International Paper Company (IP) Earnings Call Transcript & Summary

Good morning, and welcome to Citi's 2021 Basic Materials Conference. I'm Anthony Pettinari, packaging analyst here at Citi. And we're very pleased to host Mark Sutton, Chairman and CEO of International Paper. I'm going to turn it over to Mark for some introductory comments, and then we'll jump right into our discussion. And for those of you on the line, you can submit questions to me through the portal or just e-mail me also if you need any disclosures. So Mark, thank you for joining us, and I'll turn it over to you.

Thank you, Anthony, and thanks, everyone, for participating on the webcast. As Anthony mentioned, I have a couple of slides, just a few that I wanted to cover. They're available on our website if you want to download them. But anyway, I really appreciate your interest in International Paper. As normal, on Slide 2 in that material, you'll see the normal forward-looking statements. I think you're all familiar with that. And on our website, we always have our U.S. GAAP and non-GAAP reconciliations. So I'm going to move past those statements and get on to Slide 3. And the first thing I want to do today, I think this is out in the public, it's been talked about a bit, I want to give an update on the impact of our Prattville mill interruption. So as you may know or probably already know by now, on November 6, our Prattville containerboard mill had a structural failure on one of our high-density pulp storage tanks. So these are the tanks that after making pulp in the pulp mill, it's stored at a very high density, so very high thickness, ready to go to the paper machines, be diluted and made into containerboard. So it's kind of an inventory in the process, online buffer between the pulp making and the paper making, very large tanks, not pressurized, but very large tanks. And first and foremost, I want to thank our Prattville team for really managing the circumstances around this tank failure remarkably well. There were no injuries nor any adverse environmental impacts resulting from this event. We're making good progress bringing the mill back up. Paper machine #2, which represents about 40% of the output of the mill, restarted successfully last week. And paper machine #1, which is the larger machine, is on track to restart in early 2022. We don't have an exact date, and part of that is just getting the equipment and the contractors. And as you know, as we all know, things are always a little more challenging with the current environment, supply chain, COVID, capital equipment, those kind of things. We should have further information on that as we get closer. We're really leveraging the strength and flexibility of our system. We have a number of mills that we can flex to our mills. And the investment program we did over the last few years are able to make the same grades in many cases. So what Prattville needed to do and can't do, we're fitting in, in other mills. But suffice it to say, it's adding to an already complex process trying to manage in today's supply chain. It's difficult at this time to really estimate how much of the cost might be recovered in insurance and those kind of things, but we'll obviously file and do those processes. But the impact, we think, that this will have, we entered the fourth quarter with much better containerboard inventories. I commented on that in our third quarter earnings call. And unfortunately, this will undo some of that good position we were in and put further strain on our supply chain. But the current impact that we're estimating is somewhere into earnings. Impact to earnings is impact -- is estimated to be between $60 million and $70 million in the fourth quarter. And that includes the impact of lower volume and any unabsorbed fixed cost as well as the higher operating and supply chain costs. So the comment I made about moving things around the system is good because we can serve customers. It's got a negative because sometimes it means you're shipping from a mill further away and all of those types of supply chain costs. So we're working on trying to get that as low as we can, granted this is a temporary situation. So we're not going to make any permanent changes to the system. We'll get it all back up and running in early '22 and then re-sort the proper grades at the proper mills. One additional update on the fourth quarter, we expect input costs to be about $35 million higher than our original outlook for the quarter that we gave on our third quarter call. And this is really in really just 2 areas. It's not across the board like we saw in the third quarter. It's continued pressure on the wood fiber market and on the energy market. And the energy market primarily is the amount of energy we purchase via natural gas that we don't generate ourselves. So let's turn to Slide 4 and talk about the future and how we're going to accelerate value creation for IP and our shareholders. We're building a better IP with a focus on corrugated packaging. In our North American Industrial Packaging business, we have 18 containerboard mills and about 200 converting facilities, all focused on providing packaging solutions for our customers by leveraging our capabilities, our scale, our cost structure and our system flexibility. And while I hate to have a problem like we had at Prattville, the ability to flex and still serve our customers and the feedback we're getting from customers, the appreciation when everything is tight to be able to just not have to just give up and say that we have a problem and we can't serve you, I think that's the strength of International Paper and why we're a large part of most every corrugated buyers' offering. In addition, we've really strengthened the financial footing of the company significantly. We've been working on this for a few years. And that's balance sheet, both debt and pension. We're comfortable, as we've talked about recently, taking our leverage ratio down to the lower end and even below the lower end of the range based on a Moody's basis. And we're on track in 2021 to reduce debt by $2.4 billion, at least $2.4 billion, after having reduced it $1.7 billion in 2020. In addition, our qualified pension plan, and Tim mentioned this on the third quarter call, is fully funded. And we feel really good about the actions we've taken with the pension plan