International Paper Q3 2022 Earnings Call Transcript

Quartr
Provided by Quartr
October 27, 2022

There are 10 speakers on the call.

Operator

Ladies and gentlemen, good morning and thank you for standing by. Welcome to today's International Paper Third Quarter 2022 Earnings Call. All lines have been placed on mute to prevent background noise. After the speakers' remarks. You will have an opportunity to ask questions.

Operator

To withdraw a question. As a reminder, today's conference is being recorded. I'd now like to turn the conference over to Mark Millison, Vice President, Investor Relations. Please go ahead.

Speaker 1

Thank you, Paul. Good morning, and thank you for quarter 2020 earnings call. Our speakers this morning are Mark Sutton, Chairman and Chief Executive Officer quarter and Tim Nipples, Senior Vice President and Chief Financial Officer. There is important information at the beginning of our presentation on Slide 2, quarter, including certain legal disclaimers. For example, during this call, we will make forward looking statements that are subject to risks and uncertainties.

Speaker 1

Quarter. We will also present certain non U. S. GAAP financial information and a reconciliation of those figures to U. S.

Speaker 1

GAAP financial measures is available on our website. Quarter. Our website also contains copies of the 3rd quarter earnings press release and today's presentation slides. I will now turn the call over to Mark Sutton.

Speaker 2

Thank you, Mark, and good morning, everyone. We'll begin our discussion on Slide 3. Quarter. The Q3 was a very dynamic and challenging environment, which had a significant impact on our earnings. Quarter.

Speaker 2

We experienced a sharp decline in demand in our Industrial Packaging segment and significantly higher cost headwinds from higher On a more positive note, I'm very pleased with the progress our Global Cellulose Fibers team is making to improve performance in that business. Quarter. They are successfully advancing their commercial strategy and achieved cost of capital returns in the Q3. In both businesses, we also delivered strong price realization. Quarter.

Speaker 2

And for the year, we expect to exceed our $225,000,000 target related to our Building a Better IP initiatives. Now back to the demand environment. As we entered the 3rd quarter, we recognized there were macroeconomic quarter, and that our businesses are not immune to these risks. However, these macro trends shifted drastically midway through the quarter, creating stronger headwinds than expected versus our previous outlook, particularly in our Industrial Packaging business. Quarter.

Speaker 2

Based on feedback from our customers and after observing order patterns across our various channels and end user segments, We believe inflationary pressures weighed heavily on the consumer, resulting in lower demand for goods. Quarter. This had a large impact on demand for packaging as consumer priorities shifted toward nondiscretionary goods and services in the quarter. Quarter. In addition, our customers and the broader retail channel continued to work through elevated inventories of their products, which further reduced packaging demand in the quarter.

Speaker 2

In response to these trends, we quickly aligned our production with our customer demand, which resulted in significant economic downtime in the quarter for our containerboard system. Also, our significantly lower export position versus prior use quarter. All of which suboptimized our system from a cost 10 point in the quarter. I would point out that our mill system continued to operate very well before being constrained by lower demand. Quarter.

Speaker 2

The work we did in the last several quarters to improve reliability is paying dividends. Quarter. As we enter the Q4, packaging demand appears to be stabilizing at these lower levels. And finally, on capital allocation, quarter. We returned $434,000,000 to shareholders in the 4th quarter, including $269,000,000 of share repurchases.

Speaker 2

Quarter. As a result, we've returned approximately $1,600,000,000 of cash to shareholders so far this year. If we turn to the 3rd quarter in particular on Slide 4, revenue increased by 10% year over year, driven by strong price realization quarter. Operating earnings and margins were lower than prior periods due to the significant macro headwinds I discussed earlier. Quarter.

Speaker 2

However, our free cash flow generation was stable in the quarter. I would also like to take this opportunity to mention quarter. We are making good progress regarding Ilim. As I've mentioned before, the complexity of the situation and our joint venture structure impact the pace of reaching a resolution, but we feel good about the progress we're making and we'll provide another update when there is more information to share. Quarter.

