Nelson: How International Paper Stacks Up
As with other highly cyclical industries, the paper products sector is prone to bouts of under-utilization and overcapacity. The sector's operating margins vary based on product mix, but most companies that specialize in paper and packaging achieve operating margins in the 7% to 10% range. For companies as small as Boise (BZ) and Clearwater Paper (CLW) and as large as International Paper and MeadWestvaco (MWV) , a small change in operating margins can meaningfully affect operating income and free cash flow generation. Market demand in developed regions is primarily a product of GDP growth, as paper consumption per person continues to face pressure due to innovations in cloud storage and electronic communications (driving a secular decline in newsprint).
Though International Paper will certainly feel the impact of a decline in physical goods distribution, as well as a decline in print consumption during economic troughs, the company has a nice position as a leader in the consumer packaging business. It makes different types of packaging for food and beverages that cannot be displaced by digital distribution and consumption. Although the business is down year-to-date due to planned outages, additional capacity will help the company capture long-term growth, specifically in Asia and emerging markets. Rock-Tenn (RKT) and other competitors, however, may follow suit with capacity additions, absorbing outsize economic profits.
We prefer companies trading below the low end of our fair value range, as our margin-of-safety bands insulate us from risks related to the future volatility of a company's business fundamentals and cash flow. Though International Paper trades at the low end of our fair value range (and not below it), we prefer if the company pulls back even more from current levels (below $33 per share).