to improve the performance of the plan and to dramatically derisk the plan going forward. So think about where we were a few years ago and where we are now on the balance sheet, both pieces to the balance sheet, and it is just night and day. And it positions us very well to navigate through about any type of economic situation. It also allows us to focus our cash on value-creating enterprises like our investment plans, like our return of cash to shareholders, with nothing that should get in the way of that. So our focus profile with packaging and a smaller specialty pulp business and the financial strength, if you couple those 2 things together, we believe it puts us on a sustainable, profitable path for growth and value creation. We've talked about value creation a lot in different ways. And we all know what value creation means. We work very hard to get the return on invested capital of International Paper well above our cost of capital and then try to put the appropriate amount of capital to work at that spread. And if we can grow that consistently, we believe that will create the value for our shareholders. And we're finally in a position to be able to really focus on that and do that. So if we go to Slide 5, we've shown versions of this slide on our earnings call, but it's just a really good, easy way to capture what are we working on when we say building a better IP, reimagining the company after the spin-off of Papers. So we will deliver, in the overall commitment of $350 million to $400 million of earnings improvement by the end of 2023, we will deliver $200 million to $225 million, $200 million to $225 million of gross incremental earnings in 2022, which represents more than 2x the dissynergies from the recent Papers spin-off. So our value drivers ramp up in '23 and '24 with net incremental earnings improvement of $350 million to $430 million in 2024. Those are net numbers offsetting all of the dissynergies. This includes around $300 million in cost reduction initiatives. And you can imagine, as a simpler company, compared to the footprint, the geographic footprint, the number of vertical business lines compared to what we are now, there's a great opportunity for us to simplify everything and to simplify the organization. And we're beginning to do that, and we're going to -- we've got a great opportunity to have a structural reduction in our cost. Streamlining and simplifying the company is all about really agility and effectiveness, making sure that the organization that we have today is designed to support a packaging-focused company with a much more focused footprint. We're aligning our talent to accelerate this performance. So the earnings catalyst I talked about in 2022, the $200 million to $225 million are really front-end loaded. And the significant benefits that are coming from streamlining and simplifying the company, there's a number of process optimization initiatives, some of which we've talked about using data analytics. And a great example is in our converting business where we've been stretched for capacity either because of physical equipment or labor availability. Some of the work we're doing with data analytics and how we load all 200 of those plants is beginning to show us latent capacity. If we can change the way we do that, there's a meaningful amount of capacity that we can free up with capital that's already installed. We're piloting that in certain areas, proving out the concepts and then we're ready to get close to scaling it. That will be an outstanding opportunity for immediate impact for our packaging business. We do have really good line of sight to the benefits in 2022, the $200 million to $225 million, and the ramp-up as we move forward. I think in 2022, we'll report each quarter. We're going to do some things to help investors understand, well, how are we doing along this path? Are we ahead? Are we behind? What's working? What's not working? And so that will be a constant conversation through next year. And I'll close the prepared comments with Slide 6, which shows International Paper's strong -- International Paper's trend of strong and resilient free cash flow. And I've often commented on our ability to generate strong cash flows through practically any set of conditions. And I guess, in a way, we can add a 2-year global pandemic to any set of conditions comment. While it's easy to live in the moment, and boy, the moment since the summer for us and our unique supply chain and some unique challenges and then some macro issues that everybody is dealing with has been quite a moment to live in. I'm really confident we'll continue to manage and overcome today's circumstances. There's nothing that is in our way or that has happened to us or that we're dealing with in the supply chain that we don't have a solution to get around. It's just a matter of how long will it take and how fast can we get some of our improvements in. And then there's always the macro issue of labor availability, transportation velocity, but that won't be a competitive disadvantage for us. I'm equally confident and very optimistic about the future of IP. And really, the reason I say that is because of what I said at the beginning of my remarks, a very strong financial position, a proven cash generation potential and now the ability to do a much better job on that capital allocation of that cash, a much better job, meaning the balance sheet is in great shape. The focus of our capital allocation can be on value creation. And that's, for the first time in quite a while, we can say that can be almost our singular focus. So I'm excited about us flipping the page of the calendar into 2022, getting '21 behind us. I know there's a lot of noise around what's coming next, whether it's the virus, whether it's inflation. IP is a very resilient company. I was with our plant managers yesterday. We had a group of our plant managers together really for the first time in person. And the energy level in that room and the talent level we have leading our facilities, and I saw it all looking back at me as I was speaking to them, really gives me the confidence that for us, it's really about the quality of our people, the veracity of our assets and the flexibility we have to figure out how to overcome just about anything that gets thrown at us. So with that, Anthony, I'll join you for the Q&A section.

