By Jan Stoddard of Raine Consulting Editor’s Note: "Obviously, something went right this quarter," stated one analyst on today’s quarterly performance call. Despite flat demand and pricing concessions, continued high energy and fiber costs, International Paper posted an EPS of $0.19 per share; a significant improvement from the EPS of $0.09 from the previous quarter. Highly respected for his global economic perspective, CEO Mr. John Faraci predicts that the tough external environment will continue. (Some of his insights and observations as to ‘why’ can be found under the Q & A section of this report.) It will be interesting to watch the next quarter to see if Faraci, and his management team, can "tighten the belt" fast enough to offset economic challenges. July 29th, 2003 - International Paper (NYSE: IP) reported second-quarter 2003 net earnings of $88 million or $0.19 per share, as compared with net earnings of $44 million, or $0.09 per share in the first quarter of 2003. Net earnings in the second quarter of 2002 were $215 million $0.45 per share. Net sales for the second quarter totaled $6.2 billion, compared with $6.3 billion in the second quarter of 2002 and $6.1 billion in the first quarter of 2003. While operating profits of $448 million for the second quarter of 2003 were above first quarter totals of $410 million, operating profits were down compared with the second quarter of 2002 amid higher energy and fiber costs. International Paper’s (IP) President and CEO, Mr. John Faraci, with the Senior VP and CFO, Mr. Christopher Liddell, conducted the quarterly investor analyst call. Topics: - CEO Comments - Financial Highlights - Business Segment Performance - Third Quarter Guidance - Q & A CEO Comments Faraci noted "the top line is a disappointment in volume" as IP had anticipated an upturn in volume after moving out of the conflict with Iraq and a seasonally stronger quarter. The good news is IP ‘turned the operations around’ to recover from the deficiencies of the first quarter. In summary: - Volumes characterized by flat demand at low levels, volumes disappointing (generally down), took more time to balance supply and demand versus 1Q03. - Prices were flat to down. IP took downtime from curtailment and additional maintenance. - $0.04 gains in foreign exchange. - Raw materials were affected by energy and fiber costs which remain high and a new twist in lost production is due to wood shortages. - Improvements came through operations performance improvements and improving controllable costs and business mix factors ($0.07 impact per share), Financial Highlights Mr. Liddell shared additional financial impacts: - Contribution from operations were back to normal from Q1’s winter disruption ($0.05 impact per share). - An improvement in pulp was offset by uncoated papers. - Negative factors included slightly lower pricing, strike at the Carter Holt Harvey Kinleith mill, debt repayment and interest. - Downtime was also higher in the quarter versus the previous quarter (totaling 90,000 tons), but the overall inventory position is flat. - Special items included $43.0 million associated with Springhill and Naatchez mills, affecting 198 employees. Business Segment Performance: Mr. Liddell also briefly reviewed each of the four business segments: Paper businesses (includes NA uncoated white paper, coated papers, pulp, European papers, and Brazil): - Second-quarter operating profits for Printing Papers were $143 million compared with first-quarter operating profits of $122 million. - Earnings were up, $143 versus $122 million, due to intensive cost reduction efforts to offset weaker volumes and flat pricing across most grades. - Volume change compared to previous quarter shows uncoated was flat, while all other segments were down: Coated (2%), Pulp (11%), and Europe (8%). - IP has given up most of the price increase that had built up in the fourth quarter of 2002. Packaging Segment: - Industrial and Consumer Packaging operating profits were $121 million in the second quarter, up from $89 million in the first quarter. Sales were up over the previous quarter, to $1,565 from $1,500 million. - Slight volume increases for all segments: containerboard (2%), US containerboard (3%), bleached board (8%) - Price declines in linerboard and boxes were offset by cost reduction efforts as well as by somewhat better price realization. - Europe was relatively flat. Forest Products (U.S. wood products, Canada, and Forest Research) - Second-quarter Forest Products operating profits of $143 million were down from $161 million in the first quarter, although Sales were up from $675 to $740 million. - The effect of higher lumber (+6%) and plywood (+16%) volumes did not offset the impact of weather-related lower harvest volumes in the South and adverse Canadian foreign exchange rates. Timber was particularly impacted by adverse logging weather conditions in the South. Xpedx: The company's distribution business, Xpedx, reported operating profits of $22 million for the