand declined more than the average demand. Those are the customers in those segments. And we have very big customers, national-type accounts, and we have very small customers inside of each of those little segment descriptors. Those that were greater than the average a big portion of their commentary to us on their order pattern was too much inventory. And we think they think best they can tell from the consumer. I watched a few of their earnings calls earlier this week. That's a fourth quarter unwinding process, but maybe not terribly much beyond that. If you look at the other part of that chart where our decline in some cases we didn't break it out. But in some cases, we had customers inside the segments that the demand didn't decline at all. And they're very big and important customers to us. And they would say their inventories are a little high, but we'll see what happens with fourth quarter consumer demand. They're predicting a little less of a holiday pickup, but any pickup at all, and they'll feel like they're in great shape. So it's really a tale of those segments on that chart we showed. But even in the worst-case, we think most of our customers believe that this is working through the fourth quarter process. Obviously, you hate to make a prediction because there's so many variables that come up and inflation is still persistent and high. The consumer can be fickle after this holiday period and spending a lot of money on services, what happens to the goods market in the first quarter I think that's what a lot of us are trying to figure out right now.

Anthony Pettinari, Analyst

Okay. That's very helpful. And then just with the updated CapEx guidance, can you remind us kind of how you think about normalized maintenance versus growth versus regulatory CapEx to the extent that you're maybe trimming some of that maybe where is that coming from? And then understanding you're not giving guidance on 2023 just kind of directionally are there capital needs for the business that might cause CapEx to go higher next year? Could it go lower? Do you think you're kind of in a good position here? Just any incremental thoughts on CapEx?

Tim Nicholls, Senior Vice President and CFO

Yeah. Great. Thanks, Anthony. It's Tim. So over time longer term, we look to have capital investment around the level of depreciation. It can be a little bit higher in some years. What usually drives that is not so much maintenance and regulatory. We try to keep that fairly consistent. We look over a five-year period. We have five-year plans about how we're going to do maintenance schedules. What tends to drive it up and down a little bit on the margin tends to be more of the strategic projects whether it's building out capability or more recently, adding capacity in our converting operations. So — but the $900 million to $1 billion is not necessarily us actively pulling back capital. It's just coming to the realization this close to the end of the year that as hard as we've tried all through the year, supply chain has been a limiting factor about how much capital you can have installed and have it be productive in a given period of time. So that's the reason for the adjustment. Just acknowledging that we're not going to get as much done as we thought we were earlier in the year. And longer term, we'll try to be around depreciation. But where there's either good cost reduction projects or strategic needs building out capability, it could be a little bit higher than that in given years.

Anthony Pettinari, Analyst

Okay. That’s very helpful. I will turn it over.

Operator, Operator

Thank you. Our next question comes from Bank of Montreal and the line of Mark Wilde. Please go ahead.

Mark Wilde, Analyst

Thanks. Good morning, Mark, good morning, Tim. Mark, I wanted just to start out. You took a lot of economic downtime in the third quarter and you're suggesting more in the fourth quarter. I just wondered, given that level of downtime and coupling that with all the new capacity that's coming into the industry over the next 15 months, are there some more efficient ways to adjust your capital base over the next 12 to 18 months whether it's some permanent moves, or maybe moves like we saw Valeant several years ago when they just mothballed one of the machines. Or is just continuing to take kind of rolling downtime across the system is that the optimum approach?