Thank you, Mark. That's an extremely helpful overview.

Maybe just digging deeper on Industrial Packaging, putting aside the issues at Prattville, can you talk about how you're seeing underlying demand heading into year-end for board and boxes? What you're seeing in the end markets? And any notable trends that you'd flag?

So when I think about what's happening now in this moment, it's very similar to what we said on our third quarter earnings call. So we've got the month of October and November are largely in. And what we said on our earnings call, which was in the 3rd week of October, that the fourth quarter was looking a lot like the third quarter. And so elevated demand from the past, very strong. I think what was -- what's harder to predict is there's a lot of disconnects in the supply chain, either on our end, Prattville is an example; or on our customers' end, where they just run out of the ability to work over time and their order pattern slows down. The demand, what we're hearing from our customers in just about every segment, the demand, the end-use demand for their product is very strong. The challenge right now is meeting that demand with all of the challenges in the supply chain. So fourth quarter looks a lot like the third quarter did, strong, steady demand. Meeting it is choppy because of all of the things that we talked about.

And Mark, you talked a little bit about some of the levers that you can pull to improve containerboard margins and returns over the cycle. Is it possible to say, do you see incrementally more opportunity in the mill system or the converting network? And are there any sort of product or geographic gaps in IP's footprint that you'd flag?

There is a -- the good news is, Anthony, on the margin improvement, there's really good opportunity in both the mill system and the converting system, and it's in 2 different areas. We'll see about capacity and all of that. We've added capacity, as you know, in containerboard. I really thought we had enough for the foreseeable future after the Riverdale conversion. And I don't to want to get blinded by the moment of COVID and the induced demand. But our containerboard system hasn't had a lot of cost reduction capital expenditures over the last few years. So the improvement in margin that comes from the containerboard side is mostly in the cost reduction area. Some of that is just cyclical cost right now that, I think, will settle out. Some of it is structural cost that we can take out, and now we have the ability to invest in that. On the converting side, it's what you said in the way you phrased your question. We've got some geographic spots where we just -- we are flat out of capacity. The Southwest is an example, parts of the Midwest, a little bit of the Northeast. So we've got plans via capital investment in existing plants, so individual machines. And then we've got some plans to look at totally new plants in certain areas. So the contribution from the box business will be adding the capability we have so we can capture the market growth. And then there's always opportunities to look at our mix, and every business and every company has a profitability curve. Where do I make the most money? What segment? What customer? And where am I lagging? And there's always opportunities to lift that curve, and we'll continue to work on that. But it's capacity and capability on the box side, converting side, and it's cost reduction on the mill side. The jury is still out on whether we have all of the capacity we need. I will say, anything we do to invest in our containerboard system, we will continue to look at some of the high-performance, lighter-weight containerboards like we have at some of the -- like at the Pensacola mill and some of our recycled mills. So that's something we think will have some opportunity for us. But the good news is we can get this business back in the low to mid-20s in EBITDA margins, and it's not a silver bullet. It's going to come from mill and box.