second quarter compared with operating profits in the first quarter of $15 million. Again, the increase was largely due to operational cost improvements. Third Quarter Guidance Faraci summarized the upcoming quarter by noting: - The tough external environment will continue and IP will not see any real economic improvements, especially in July and August. - Demand will stay flat with the exception of coated papers. - Wood and energy costs will improve. - IP will continue its’ strong operating performance. - Cost reductions are underway. - There will be a continued intense customer focus. Faraci did note that "he remains positive on economy, and as we move into Fall 2003, he would be surprised not to see some improvements" due to stimulus in the economy and working out the excesses of the late 1990’s. He also referred to the announcement that IP will be taking another $500 million out of their cost of running the business noting that there will be more large cost reductions coming. Q & A 1. Faraci noted considerable operational improvement opportunities in printing papers ran extremely well in the second quarter. All facilities had nice gains in their cost structures. There is more upside in printing papers, mills, and supply chains versus container mills (noting, however, that the container mills also ran well in the quarter). 2. Unless demand for lumber continues to fall, demand will be very good for wood products in general for the third quarter noting that IP has experienced some modest price improvements at this point. 3. IP will continue cost reduction drives in every single part of the company. Faraci noted that there was good improvement in second quarter on an operational basis and they have been pleased with S&A reduction. S&A is now down below second quarter budget and IP has announced another S&A reduction in the third quarter. 4. The growth strategy for IP is the focus on getting cost down and realizing earnings improvement. A strong customer initiative is as important as everything else and IP is working everyday to eke out share. By working both on the customer and operations sides, IP is very well positioned for economic recovery. 5. The severance charges related to $500 million reduction over budget set for this year are not in the second quarter numbers. Faraci noted they are now going through every part of IP looking at organizational structures and programs to get to that $500 million reduction. This will obviously involve personnel changes. 6. When questioned about the import dynamics of coated paper (citing a mill rebuilding project), Faraci said that IP is realizing cost opportunities in that business. There are specific initiatives of significant magnitude to lower cost structure. He noted, "Imports are just pouring into North America (due to the weak European market)." 7. The increase in packaging earnings improvement came from a terrific mill system but converting was not where IP wanted it to be. While industrial packaging performance is where we want it, we have not had much help from customers or the market. It is the cost improvements from operations that are beginning to show. 8. IP has seen appreciating currencies in export share and export marketability. Currency changes have helped in both areas and, earlier in the year, in market pulp. It is having an impact on some of IP’s European competitors that are ‘euro-dominated.’ Liddell noted that Carter Holt is in a favorable position due to locked-in exchange rates from existing contracts (mid-40’s versus high 50’s). While currently shielded from impact, Carter Holt is also looking to take out costs (restructuring). 9. When asked if IP would switch from an internal focus (e.g., the Champion integration) to look at external opportunities, Faraci commented that "we have our nose to the grindstone working in all areas, and while we never stopped looking at the external, we have not seen anything that is of interest to us." 10. The Naatchez mill is completely closed out as of last week although there are still people in the mill to clean it out. When asked about rumors of an employee or management buyout, Faraci commented that it was premature to determine if anything will happen there. 11. Across IP there is price pressure in a number of grades. "There is price pressure in the uncoated white area, which started earlier in the quarter in offset and then moved to cut size and envelopes. Containerboard is experiencing modest price pressure as we move through this weak period. In the box business, there are literally numerous negotiations taking place everyday. Overall box and containerboard is modest. Coated paper market is flat. Plywood and lumber moved up some, and we have lost a bit of that." 12. When asking if gaining share in some of the bleach board export market (for the folding carton side), Faraci did not comment on specific volumes. IP is currently a large exporter of bleach board. No substantial share in share position. Anything going to China is a dollar dominated business. Pricing has been flat in North American bleach board. 