Mark Sutton, Chairman and CEO

It's a great question, Mark. I think the variables we look at of course, we don't know what the demand environment is going to be over the next year or two and we don't know exactly what the ramp of the new capacity you mentioned will be. So there's a lot of variables. The other thing that's a little different and a unique addition to the algorithm we use to figure out how to take downtime is one, we have very high natural gas costs, which changed the competitiveness of your recycled mills and we have a few that are 100% recycled. The flip side of that is you've got a very expensive and congested supply chain. So an IP example would be our large recycled mill that's up in the Midwest might be a candidate to scale back for energy costs, but it defeats our ability to save on logistics because it's so close to the market. So one of the reasons you see us doing more of as you described rolling, so not fully shut them down but adjusting the output of multiple plants is to try to make all of that balance, get our integrated mills to be as close to energy independent as possible. And our non-integrated mills, which tend to be located physically in places, and they were built for that reason to be close to the end-use market and they're beyond a lot of the real choke points to get those to serve as much. As things change, as supply chain costs change, as energy changes, it will lead us to different conclusions. So that's how we make that decision on how much we run to our order book and where we do it.

Mark Wilde, Analyst

Okay. And then I wanted to just turn to sell. I know that this whole strategic effort in cellulose over the last few years has a number of different elements. And so just, if we look at the pulp price charts right now, they're at the highest level any of us have ever seen. So can you just help us on this call, get confidence that if pulp prices start to rollover, you're actually going to be able to maintain those cost of capital returns going forward in cellulose? So it's not just the market that's gotten you there at this point?

Mark Sutton, Chairman and CEO

I believe if you examine a few indicators, you'll notice that we've aimed to enhance our value proposition by forming strategic arrangements with customers instead of merely relying on contractual volume for pricing. Additionally, our participation across various global regions reflects the nature of our products and the requirements customers have regarding substitutions and ensuring we receive appropriate compensation. Some charts in specific regions already show signs of this trend emerging without affecting the economics of our absorbent products. This is because we've adjusted our strategy to collaborate more closely with customers, effectively decoupling our operations as much as possible. Your observation is valid, and we will see how this develops through a typical business cycle. We are confident that we've made fundamental changes in our market approach. While there may still be some cyclicality, we anticipate a different spread over time compared to what we've seen in the past, with upcoming quarters serving as proof. As I mentioned over a year ago, investors should expect that the changes we are implementing for Global Cellulose Fibers will lead to consistent improvements, allowing us to achieve cost of capital returns in the second half of 2022. You can expect this business to create value as we transition into 2023, and so far, we're on track. Let's continue to discuss our progress quarter by quarter. Your point is very relevant, and we will gain more insight into whether our strategy adjustments demonstrate resilience and sustainability as we move into 2023, and I believe they will.

Mark Wilde, Analyst

Okay. That’s helpful, Mark. I will turn it over to some other questions.

Operator, Operator

Thank you. Next from Seaport Research Partners, Mark Weintraub. Your line is open.

Mark Weintraub, Analyst

Thank you. I'm trying to understand the extent of downtime you experienced in the third quarter while adapting to the demand environment. Your North American system order volume is 13.5 million tons, translating to about 3.5 million tons per quarter. The economic downtime was around 400,000 tons, which suggests your operating rates are at approximately 85% to 90%. Additionally, Containerboard production appears to have decreased by more than 10% year-over-year. I have two questions: first, have you been reducing Containerboard inventory during this quarter? Second, did I understand correctly that you expect to take as much or potentially more in the fourth quarter?

Mark Sutton, Chairman and CEO

So Mark, it's a multifaceted question. Let me just take you back to a higher level. So the Containerboard system has a certain capacity. It's a little higher than the number you mentioned. And the way we run it is not by quarter. I mean, we have to do what we have to do in a single quarter. The way we think about our system is we have a certain amount of output capability. We strategically target about 3% of that, and you can look at our earnings calls from the past and how much volume we take out for planned maintenance ends up being around between 3% and 4%. Then there's another 3% to 4% that we tend to average just in terms of being flexible for customer service for unforeseen problems. And so every once in a while to match a change in demand like 2019, we'll adjust our output to match a reduced demand environment. And that again has multiple variables. It depends on how strong the export market is during the same period. Sometimes the markets are connected, sometimes they're not. That number as a percentage of our total capacity in 2019 was probably 6%, 7% of our total capacity once in a multiyear period. And I don't know what it's going to be. We don't forecast. We're just trying to match up the principle of we're going to make the Containerboard we need to serve the order book we have and to maintain what is much healthier inventories for our supply chain. And those numbers as you know for almost every industry are a little higher in this type of supply chain environment. But that's the way you should think about it. Think about it big picture not in a 60- or 90-day period. There's a system, there's maintenance, there's flexibility time, and occasionally there's an adjustment. And that's the kind of way it's going to play out. Roughly the percentages I gave you if you annualize; what's unique about this, and I mentioned it in the prior answer, is the market slowdown in quarters that normally the market is not slowing down and for IP in quarters where we don't have any other maintenance outages that would normally be taking production offline like we had in the first half of the year. So that's the difference is. That's what adds to the cost mitigation challenge.

