Recently, a subscriber asked me to write an article on International Paper (IP). I’d like to start this piece out by saying that this isn’t a name that I own. It’s not a name that I follow closely. But, I am aware that IP and various materials names have sold off recently. The threat of slowing global growth doesn’t bode well for this cyclical type of name. It’s actually this cyclicality that has kept me away from the stock in the past. It’s difficult for me to own names with relatively unpredictable earnings. Earnings volatility also makes dividend growth unpredictable. And, in IP’s case, the stock’s economic sensitivity resulted in a large dividend cut during the Great Recession. However, with all of this being said, it’s true that IP is on a 9-year annual dividend growth streak and the stock’s valuation is incredibly cheap. Now, it’s time to attempt to figure out whether or not this is a great value or a value trap drawing income oriented investors in with its 5.4% yield.
The paper industry is an interesting one to study. This space has seen a ton of consolidation in recent years. IP has been the biggest player all along, and throughout this consolidation process, the company has been able to raise prices and therefore margins. This has resulted in strong profitability growth. Now that the consolidation has run its course, IP has strong competitors in the market and it appears that much of its volumes are being commoditized. Furthermore, competition is coming from emerging markets (paper products don’t exactly take rocket science to produce) and this could create another headwind for IP’s margins. With this in mind, I don’t think that IP has much (if any) of a competitive moat.
With the rise of eCommerce, one might think that the paper business has secular growth headwinds. Someone has to produce all of those Amazon (AMZN) boxes, right? But, other than in the corrugated packaging business bolstered by eCommerce, the paper space is seeing demand headwinds. As we move further into the digital age, paper consumption continues to fall. This doesn’t bode well for IP. Fluff pulp demand appears to be steady, yet margins are falling in this space. In short, IP appears to be facing secular headwinds. Personally, I’m avoiding this name for some of the same reasons that I’m avoiding another yield high dividend growth investor favorite, Iron Mountain (IRM). To me, these are twentieth century businesses and we’re operating in a new millennium.
In recent quarters, we’ve already seen the company having to take economic downtime in an attempt to maintain pricing levels. The largest players in the industry are doing the same thing. I am impressed by the discipline that these management teams maintain. Thus far, even in the face of demand headwinds, they’ve maintained margins and cash flows. The macro issues that the global economy has faced in recent quarters due to trade concerns and geopolitical fears certainly haven’t helped names like IP, yet I can’t be certain that the demand issues in the present are going to recover once the trade war is over. As a long-term investor, I’d rather not expose myself to companies (or broader industries) that face secular headwinds like these.
At first glance, valuation is the most appealing aspect of International Paper at the moment. While I wouldn’t put this stock in the blue chip/S.W.A.N. (sleep well at night) category from a dividend growth perspective, I do acknowledge that it’s a market leader with its nearly $15b market cap. Regardless of industry headwinds, one would assume that the increased volumes that a market leader like this has would result in some degree of pricing power relative to smaller peers and this in itself should result in a slight premium. However, IP shares are trading with a discount relative to the company’s closest rival, WestRock (WRK). WRK shares are trading for ~8.1x TTM earnings whereas IP shares are currently being priced with a 7.65x multiple.
This 7.65x multiple is essentially in line with the TTM multiple that the market assigned to IP during the Christmas Eve sell-off. This is my go-to short-term comparison when looking for value in today’s market. The steep dip that we saw late last year ended up setting a lot of 52-week lows in the market and the bottom there has become strong support for many stocks that I follow. IP hasn’t quite crossed below that thresh from a valuation perspective, though it is worth noting that the stock price is actually much cheaper now than it was back in December of 2018 because IP has posted significant negative earnings growth year-to-date.
This is a perfect example of when a lower stock price does not exactly mean that the shares are cheaper. Moments like these are oftentimes what create value traps. Investors see stocks down double digits, hitting 52-week lows, or in this case, hitting multi-year lows, and assume that they must be great bargains. But, it’s much more important to pay attention to the underlying fundamentals that share prices are based off rather than the share prices themselves.
Looking at the F.A.S.T. Graph below, it’s clear that IP shares are beaten down. But, deciding whether they’re cheap, or more importantly, at which level discount level would I potentially feel comfortable buying shares, is a much more difficult decision.
IP is trading at levels well below their average over the last decade or so. Looking back longer term, the present discount is even greater. But, that’s only part of the story. IP’s bottom-line growth story is a bleak one (looking out into the short term at least).