13. Both Consumer Packaging (Shorewood assets) and Food Service areas had a tough quarter. Food Service had a tough quarter from the demand perspective as horrible weather affected food service. People were not out doing what they normally due in the spring. Volumes in food service were weak in the second quarter. "In Shorewood, it’s a mixed story. IP is big in music and entertainment, and music remains negatively impacted by Internet. Volume in Shorewood folding was where we thought it would be. Our Personal products were also where we thought it would be, with tobacco off a bit)." There is an intense focus on internal improvements – huge amount of cost out of food service (huge inventory and S&A reduction). 14. The hardwood shortage comes from three factors: 1) the big impact is weather including excessive rain. Faraci noted that IP is worried about inventories for Fall, although the industry is beginning to recover in the mid-part of South, remaining tight in hardwoods across the coast. 2) Workforce and amount of contractors available is also an impact. The intense weather caused loss of a lot of days and there is not enough capacity to make it all up. 3) Hardwood in the U.S. South is becoming less available over time. IP is beginning to convert some of their products back to softwood. Now economics are crossing back over so in some cases, IP is converting to pine. Faraci also agreed that there is the possibility to bring hardwood up from South America. IP has plantations in Brazil. 15. Faraci was asked if any lobbying efforts were warranted regarding the U.S. trade deficit for years and U.S. manufacturers moving offshore. Faraci noted that this was complex subject, but one he was worried about. Inevitably, there is a change in the economy where manufacturing is moving to lower cost regions in the world and this is effecting demand on IP products. Recent data on production of non-durable goods moving out of the U.S. is a substantial number. It is pretty clear that wage rates have moved to the point of being non-competitive with other places in the world where IP products could be produced. He also noted medical insurance protection and benefits are a major issue. The strength of the U.S. dollar (in the latter part of the 1990’s) actually aggravated this trend in a major way and provided an opportunity for some parts of the world to make investments. Exchange rates continue to be an issue. Faraci said he spends a lot of time working and talking to policymakers. He wants to make it clear to trading partners that U.S. market (and access to it) is valuable, and that the playing field is level. He is not seeing much happen to current account deficient, noting it is a very long cycle phenomenon. However, he is beginning to see trade flow effects in terms of seeing U.S. trade flows more competitive although no impact on the loss of U.S. jobs. He also noted that China is a very, very competitive place to produce a lot of these products. Perhaps the effect of SARs will cause people to ask the question about sole placement of production in one particular geography versus balancing locations from a risk perspective. 16. When asked about IP long-term strategy for risk within a geographic mix perspective, Faraci noted that they want to compete on worldwide basis with a mix on paper and packaging. They are pleased with the Latin America and Brazil businesses, and look at other parts of Latin America to see if IP can compete. The open question is China; as a big and growing market. IP has a relatively small packaging and merchant/distribution there and are using these to learn about the market. "We don’t think about it in the sense that we have to be here or there. We want to be a global competitor and we have the competencies to move to a set of opportunities where we have a return to be made. As interesting as China is, we will not invest without a return." 17. In contrasting the IP box business against Packaging Corp and Smurfit (which has combined 20M employees in box plants customizing for customers), Faraci noted IP has a strong segment focus. They identify the segments with product mix or facility locations. The paper mill system is a good system with perhaps a better fiber strategy than others. It cost roughly as much to produce a box and get it to a customer, as does a linerboard. Opportunities are great in both the mills and the box plants. 18. In further discussing energy impact, there was a benefit from first to second quarter due to reduced demand versus pricing. Natural gas came down a bit and IP benefited from the price change IP conservation programs are important IP expects some additional benefit in gas cost reduction as we move through the year. IP has hedged some of our energy purchases (30-50% purchases are hedged) as part of its’ purchasing strategy. 19. IP is working on various lobbying efforts included reinstatement of preferential gains for timber corporations.