Mark Weintraub, Analyst

Thank you. That was helpful. To clarify, I want to understand whether the downtime you experienced was due to maintenance and related factors. If we remain in a demand environment that's down 6%, do you expect to maintain this level of downtime? Or was the downtime on the board side greater than what the box shipment environment would suggest?

Mark Sutton, Chairman and CEO

So again, Mark, the way you need to think about the answer to that question is any downtime we take is a product of doing the analysis of our North American order book, our export order book, any maintenance outages that would already take production offline, and I think Tim mentioned it, how well we're running in the moment. So we're running really, really well right now i.e., we're making too much containerboard, which is where you want to be, that's what we worked on to be reliable. What that means in plain speech is, the lack of reliability interruptions in the quarter which is a good thing, but not in a quarter where you necessarily don't need the production so you end up slowing back. But at least you didn't have a repair cost. So it's impossible to answer the question without knowing the answer to all four of those variables I just gave you.

Mark Weintraub, Analyst

That's really helpful. I believe you have enhanced your system. You can actually produce more products if you maintain this pace, which relates back to Mark Wilde's question. Does this provide you with some added flexibility to reconsider your footprint based on your current situation? Is that a fair observation?

Mark Sutton, Chairman and CEO

I believe it's important to consider my response to Mark's question in the context of the current situation. If we look at other factors like transportation and logistics costs, along with energy costs, and aim for production at the lowest marginal cost, that could change rapidly due to unforeseen events like a hurricane affecting operations. My point is that the decision-making involves a dynamic range of variables, and we assess these not in real time but typically over a span of 7 to 10 days. So, if the answer to how we produce what we need at the lowest cost includes some of the examples you and Mark mentioned, then that's the approach we would take. However, given the current circumstances related to supply chain and energy, it's not the most cost-effective way to proceed right now.

Mark Weintraub, Analyst

Thanks very much.

Operator, Operator

Thank you. Then our next question comes from Truist Securities and the line of Mike Roxland. Please go ahead.

Mike Roxland, Analyst

Thanks. Hi Mark, Tim. Thanks for taking my question. Just wanted to follow up I guess on your inventory as well just following up on Mark's question and Anthony's questions about the overall aggregate level of your inventories during the quarter. Can you give us a sense of where they stand? I mean I remember last quarter you mentioning that your containerboard inventories are now back to sufficient levels. But with demand slowed aggressively that has given the economic downtime you've taken given some of the slow backs would you be starting to say that your inventories have declined sequentially and relative to your comments from last quarter?

Tim Nicholls, Senior Vice President and CFO

Yes, we achieved the inventory levels we aimed for during the quarter. The reaction observed was primarily in the middle of the quarter, as Mark mentioned, and it was a response to ensuring that our inventories remained manageable. We are closely linked to demand, and our Sales & Operations Planning process is designed to consider not only immediate needs but also future product availability requirements. Consequently, we successfully maintained our inventories at desired levels through effective system management.

