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International Paper Remains Neutral

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We are maintaining our Neutral recommendation on International Paper (IP - Free Report) given integration risks associated with the Temple-Inland merger, margin headwinds and high debt levels. Currently, the stock retains a Zacks #3 Rank, implying a short-term Hold rating. 
Looking at the second quarter numbers, International Paper reported EPS of 46 cents, sailing past the Zacks Consensus Estimate, but revenues of $7.1 billion failed to beat. Within segments, a 27.5% increase in revenues in the Industrial Packaging segment was a saving grace as it helped offset declines in the Printing Papers, Consumer Packaging and Xpedx segments. 
Mergers and acquisitions remains International Paper’s key strategy to strengthen its businesses over the long term. The acquisition of Texas-based Temple-Inland is its largest since it acquired Weyerhaeuser Co.’s (WY - Free Report) corrugated-packaging business for $6 billion in August 2008. The company generated $60 million in synergies to date.
The transaction is expected to be accretive to EPS within one year of closing and incrementally beyond 2013. The combination will yield synergies of $240 million in the first year and $400 million by the end of 2013, derived largely from operations, freight, logistics, selling expense and overheads. Moreover, the combination will strengthen the packaging business of North America by increasing its share in the corrugated packaging market to 34% from the current level of 27%.
The International Paper Ilim joint venture in Russia has been growing rapidly. It is currently working on two major projects, which are expected be completed by 2012 end – modernization and expansion of a pulp mill in Bratsk and a new paper machine at Koriatza mill in Russia. These represent a combined $1 billion of investment and are expected to generate over 20% returns.
In China, the International Paper-Sun joint venture is building a new consumer paperboard line that should come online in late 2012. Going forward, these initiatives will contribute to both earnings and cash flow immensely.
International Paper is working toward transforming and improving the profitability of its distribution business, Xpedx. Improvements are expected in procurement, replenishment of orders, reduced stock keeping units (SKU) and supply chain (including fewer/larger warehouses). We believe that these initiatives will boost results and be accretive to EPS going forward.
On the flipside, International Paper’s debt levels remain high, further aggravated by the Temple-Inland acquisition. Debt-to-capitalization ratio was 62.9% as of June 30, 2012, compared with 62.2% as of March 31, 2012, and 59.9% as of December 31, 2011.
Given the magnitude of the Temple-Inland deal, integration risks continue to be a concern. In addition, International Paper’s failure to realize synergies from the acquisition could negatively impact the company’s earnings.
Furthermore, under its consent decree with the Department of Justice, International Paper had to divest 970,000 tons of container board capacity. Even though the company maintains its synergy targets, this has reduced some of the positives from the acquisition and adversely benefited its peers.
Rising energy, chemical and OCC costs remain headwinds. Margins will also be affected by the startup costs from the aforementioned investments in Ilim and Sun projects, higher interest expense due to debt issued for the Temple-Inland acquisition.
Memphis, Tennessee-based International Paper is a global paper and packaging company with operations in North America, Europe, Latin America, Russia, Asia and North Africa. International Paper conducts its businesses through five segments: Printing Papers, Industrial Packaging, Consumer Packaging, Distribution (Xpedx) and Forest Products. International Paper competes with MeadWestvaco Corporation and Weyerhaeuser Co.

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