Analysts expect to see IP’s EPS drop nearly 20% in 2019. And, things don’t get brighter after that. The consensus analyst estimate for 2020 EPS is $4.07/share, which represents another 10% drop from the 2019 year-end estimate. And, in 2021, they’re still expecting to see negative EPS growth. In short, there doesn’t appear to be a turnaround anywhere in sight. Granted, these analyst estimates should always be taken with a grain of salt. No one can predict the future. But, considering that IP is a relatively large company with a decent analyst following (according to Yahoo Finance, there are 12 analysts on Wall Street with a price target for IP at the moment), I’m happy to consider the consensus estimates into my due diligence process.
But, even with this negative outlook, one could still consider IP to be an attractive value. Even if the analysts are correct and 2021 EPS comes in at $4.00, we’re still talking about a multi-year forward multiple of 9.2x. That is well below IP’s long-term average, signifying that if IP experiences any sort of mean reversion resulting in multiple expansion, shares purchased in the $37 range have double-digit potential upside.
But, the question remains, will mean reversion occur? And, should it even occur? Because if growth is going to be negative in this industry long term because of secular headwinds, then the stock should be priced with a discounted multiple.
IP’s 5.44% dividend yield is certainly attractive. As I said in the introduction, IP has a 9-year dividend increase streak. That’s not bad. It implies that management is generous to its shareholders. Management has also used cash flows to successfully retire a decent amount of IP’s outstanding share base in recent years via a repurchase program, further solidifying this idea. However, I think it’s important to note that dividend growth has slowed down significantly in recent years.
IP has gone from a company known for double-digit growth to one posting dividend growth in the mid-single digits. IP’s most recent dividend increase came in at 5.26%. Granted, 5% dividend growth on a 5%+ yield is nothing to scoff at. IP’s Chowder Number is in the double digits, which is one of the things I usually look for in a potential investment. But, Chowder Numbers are largely backwards looking and I worry that the recent slowing growth trend that we’ve seen will continue as IP’s EPS growth outlook suffers.
Slowing growth aside, for the time being, IP’s dividend appears to be safe. Though, I want to really emphasis the phrase “time being”.
IP’s annual dividend is currently $2.00, so taking the current consensus 2019 EPS estimate of $4.53 into consideration, we’re talking about a relatively conservative payout ratio of just 44%. Even if the multi-year negative EPS growth scenario that analysts are expecting plays out, we’ll still be looking at a ~50% payout ratio in 2021.
That’s using the current $2.00 dividend. I’m sure some of you expect that IP will continue its growth streak and, therefore, will be paying a higher dividend in a few years. I imagine that this is possible due to the current low payout ratio, though I fear for long-term dividend sustainability if management cannot generate top- and bottom-line growth.
In other words, this dividend growth story could easily last a few more years regardless of industry headwinds, but for IP to become a dividend aristocrat, the company is going to have to evolve in some way that I can’t current imagine. To me, history is set to repeat itself here. If/when a recession hits, I suspect that we’re going to hear about even more economic downtime in the paper industry. This may help the companies to maintain margins, but if volumes fall too far, the cash flows will no longer support dividends at current levels and I think we’ll see another cut. The falling dividend growth rates that I discussed above could be the harbinger of this potential reality coming to fruition.
With this in mind, I’m not interested in owning shares of IP. Obviously calling for a dividend cut at this point is speculative, but all forward looking estimates are and I see much more risk here than I do reward. The best thing about IP’s current dividend is its yield, and while the 5.44% yield is roughly 50% higher than the company’s 5-year average dividend yield of 3.61%, I think there are other 5%+ yielders in the market that offer me better relative dividend safety and dividend growth outlooks.
Because of my concerns about dividend safety/sustainability long term, IP can cannot be viewed as a dividend growth investment (in my eyes, at least). To me, this is a contrarian deep value pick, at best. This is essentially the same conclusion I came to when writing about WestRock a few months back.
I certainly understand the draw that these paper names have to investors with their low P/E multiples and their high dividend yields, but at the end of the day, they just don’t meet my portfolio goals. My priority as a portfolio manager is to generate reliably increasing dividend income. This time I want to emphasize reliably. That’s the most important part of my mission statement and IP doesn’t fit the bill.
With that being said, I will be the first to say that IP could have major upside potential for those with the intestinal fortitude to buy at these levels. If I’m wrong at all about the secular nature of the headwinds in the paper industry, not only could the stock’s share price increase dramatically, but management could continue to provide strong dividend raises. If you’re bullish on the paper space, then this stock is a no-brainer pick here at 7.6x earnings. If the headwinds turn out to be short term and dissipate and this stock starts to trade closer to its long-term average, you’ll be looking at total returns in the ~50% range. This is usually the nature of contrarian value picks, and I imagine to some, that sort of risk may be worth the reward. If that’s you, I wish you the best of luck. I’ll be rooting for you from the sideline with no position one way or the other.
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Disclosure: I am/we are long AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.