Speaker 2

I'll now turn to Slide 5, which is one that we shared with you last quarter as we recognized quarter. Our outlook for the Q4, which Jim will share with you shortly, assumes our earnings will remain under pressure in the near term. However, I want to reinforce my confidence in the resiliency of IP and quarter. Our teams at International Paper know what it takes to successfully manage through a business cycle. Quarter.

Speaker 2

And given the rapid change in demand, it will take some time to realign and optimize our system to the current environment. We have a wide range of options and capabilities across our large system of mills, box plants and supply chain, and we know how to leverage them while taking care of our customers. Also later in the presentation, Tim is going to share some specific actions that our teams are taking to shift production to our lowest cost operations and shared high margin cost across the system. We're also continuing to invest in projects to drive structural cost reduction through efficiency improvements. And finally, we have built a very strong balance sheet, which we will preserve because we believe it's ensuring our financial quarter.

Speaker 2

This allows us to continue investing in our businesses and to return cash to shareowners in a meaningful way by maintaining our dividend and through opportunistic share repurchases. I'm now going to turn it over to Tim, who will cover our business performance and outlook. Tim?

Speaker 3

Quarter. Thank you, Mark. Good morning, everyone. I'm on Slide 6, which shows our sequential earnings bridge. 3rd quarter operating earnings quarter.

Speaker 3

Price and mix improved by 1 $151,000,000 or $0.31 per share with strong price realization across both segments. Volume was lower in Industrial Packaging as result of the software demand across all channels. In Global Cellulose Fibers demand was stable. Quarter. However, pulp shipments were higher due to improved supply chain velocity.

Speaker 3

Operations and costs were impacted by the non repeat quarter. Significant economic downtime in our industrial packaging business and higher distribution quarter. As you may recall, our operations and costs in the second quarter benefited from $96,000,000 or $0.19 per share of favorable one time items related to insurance recovery for our Prattville mill as well as lower employee benefit costs, medical claims and workers' comp expenses. Maintenance outages were lower in the 3rd quarter as planned improving earnings by 0 point quarter. Info costs continue to be a headwind and were $75,000,000 or $0.15 per share higher in the 3rd quarter, quarter, driven by higher energy and chemicals, partially offset by lower OCC cost.

Speaker 3

On Slide 34 of the appendix, we provide details on our consumption of key inputs, including natural gas, which was a significant cost headwind quarter for our businesses in North America and Europe. Corporate and other items include benefits from lower tax expense and a lower share count. Lastly, equity earnings were below the quarter prior primarily due quarter sales price and FX related to ill. So turning to the segments and starting with Industrial Packaging on Slide 7. Quarter.

Speaker 3

We had very strong price and mix improvement in the quarter as we successfully completed implementation of our March price increase. While also benefiting from higher average export prices and commercial initiatives focused on margin improvement. Quarter. As Mark mentioned earlier, the challenging macro environment resulted in much lower volumes and unfavorable costs in our North American and European Packaging businesses. Quarter.

Speaker 3

Demand for packaging weakened significantly mid quarter across all channels and segments from lower consumer demand and retailer inventory destocking. This large decline in volume impacted operations and costs in the quarter as we adjusted our system to quarter. These actions resulted in approximately 400,000 tons of economic downtime across system resulting in higher unabsorbed fixed cost and a sub optimized system. This represented approximately 1 third of the higher Cost and Knobs Quarter Over Quarter. In addition, when not constrained, our mills ran very well, which increased the amount of quarter.

Speaker 3

Sequentially, operations in cost was quarter. It was also impacted by significantly higher distribution costs, inflation on materials and services and the non repeat of favorable one time items we discussed in the Q2. It also includes some additional spending on recovery boilers and bark boilers quarter across our mills to make our own energy given the significant increases in natural gas prices. Quarter. Info costs were another significant headwind in the quarter and much higher than we expected, primarily due to higher energy costs that were only partially offset quarter by lower OCC cost.

Speaker 3

These cost headwinds are even more significant for our Packaging business in Europe, where natural gas prices quarter. Turning to Slide 8, we thought it would be helpful if we share some additional perspectives on underlying segment trends for our corrugated packaging business. Quarter. As shown on the previous slide, our U. S.