And Mark, I mean you've made a tremendous progress this year in terms of streamlining the portfolio and creating kind of a much simpler business. When we look at containerboard and you look at the European footprint that you have, I mean, would you potentially look to get bigger or smaller in European containerboard? And how do you think about improving profitability in that business?

The primary catalyst for improving profitability in the European business is integration with our Madrid recycled mill and our North American virgin kraft system and integrating those Southern European box plants into those 2 containerboard streams. And we've made a lot of progress. That business is well on its way to value-creating returns. It used to be there a few years ago. Some things changed. As you know, we've also simplified that portfolio by selling our business in Turkey, repositioning some plants in Northern Europe in exchange for plants in Southern Europe, either via acquisition or actually, in some cases, asset swaps with other companies. So really, it's about integration. So the question of more containerboard, I think that the answer will be, are there good tuck-in opportunities for us to add converting that's beyond the Madrid mill's capability to produce containerboard? And of course, as you remember, that was a purchase of a newsprint mill, a relatively new newsprint mill and a conversion to containerboard after about a year. That's one way to do it. There are other ways to look at more containerboard capacity if we need it. It's not the highest priority for the company right now. I think the most value-creating investments we can make, and you will see us making, will be in our North American packaging business. But that's really the driver for Europe. It's a regional business. We're focused in the South. Recycled integration, which used to not be critical many years ago, is pretty essential now.

And Mark, you touched on this a little bit, but in terms of your packaging network, how have you adapted to rising labor costs and maybe labor availability issues, whether it's automation or other strategies? Is it possible to kind of quantify the impact that labor cost inflation has had on you, either directly on your business or maybe on your customers in terms of lost business? Just wondering if you could talk a little bit more about what you're seeing in the labor markets.

Well, I think on the labor availability, it's regional. In some places, we are holding our own in terms of retention of our existing employees and even hiring some additional employees. In other regions of the country, we've actually gone from trying to hire more people to add a shift to raise our capacity to try and to protect the people we have. So it's not the same everywhere. But as a general statement, the box plants we have that were designed to run 3 shifts a day, 5 days a week, we have tried to move those to 6 days a week. The first way you do that is you ask employees to work overtime, and they're happy to do it for a while. And then after a while and there's no time off in their life, they begin to ask you, when are you going to hire some more people? And that's been the challenge. So it's not an exact answer to your question, but one way to think about the missed opportunity is if you could add a shift of people to run the plant 1 more day, so 20% more capacity would be available to you, give or take. And that's not every plant. Some of our plants run 24/7 like mills. They were designed to do that. They're staffed to do that. So there's somewhere in less than 25% of latent capacity that, in some cases, if you can't operate at least 6 days a week, 3 shifts a day, you're theoretically leaving some business on the table. Now that business is obviously being met somewhere, so you might have our company meet it for a 3-month period, and then you end up with some labor turnover. And somebody else has the capacity or business changes hands or inventory gets very low, but there's ways to do it. But that's the challenge for us, and it's been difficult. In the areas where it's difficult, it's really difficult to hire and then to retain -- to train and then retain the people that you've hired. And sometimes, it's just a bad fit. People come in from another job. They want to work in manufacturing. It's a good wage. It's a good benefit package, but it's a different kind of work. And it's shift work, and so you end up with a 1-month experiment. And the employee says, this is not for me, and you start all over. So we're trying all the tools that people are using, retention bonuses, signing bonuses, making sure our leadership is attentive to our employees so we can manage any kind of turnover. That hasn't -- turnover hasn't been a real big issue for IP in the past. And it's -- again, our box plants are in a much more competitive zone. They're in urban areas. They're in -- there's a lot of other jobs to compete with. Our mills are a little more isolated. They're really, really good jobs in very rural areas where those jobs aren't readily available. So the turnover is a lot lower. But the box challenge, which I would say, I'd put that in with light manufacturing and sophisticated warehousing, all that, those starting wages are all pretty similar, it is an absolute war for talent out there.