Mark Sutton, Chairman and CEO

Mike, I want to emphasize that our decisions are based on what we anticipate in the future. We need to consider the calendar and how adjustments to inventory at this time of year differ from those made in the middle of the year, especially as we approach the first half of the year, when 75% of our maintenance outages occur. A key aspect of our operating strategy is to ensure we have the necessary inventory for the first and second quarters of next year to avoid losing sales due to inventory decisions made in the fourth quarter without considering upcoming events. Our planning includes more than just managing inventory for the fourth quarter; if we were in the second quarter after the outages, we would have ample inventory without any mills down. However, we are heading into our regular outage season, which influences our expectations and preparations, regardless of whether there is an economic slowdown, to effectively manage our outages.

Tim Nicholls, Senior Vice President and CFO

Yes. The other thing I would add is, even though we've seen some modest improvement in transit times with ocean vessels here on the ground in North America as well in trucks. Our network, the supply chain has not picked up a lot of velocity. So, we're still dealing with the extra time it takes to move product in between mills and converting operations.

Mike Roxland, Analyst

I understand, thank you for the clarification. I just have a quick follow-up. If demand continues to be low during this quarter and into the early part of next year, would it be correct to assume that if production doesn't ramp up as needed, that would be the point at which you would begin to reduce your inventory? Mark, you mentioned this might happen in the second quarter. However, if we find ourselves in early first quarter with a demand drop of around 6%, would you start to decrease your inventory at that time?

Mark Sutton, Chairman and CEO

We will adjust our system to align with the demand we are anticipating. While we are uncertain about the demand in the first quarter, we will have a clearer picture as we approach that time. If supply chain efficiency has improved, we won’t focus solely on inventory levels but rather on ensuring we can meet our customers' needs. We prepare our business because what we produce today will be utilized in the future, not immediately. Consequently, we have already accounted for today's inventory with yesterday's production. This uncertainty makes it challenging to provide a definitive timeline, as many factors are involved. We require less inventory when the supply chain is functioning smoothly than when it is not. Currently, the supply chain is not fully operational, particularly with rail transport, as many of our mills are located in the Southeast, where rail issues persist along with a challenging labor situation. Therefore, we are working with the information currently available. This information indicates that our current inventory levels correspond to the slow movement of the supply chain. If that dynamic shifts, we will modify our production to reflect the faster movement of inventory. Ultimately, it is not a simple decision to reduce inventory; rather, it is influenced by various factors that dictate the inventory number.

Mike Roxland, Analyst

Got you. Appreciate all the color. Good luck for the balance of the year.

Mark Sutton, Chairman and CEO

Thank you.

Operator, Operator

Thank you. Then our final question for today comes from Adam Josephson of KeyBanc. Please go ahead.

Adam Josephson, Analyst

Mark and Tim, good morning. Thanks very much for taking my questions. Mark just one more kind of way of asking that capacity question that I think both Marks were getting at is obviously you have to hazard a guess as to what long run demand will be to figure out what the optimal level of capacity is. And obviously, there is this exceptionally unusual surge in demand during the pandemic and now we're starting to see the other side of that. So, when you're thinking about the right amount of capacity to have long term how are you thinking about the right level of demand? Obviously, it's near impossible to forecast it. But are you thinking that 2019 levels were kind of normal or what the long run rate of demand growth will be? Obviously, there's capacity coming that I think Mark Wilde mentioned. So, how are you thinking about all those factors when determining what the right level of long-term capacity is for you?