Speaker 3

Box shipments were down 4 5.4% year over year and our overall U. S. Channel was down 5.9%. As a reminder, our U. S.

Speaker 3

Channel includes the U. S. Box system quarter. The yellow indicators represent segments where the demand decline was less than our overall average quarter of 5.4 percent and the red indicators represent declines that were worse than our overall average. Segments including beverage, durables and non durables, which are more discretionary in nature came under the most pressure as consumers had to make choices while dealing with high inflation.

Speaker 3

In addition, retailer inventory destocking has quarter. The demand declines for most segments in the near term. Based on feedback from our customers and our performance in October, quarter. Demand appears to be stabilizing at these lower levels as companies continue to work through their inventories in the Q4. Despite these near term headwinds, we understand the critical role corrugated packaging plays in bringing essential products to consumers and believe that IT is well positioned to grow with our customers over the long term.

Speaker 3

Turning to Slide 9. As Mark mentioned earlier, in the software demand environment where we aren't quarter. We have the ability to shed high marginal costs due to a wide range of options and capabilities quarter. For example, we are shifting between fiber options based on the marginal cost of wood versus OCC. In this case, our mill teams consider the total cost to process fiber including the benefits from own make energy when consuming wood versus the cost of natural gas used to process OCC.

Speaker 3

Another example would be in the supply chain area. Our teams are reducing premium freight through mode optimization and increased availability of lowest cost Carriers. At Mills, we're working to lower our planned maintenance outage costs by reducing overtime and premium pay that is traditionally quarter. We are also continuing to invest in our operations to drive structural cost reduction from efficiency improvements quarter. Ultimately, we are focused on restoring margins to historical levels by aligning our production with customer demand while optimizing our cost structure.

Speaker 3

Quarter. Turning to cellulose fibers on Slide 10. I'll start with an update on the demand environment and supply chain. Demand for fluff pulp remains stable across all regions. Quarter.

Speaker 3

Feedback from customers continues to indicate that fluff pulp inventories are near historical lows. Quarter. We are experiencing moderate improvement in supply chain efficiencies. However, they continue to remain stretched driven by ongoing port congestion and vessel relief. Quarter.

Speaker 3

We believe Fluff pulp will continue to grow over the long term and are confident in the essential role of absorbent personal care products and meeting consumer needs. Taking a look at the 2nd quarter performance, price and mix improved by $62,000,000 due to the successful execution of previously announced price increases with solid momentum as we enter the 4th quarter. Volume in the quarter was higher due quarter. To some improvement in supply chain velocity, however, I would note that backlogs remain above normalized levels due to ongoing logistics Challenges. Our mills continue to run well.

Speaker 3

Operations and costs were unfavorable in the quarter due to higher distribution costs and non repeat favorable one time items in the 2nd quarter. Planned maintenance outages were lower by $26,000,000 sequentially while input costs were higher by $12,000,000 Turning to Slide 11. On Global Cycle of Cyber's business continues to make significant progress quarter. Towards growing earnings and delivering cost of capital returns in the Q3 and the business remains well positioned to sustain this level of performance in the Q4. Quarter.

Speaker 3

Our team successfully deployed a commercial strategy focused on building strategic relationships with key global and regional customers and aligning with

Speaker 1

the most attractive regions and segments.

Speaker 3

We are focused on creating value for our customers by delivering products that meet their stringent product safety Standards and Deliver Innovative Value. In addition, we are driving structural margin improvement by ensuring we get paid for the value we provide. Today, we have made solid progress in our fluff pulp contract negotiations, which will provide additional commercial benefits as we move into 2023. We are committed to building on this momentum and delivering value creating returns over the business cycle. Quarter.

Speaker 3

I would also note that this is a key part of building a better IP initiative in the category of strategy acceleration. Turning to slide 12, I would like to update you on building about our IP set of initiatives. Quarter. We're making solid progress in delivering $70,000,000 of earnings in the 3rd quarter for a total of $175,000,000 year to date quarter. And we're on track to exceed the high end of our full year target.