Got it. Got it. And you talked about the impact of the pandemic. Just zeroing in on e-commerce, can you talk about the level of growth that you've seen in e-commerce demand maybe since the onset of the pandemic? And is it possible to kind of quantify a percentage of your Industrial Packaging business that's going into that category? Any sort of unique challenges in negotiating with maybe larger e-commerce customers? And anything you can say about margins versus your -- the rest of your business?

Well, on the growth question, even before the pandemic, e-commerce is still a relatively small part of the overall market. But if you look at some of the census data, we track all of this stuff, and most of it is publicly available. If you look at the data for revenue, e-commerce revenue, the channel for e-commerce, and you got to look at that definition, but it's basically what we think of as e-commerce, is up over 50% from the second quarter of '19 to the second quarter of '21 and up over -- up to almost 40% over in the third quarter of '21 versus '19. So it really started and has been growing, but the step-up in it started even before the pandemic. And then it just kind of -- either consider it got pulled forward or accelerated during the pandemic. And it's a significant and meaningful part of our business. But again, it's still in the minority by a long shot when you consider all the other food segments. So -- but again, you keep saying that one day, we'll say it's 40% of our business because it will be 40% of our business, but it's not there today. Margins-wise, there's no single answer, but when people say e-commerce, they think of the big players of business to consumer. Those margins are right in the middle of the fairway usually of our entire margin profile, but there's a lot more to e-commerce. There's the industrial side of e-commerce, business to business, and then there's the type of packaging and the supply chain service. And those margins can rival, in many cases, the best margins you'll get in any other segment. But overall, the good news about e-commerce is, is the volume is growing. It's a lot of boxes. And because it plays such a supply chain role, so we've talked about this before, many of the business-to-consumer e-commerce companies will pay more for the box experience if it helps them speed up their delivery versus trying to penny-pinch on the package only to slow down everything, so like the number of SKUs, how the box is designed, how fast people can pack it, all of those kinds of things. So the downside of e-commerce is the seasonality is a challenge. That's leveling out a little bit because it's becoming a way of shopping all year, but there's still a seasonality. There's a huge inventory build for the fourth quarter. That gets in the way when you have the kind of demand we have right now for every other segment. So that's a bit of a challenge. And then the kinds of boxes and the size weren't really designed for a lot of the capital installed out there. So some of our newer plants and any of our competitors' newer plants with an e-commerce mindset, you would order different-sized equipment where you would use more of the equipment to make the packaging. And we're working on that. We're working on e-commerce-specific plants where they will make just that. But there's some inefficiencies in that whole segment because the box-making equipment that's installed was made more or less think about some of the things you see at the grocery store. So they're larger format. They use the full width of the machine. So there's a theoretical inefficiency where you're just not able to use the full output of the machine when you're targeting e-commerce packaging.

Great. Great. And then maybe just one last question on Industrial Packaging. Can you talk broadly about how you kind of view supply/demand and maybe the potential impact of new supply in the market in '22? Has this pandemic demand maybe enticed some new capacity but, at the same time, you have supply chain constraints that are maybe making it harder to bring that capacity online? Just wondering if you could talk about sort of the competitive intensity that you're seeing in the containerboard market and how that compares versus previous cycles.

