A Promising Paper Route

IP's reorganization is the reason why

Worse even than holding newspaper stocks this year has been owning shares in the companies that supply the paper. Bowater (BOW ) is off 35%, Abitibi-Consolidated (ABY ) 50%. It's not just weaker demand for newsprint. Papermakers as a group are down more than 18% this year, as higher energy costs rip into profit margins.

Which got me wondering: Is there a paper stock worth buying now? I confess, this was a reflexively contrarian impulse, given that much of Wall Street sees demand for paper, cardboard, and cartons as near the top of a cyclical peak and nowhere yet near a trough. Depending on the global economy's course, that could be so. But for investors with more than the two or three quarters' worth of patience common on the Street, shares of the industry's single-biggest player, International Paper (IP ), may prove unusually rewarding. From more than 42 early this year, the stock lately trades near 29 after dipping below 27, where it caught my eye.

AT FIRST GLANCE, EVEN THAT HARDLY appears cheap -- 23 times the $1.18 a share that IP will earn next year in the Street's consensus view, according to Reuters Fundamentals (RTRSY ). But IP has just begun a vast corporate makeover that renders near-term forecasts of small use. Today, IP is a sprawling mass, with operations in uncoated paper (such as what you have in your computer printer), plus cardboard boxes, lumber, plywood, chemicals, beverage containers, and the highly processed coated papers used by the likes of magazine and catalog publishers. All that, plus vast tracts of timber. Within two years, however, IP expects to have shed assets generating 30% of the $25.6 billion in 2004 revenue. Even if it's smaller, by focusing in the future only on two businesses where it has compelling advantages in scale and costs -- uncoated paper and packaging -- IP expects to enjoy better returns on its assets.

In the process, IP expects to raise some $8 billion to $10 billion via sales of assets, notably those 6.8 million acres of forestlands. With timber today taking a growing share of institutional investors' portfolios, demand for acreage and the prices it fetches are high. Some, perhaps 20%, of the proceeds will be plowed back into paper and packaging operations. Most, however, is earmarked to benefit investors. For starters, up to 50% is being directed toward strengthening the company's balance sheet by paying off debt. IP in September got a start on lowering its burden by some $500 million after selling its majority interest in a New Zealand paper producer. Another 30% or so of the proceeds is supposed to be returned to shareholders, via share repurchases, special dividends, and, if sustainable, a higher quarterly payout. To date, IP is being coy about exactly how and when it will deploy these funds. IP now yields 3.4%.

IP's maneuvering won't be limited simply to shuffling assets and liabilities on the balance sheet. It also is at work on operations, closing some paper and packaging plants while reconfiguring others for more profitable uses. How much of IP's 80,000-person payroll will be cut is not known. These changes, plus a move of the company's headquarters from Stamford (Conn.) to Memphis, where it already employs some 3,000 people, promise to lower annual costs an average of $400 million. In all, IP estimates 2007 earnings per share will be 30% more than they would have been without embarking on its transformation. Meantime, if IP's costs for raw materials moderate even by a little bit, then the effect on the bottom line should be dramatic. This year, had energy and other input costs run flat vs. 2004 levels, earnings per share through September would have been 60% higher. As it was, they rose to 96 cents, vs. 84 cents in 2004, on a 4% rise in revenue.

It's doubtful IP will run through such a full restructuring without a stumble or two. But much of the risk appears to have been beaten out of the stock. Its enterprise value -- that is, market capitalization plus net debt -- now comes to just one times annual revenues, a multiple that's down sharply from last year. In any case, IP already is one big step ahead of its rivals: It doesn't make newsprint.

By Robert Barker

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