Speaker 3

About half of the benefits to date are from our lean effectiveness initiative quarter. By rapidly streamlining our corporate and staff functions to realign with a more simplified portfolio, we have already offset 100% of the dissynergies quarter. Although most of these benefits have been achieved, we will continue to pursue additional opportunities. Quarter. The process optimization initiative has the potential to significantly reduce costs across areas such as maintenance and reliability, distribution and logistics and sourcing as we leverage advanced technology and data analytics.

Speaker 3

These initiatives will deliver meaningful benefits in 2020 3 as we finish implementing new capabilities across our businesses. And finally, strategy acceleration is about delivering profitable growth Commercial and Investment Excellence. Getting our global cellulose fiber business to deliver value creating returns is one example of this. Quarter. We are also focused on profitably growing our Industrial Packaging business by improving margins and investing for organic growth.

Speaker 3

Quarter. Turning to Slide 13 and a look at the 4th quarter outlook. As Mark mentioned, our earnings will remain under pressure in the near term because of the current demand environment. With that, I'll start with Industrial Packaging. We expect price and mix in the export channel to be lower by $10,000,000 Volume is expected to decrease by $30,000,000 with 4 less days sequentially in North America.

Speaker 3

Quarter. And the traditional seasonal pickup from holiday demand is not expected to be as strong this year. This will be partially offset by seasonally higher Refillage Volume and EMEA Packaging. Operations and costs are expected to decrease earnings by $120,000,000 quarter. A little more than half of this is from the higher unabsorbed fixed costs resulting from lower volumes as well as seasonally higher Cost, primarily from energy consumption and labor benefits.

Speaker 3

The remainder includes such items as inflation on materials and Services and Timing of Spending. Maintenance outage expense is generally flat. And lastly, input costs are expected to increase by $80,000,000 from lower fiber and energy costs. In Global Cellulose Fibers, quarter. We expect price index to improve by $20,000,000 on the realization of prior increases.

Speaker 3

Volume is expected to decrease by $10,000,000 based on timing of shipments through the supply chain. Operations and costs are expected to increase by $5,000,000 due to seasonality, quarter. While maintenance outage expense is expected to increase by $34,000,000 Lastly, input costs are quarter. We're expected to increase by $5,000,000 primarily related to energy costs at our converting

Speaker 2

operations this fall.

Speaker 3

Turning to Slide 14, I'll take a moment to update you on our capital allocation actions in the 3rd quarter. Quarter. As Mark mentioned earlier, we have a very strong balance sheet which we will preserve because we believe it is core to our capital allocation framework. Our 2021 year end leverage was 2.3 times on a Moody's basis, which is below our target range of 2.5 times to 2.8 times. Quarter.

Speaker 3

Looking ahead, we have limited medium term maturities with about $1,300,000,000 due over the next 10 years. Quarter. And finally, even in this environment, the risk mitigation strategies we've taken to ensure our pension plan remains fully funded quarter. Returning cash to shareowners is a meaningful part of our capital allocation framework. Quarter.

Speaker 3

In the Q3, we returned $434,000,000 to shareholders including $260,000,000 through share repurchases, quarter. We earned approximately $1,600,000,000 of cash to shareholders so far this year. In October, our Board of Directors authorized an additional 1.5 $1,000,000,000 of share repurchases, which brings our total authorization to approximately $3,400,000,000 quarter. Going forward, we are committed to returning cash through maintaining our dividend and through opportunistic share repurchases. Quarter.

Speaker 3

Investment excellence is essential to growing earnings and cash generation. We are targeting between $900,000,000 to $1,000,000,000 which includes The funding cost for the funding for cost reduction projects with attractive returns and for strategic projects to build out capabilities and capacity quarter. We will continue to be disciplined and selective when assessing M and A opportunities that may supplement our goal of accelerating profitable growth. You can expect M and A to focus primarily on bolt on opportunities in our packaging businesses in North America and Europe. Any potential opportunity we pursue must create compelling long term value for shareholders.

Speaker 3

Quarter. And with that, I'll turn it back over to Martin.

Speaker 2

Thanks, Tim, for all the details. Look, this is clearly a very dynamic environment with a lot of moving parts. Quarter. And as I look back across our company, I'm really proud of the improvement we've made in customer service over the last several quarters, Considering where we were in the middle of last year with containerboard inventory issues and box plant availability quarter. The reliability improvements we've made in our mill system, both in global cellulose fibers and in containerboard, I feel really good about because we're running very, very well, in some cases at levels productivity levels that are the best we've ever run.