Yes. I think the '22 announced capacity, I think everybody will update their plans. I think everything that involves capital equipment and installing capital equipment and checking it out and getting it ready to run has run into challenges. And part of it is labor, part of it is the backlog in equipment OEMs, and that's for a different reason, materials. And there's an inflation issue. You start a project at X, and you use all of your escalation because the price of everything before you finally buy it has gone up 25% or 30%. So with all that said, I would think this capacity that's written in all of our analyst reports and everything that you see in the announcement date, I think that's going to drag out a bit just based on all these challenges. The market could actually use a little more containerboard right now. So the question is, does this demand stay in a, whatever that means, "post-pandemic" environment? I don't know if we ever get there. But -- so I think right now, the thing that's clouded it is how efficiently can you do these projects. I mean we did Riverdale almost entirely inside of a pandemic. And we got it done, but there was a period where we couldn't get our foreign suppliers in the country and things like that, that we had to do start-ups via Zoom. And it just took a lot longer than it should have. And I think most people are going to have those types of challenges in one way or another. The demand environment is very strong. The supply/demand environment is actually probably has been a bit unhealthy. It's been exasperated by the velocity in the supply chain, but there has been inventory levels in certain grades of containerboard that have been dangerously low across almost a just-in-time environment. So I think the market is growing and the market can use more containerboard, obviously, in an orderly way. That's always the challenge because capacity for containerboard is built in big chunks because it's a process industry and then it's metered in, in smaller increments. But as I look at where we are now, I know I can speak for IP, and I can say we're going to make more containerboard in '21 than we made in '20. '19, we had some economic downtime. With -- even with the challenges we had in the early part of the year with the winter storm where we lost 150,000 tons of production with Prattville, our mill system is operating when it's operating. And we'll produce more output than it did last year and a lot more than 2019. We invested in Riverdale 400-plus thousand tons, and I'm sitting here wishing I had more. And that includes pulling back on some of our export business that's more transactional and not strategic and redeploying that capacity into the U.S. market. So as the largest producer, I kind of wish -- I feel in a way I undershot our capacity. I had no way of knowing, but I feel like I could sure use a little more containerboard right now. I don't -- I can't speak for anyone else, but that's how we feel about it. And then the second piece for us, to your margin question earlier, is we've got great opportunities to expand our converting business organically and inorganically.

And Mark, you talked about the levers that you can pull to improve the Industrial Packaging business. How would you frame that opportunity in Global Cellulose Fibers? Maybe why is profitability lagged in recent years? And what are some of the levers that you can pull to improve that business?

I think on the sort of journey we've been on, we got caught in this commercial and pricing vortex. IP did and in a way that the industry has some challenges with the connectivity of this specialty absorbent pulp and the broader market pulp environment, and it's just the classic old supply and demand. There's enough on the fringe that you can bring in and out of a market that, depending on how you respond to that, and that's where we -- we have changed our responses to those things with customers and with commercial arrangements and deals. And what you've seen so far, and what we've been talking about each quarter, is steady improvement in the ability to get paid for value. That's the biggest and most important change we have to make. We had made progress right after the Weyerhaeuser acquisition, but there was also a little bit of a pulp run-up. And so you can just be there and sell and you would get the gains. How you deal with the next cycle in pulp and how you disconnect your absorbent pulp from the broader sense takes a lot of commercial courage. It takes a lot of commercial precision around knowing who can do what and should I respond to this price pressure. So pricing was a big part. Pricing management by IP and how we dealt with certain customers, large and small, contract and noncontract that we've revamped and we're practicing that new approach now, and it's working. If I'm comfortable, and we're comfortable that, that is the new way of doing commercial business, the next tranche of improvements is cost reduction on primarily the IP legacy fluff pulp mills. All of the IP mills were converted mills from other products. So by doing that, you end up with too many operations and you end up with higher cost. The Weyerhaeuser mills were almost all, if not all, built for purpose, built to make pulp. And so they're designed in a way that inherently, they have lower cost. So we've got kind of 2 businesses within a business from a cost standpoint. The good news is the quality on the IP legacy and on the Weyerhaeuser is outstanding. It's just our cost structure is -- and it's not that we have too many people, and we have too many pipes, tanks, pumps. And that can be fixed over time. It does take a little bit of CapEx, but I wouldn't do that until I'm sure we got the commercial piece figured out. When you put the 2 together, you got a business well into the 20% EBITDA margin zone, first half in the 20s, and solidly above cost of capital and contributing between $450 million and $600 million in EBITDA to IP. And that's meaningful for the company.

Great. Great. That's extremely helpful detail. So Mark, we're coming up on time. So I want to thank you for your time and just sharing the progress that you've made, especially this year in creating what seems like to us just a much simpler and much more focused company that's really in a position to accelerate value creation. So thank you for your time. And with that, we'll conclude.

Thank you, Anthony, and thanks, everyone, for your interest in International Paper.

Thank you.