INTERNATIONAL PAPER CO quarterly report, Q3 FY2012

Business Context and Reporting Period

International Paper Company filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2012. The company operates Industrial Packaging, Printing Papers, Consumer Packaging and Distribution businesses, and owns a 50% interest in Ilim Holding S.A. in Russia. Temple-Inland results are included from the February 13, 2012 acquisition date; APPM results are included from the 2011 acquisition.

Key Financial Metrics

Metric	Q3 2012	Q3 2011	9M 2012	9M 2011
Net sales	$7,026 million	$6,632 million	$20,758 million	$19,667 million
Earnings from continuing operations attributable to IP	$223 million	$468 million	$524 million	$992 million
Net earnings attributable to IP	$237 million	$468 million	$559 million	$1,041 million
Diluted EPS	$0.54	$1.08	$1.27	$2.38
Industry segment operating profit	$539 million	$571 million	$1,427 million	$1,639 million
Cash provided by continuing operations	Not separately provided	Not separately provided	$2,274 million	$2,038 million
Free cash flow	Not separately provided	Not separately provided	$1,186 million	$1,399 million

Q3 operating profit margin was approximately 7.7%, compared with 8.6% in the prior-year quarter. Net margin attributable to International Paper was approximately 3.4%, compared with 7.1% in Q3 2011. Nine-month continuing-operations margin attributable to International Paper was approximately 2.5%, compared with 5.0% in the comparable period.

Q3 sales increased approximately 6%, primarily reflecting Temple-Inland; nine-month sales increased approximately 6%.
Q3 diluted EPS before special items was $0.75, compared with $0.81 in Q3 2011 and $0.46 in Q2 2012.
Q3 net interest expense was $163 million, up from $130 million in Q3 2011, mainly because of Temple-Inland acquisition debt.
Cash and temporary investments were $1,275 million at September 30, 2012, down from $3,994 million at December 31, 2011.
Total debt was approximately $10.5 billion at September 30, 2012, including $10.048 billion of long-term debt and $413 million of current maturities and notes payable. The fair value of debt was approximately $12.5 billion.
Committed credit agreements totaled $2.75 billion, including a $1.5 billion bank facility expiring in August 2016 and $1.25 billion of receivables securitization capacity. No borrowings were outstanding under the receivables securitization facilities at quarter-end.

Material Changes Versus Prior Comparable Period

Temple-Inland was acquired for approximately $3.7 billion in cash, with approximately $700 million of debt assumed. The acquisition increased Industrial Packaging sales and added significant goodwill, debt and integration costs.
International Paper completed the required divestiture of three containerboard mills in July 2012, reducing Q3 operating profit by approximately $33 million and recording additional divestiture costs.
Q3 operating profit declined 6% year over year despite higher volumes, lower outage costs, lower raw-material and freight costs, and $75 million of Temple-Inland synergies. Lower price realizations and higher operating costs were the principal offsets.
Q3 earnings benefited from $33 million of Ilim equity earnings, compared with $1 million in Q3 2011, including a favorable $21 million foreign-exchange effect. Management did not expect a similar currency benefit in Q4.
Q3 net special items were a $107 million loss versus a $116 million gain in Q3 2011. Q3 2012 included restructuring charges, divestiture costs, and acquisition integration costs; Q3 2011 included a substantial Shorewood-related tax benefit.
Capital spending rose to $1.001 billion in the first nine months from $725 million in the prior-year period. Full-year 2012 capital spending was expected to be approximately $1.5 billion.
The company increased its dividend 14% on a year-to-date basis, paying $0.7875 per share through nine months versus $0.7125 in the prior-year period.

Guidance, Outlook, Risks and Unusual Items

Management expected Q4 volume to be seasonally stronger in EMEA boxes and Brazilian papers, offsetting normal North American packaging seasonality.
Expected Q4 pressures included higher wood, recycled fiber and energy costs, more normalized maintenance outages, weaker North American paper mix, and business interruptions from Hurricane Sandy at Northeastern box plants and distribution centers.
Management expected Q4 Ilim earnings to decline because another significant positive currency adjustment was not anticipated.
Management expected full-year 2012 operating cash flow and existing cash and credit facilities to fund capital expenditures, debt service, working capital and dividends.
Pension expense increased to $256 million for the first nine months, from $146 million in 2011. Management expected a material increase in the pension liability at December 31, 2012 and higher pension expense in 2013 because of lower discount rates.
The company had approximately $979 million of unrecognized tax benefits and estimated that approximately $855 million could be reduced during the following 12 months, with approximately $820 million potentially benefiting the effective tax rate.
Environmental remediation liabilities were estimated at approximately $95 million, with additional recorded liabilities of approximately $45 million for other remediation matters. Certain Superfund, San Jacinto River and Bogalusa-related matters remained unresolved and could not be reliably estimated, although management did not believe material losses were probable in the described litigation.
Temple-Inland agreed to an $80 million settlement, subject to court approval, concerning Guaranty Financial Group litigation. The company had recorded a corresponding purchase-accounting reserve and was seeking insurance recovery.
Pending and announced transactions included the approximately $56 million purchase of Sabanci’s stake in Olmuksa and an approximately $470 million investment for a 75% interest in a newly formed Brazilian industrial packaging joint venture with Grupo Orsa. Both were expected to close in the first quarter of 2013, subject to conditions and approvals.
International Paper disclosed a potential obligation under the Ilim deadlock provisions to purchase its partner’s 50% interest for approximately $400 million to $450 million, although the parties stated they had no current intention to initiate the process.
The company maintained BBB and Baa3 investment-grade long-term credit ratings, both with stable outlooks. Key risks included leverage and interest rates, cyclical product demand and pricing, input costs, currency movements, environmental and litigation exposure, pension funding, manufacturing disruptions, joint-venture risks, and execution of Temple-Inland synergies.

Most Important Facts to Verify

Reconcile reported EPS with the company’s non-GAAP EPS before special items and assess the recurring earnings impact of integration, divestiture and restructuring costs.
Assess leverage, debt maturities, refinancing needs and liquidity after the Temple-Inland acquisition; debt maturities totaled approximately $7.7 billion after 2016.
Evaluate whether Temple-Inland synergies remain sustainable after the divestiture of three mills and whether the $300 million run-rate target is achieved.
Monitor operating trends in North American packaging, printing papers and consumer packaging, including price realization, market-related downtime and input-cost inflation.
Review pension funding requirements and the potential effect of lower discount rates on liabilities and future expense.
Track the tax-benefit realization, APPM litigation and escrow exposure, environmental matters, the $80 million Guaranty-related settlement, and other unresolved legal contingencies.
Confirm the accounting and final purchase-price allocation for Temple-Inland, including goodwill, special-purpose-entity assets and nonrecourse liabilities.
Consider the execution, funding and regulatory risks of the planned Olmuksa and Grupo Orsa transactions and the potential impact of Hurricane Sandy-related disruptions.