Mark Sutton, Chairman and CEO

Yes, Adam, I appreciate your perspective. The long-term capacity we anticipate is based on our views of the markets we serve, particularly as they normalize post-pandemic, unless there are significant changes in the US economy structure. Traditionally, the growth for box demand has been around 1% to 2%. The open market is similar since we sell to box manufacturers in the same market, and global virgin containerboard also shows a growth rate of 2% to 3%. We usually aim to position ourselves strategically within the most profitable segments of these markets. Currently, taking these figures into account, we feel confident about our containerboard capacity. We made a substantial investment in Riverdale in 2020, enhancing our high-quality white top capacity, and have also undertaken smaller project investments across the North American system in previous years. We've developed the necessary containerboard capacity and are exploring various grades and lighter weights. Our approach is to align our containerboard capacity with anticipated demand for box production, which is the largest segment, as well as the open market for North America and exports. We didn't pivot our strategy in response to pandemic-driven demand; rather, we recognized that we couldn't operate at full capacity in our converting operations. While it's possible to temporarily increase capacity with overtime labor, that isn't sustainable long-term. The pandemic taught us the importance of a robust asset strategy. However, we haven't altered our long-term growth outlook for containerboard and its applications.

Tim Nicholls, Senior Vice President and CFO

No, I think part of what you're getting at, Adam, is the pull forward that maybe some of the industry saw primarily around durable goods, but durable goods is a small segment for us and small in total. A lot of what people are buying are consumable items. So, it's not like there's a significant demand pull forward in some cases, but I don't believe that's the bulk of it. I think we have seen the shift that Mark talked about between goods and services, and that will normalize at some point too.

Adam Josephson, Analyst

Yes. No, I appreciate that. And just Tim one on the dividend. So, your balance sheet, you've done a lot of work to get it in much better shape than it used to be and kudos to you for that. When I think about the dividend payout, so just in light of what you're guiding to for this year, the $900 million to $1 billion, if I assume that you sell or do something with your Ilim stake, that would mean that you wouldn't get that $200 million-ish of cash dividends next year and thereafter for that matter. Such that ex-Ilim you'd be paying out, I think what 90% of your free cash flow this year. And obviously you have a view of where trough cash flow is a normalized cash flow peak cash flow. How are you thinking about the dividend path in light of what you're guiding to for this year in light of what you're hoping to do with Ilim et cetera?

Tim Nicholls, Senior Vice President and CFO

Yes, that's a great question, Adam. We consider 40% to 50% of free cash flow as our target for dividends. However, this is not a fixed figure; it varies over time. There have been instances when our dividend payout has exceeded this range, and at other times, it has been on the lower end as well. Currently, we believe that our dividend structure remains solid. While we have also bought back a significant number of shares, it still aligns within that 40% to 50% range of free cash flow. We continue to have confidence in the resilience of our cash flow over the long term.

Mark Sutton, Chairman and CEO

Yeah. I think it's important to know, Adam, that what Tim said is really, really important. 40% to 50% over a cycle, which means it's going to be at the upper end. And it could be the number you just gave. And it could be much lower and be at the lower end it has even dipped into 30-something percent of free cash flow. But the dividend is really important to us. It's really important to our investors. That's what we hear from investors. And it is important for us to make sure that it's not a tactical thing that we calculate free cash flow for a given year, and then we say oh 50% of that. That's not how we do it. It's 40% to 50%. It's an overall guideline through a cycle. And a lot of things happen to converge in trough conditions which you might describe as low demand and all its negative impact usually followed by lower cost environments unwinding of working capital. Cash, as you know, has many components but that's the way for people to think about our dividend. It's not a calculation in the moment pick your moment quarter half year, year. It's through a cycle. And I just want to be really clear about that.

Operator, Operator

Thank you. Then our final question for today comes from Deutsche Bank and the line of Kyle White. Please go ahead.

Kyle White, Analyst

Hi. Good morning. Thanks for taking my question. I was just hoping to get some more details on demand. I know it's been talked about a lot, but I'm just trying to understand the two large dynamics impacting demand here the destock impact and no inflationary pressures on consumers. We kind of knew about the destock impact heading into the quarter but you mentioned that demand saw a sharper decline midway through. So it seems like inflationary pressures are now taking over and having a larger impact on demand going forward. So should that not carry kind of forward into 2023 such that we could see mid-single-digit declines in the first half of 2023, or just what are you seeing now, and how are you thinking about that for next year?

Mark Sutton, Chairman and CEO

Sure, Kyle, that's a really insightful question. We're engaging in discussions with our customers about this. Our business typically has a shorter cycle, so we have some insight into the fourth quarter. However, looking into the first quarter, the visibility is limited mainly to algorithms and analytics. What we've heard from our customers is that due to persistent inflation, they are faced with choices. Given the time of year as we approach the holidays and more travel, they are opting to spend on services or save for future travel instead of discretionary items. As we move through the fourth quarter and consider the impact of service spending, it raises the question of where consumers will be in the first quarter. This largely depends on how the slowing market and economy influence policies and interest rates, along with consumer sentiment. Bank CEOs suggest that consumers are still in relatively good financial shape, which is evident in their bank balances. However, this could change if inflation stays around 9% or 10%, along with high rents and other factors. These are the key variables we are monitoring, as are our customers. Regardless of the economic conditions in the early part of next year, we will adapt. We'll need to see how consumers navigate through their service-oriented holiday spending and whether their choices will shift. It appears they are favoring services over goods right now, but once service spending is done, will they return to purchasing goods? As Tim pointed out, some of this relates to consumables—will we see a return to usual purchasing patterns in the first quarter? It's an important question, and we will have a clearer understanding as we progress through the fourth quarter. By the end of January, during our full year call, we'll have a much better perspective on the situation.

Kyle White, Analyst

Got it. That's very helpful. And then what's the latest on Ilim? Understanding you can't share all the details, but just curious what you can on the call like this regarding the timing of potential sale that you think could happen there? And then also curious do you expect to receive any additional dividends from Ilim next year or in the future?

Tim Nicholls, Senior Vice President and CFO

Yes. We're not forecasting dividends into next year. We're in the middle of the process. And you're right there's not a whole lot more we can say about it. But we feel good about where we are. We have made progress and we're pushing hard.

Mark Sutton, Chairman and CEO

I mentioned earlier that we are not at the same point we were at the beginning of the quarter. We have made significant progress, but it is a complex process. Since it is a joint venture and not wholly owned, executing strategic options under the current guidelines from both governments is more time-consuming and complex. However, we have made considerable advancements in the timeline of that process. I am pleased with our progress, but we are not quite there yet, which is why we are being cautious about our position. Overall, I feel good about the progress we made during the quarter.

Kyle White, Analyst

Got it. Thank you for all the details.

Operator, Operator

Thank you. Then I'd like to turn the call back over to Mark Sutton for closing comments.

Mark Sutton, Chairman and CEO

Thank you, operator. I'd just like to close by really saying thank you to all the International Paper team members and employees around the world for what they're doing every day for our customers and for each other. To stay safe and to operate in environments that I don't think any of them ever thought they'd be operating in and they continue to do an outstanding job. I'd just like to close by reiterating a couple of comments I made. We think the second half of this year is clearly transitory. We're taking the actions we need to take, pulling the levers we need to pull to make sure International Paper gets through this period in a very good way. And I'm really pleased with the kind of financial underpinnings we have entering into any type of economic environment. We have a lot of opportunity and flexibility even at lower demand levels. And in some cases, there could be a silver lining and the fact that it allows us to get some of our supply chain dysfunction back into a proper alignment. The strong balance sheet gives us options. So we can continue to make organic investments in structural cost reduction and in strategic capacity and capability. In the past we would have probably had to stop some of that, just to manage the balance sheet. There's no meaningful debt for the foreseeable future that we need to deal with. So we've got a lot of risk off the table. We're built for this type of environment, and we're built for a strong environment. And I feel good about our ability to get through it. Look forward to talking to you with our full year call at the end of January. So thank you for your interest in International Paper.

Operator, Operator

Then ladies and gentlemen, thank you for your participation in International Paper's third quarter 2022 earnings call. You may now disconnect.