Speaker 2

I also feel good about the progress our Global SoluMoS Fibers team is making and the trajectory of the profitability, earnings and business model changes we've made that Tim described a bit earlier. At the same time, I'm not at all satisfied with the level of our profitability, quarter, which has been impacted by supply chain disruptions, inflation and falling demand in the second half of this year. But I am certain we will make improvements in this area. I'm also very certain about the resiliency of International Paper. During the past few years, we have significantly enhanced our financial strength capability and taking a lot of risk out of the company.

Speaker 2

This strong foundation makes IP well positioned for success across a wide spectrum of economic environments. So with that, operator, we're ready to take questions.

Operator

Our first question comes from Bank of America and the line of George Staphos. Please go ahead.

Speaker 4

Hi, thanks very much. Hi, everyone. Good morning. Thanks for all the details, Mark and Tim. Quarter.

Speaker 4

First question broadly on containerboard and the second one on pulp. So in containerboard, can you talk to us about quarter. What benefit do you expect to get from the optimization efforts on a run rate basis? What the horizon would be in terms of when you expect to be at a more optimized level that you're targeting and how do current box shipments and brands play into your optimization? What are you seeing early in the quarter?

Speaker 2

So early in the quarter, we are seeing, as Tim mentioned box shipments still kind of stabilized from where they exited the Q3. That's down Yes, 6% or so from where the quarter progressively got a little worse. I think, George, the Q on optimizing, which we have called in the past, variableizing our cost structure. I think part of what's unique right now compared to maybe prior periods is the amount of production slowbacks quarter. We're taking over a relatively short period of time and in a period where most of our maintenance out almost all of our maintenance outages are behind us.

Speaker 2

If you look at prior periods, Bill, we noticed that our output to match our demand, a, it was spread out more evenly. Some of it was in the first half of the year where we also had maintenance quarter. So the Q3, we did a lot and it was really in the last 2 months of the quarter. In the 4th quarter, it's spread out more evenly, but it's still trying to anticipate the demand that we think we see, but being willing to turn it quarter. Back on if the demand picks up.

Speaker 2

And so I think that Q4 is going to be a transitionary quarter. I will say from the last time We took economic downtime in our containerboard system in any appreciable amount. You will all remember that was 2019. If we look at the variable cost per unit of production in that environment, we're actually doing a little bit better than that. What's different this time As we're doing this in a really high inflationary environment, so the price part of a lot of our inputs is persistently sticky.

Speaker 2

Quarter. We think some of that will start to relieve itself in the Q4, but it hasn't all happened yet. We weren't dealing with that part of the cost component in 2019. But our teams know what to do. The goal right now, we also didn't have a Energy environment and the goal right now is to maximize our own bank energy as anybody who makes their own energy in any industry would be trying to do right now.

Speaker 2

But you got to match that goal with the actual production output you need and that changes the way we

Speaker 1

run our pulp mill.

Speaker 2

So I think we'll see Through the Q4, continued improvement in how we shed those marginal costs.

Speaker 4

Thanks, Mark. My other question on pulp. Quarter. So you said, I believe demand for GCF was stable, yet your customers' inventories are still relatively low. Quarter.

Speaker 4

You've seen some improvement, but not a lot, I'm paraphrasing there, in the supply chain. So with inventories low, Did customers pick up their purchases relative to where they otherwise would have been because they could access more material because the supply chains improved? And as we look out over the next couple of quarters, presumably the supply chain improves, do you think that will lead customers to purchase more and improve your inventory position or know that it will be much more hand to mouth because supply chain has improved and so the need to have inventory will diminish somewhat. Thanks guys. Good luck in the quarter.

Speaker 2

I think the low levels of inventory for this particular product given it's not easily substitutable in the short term, given the qualifications. The low levels of inventory make the value chain very nervous. And so I think customers will work to get some level of comfort that they're used to. I don't think anyone will trust the supply chain for quite a while to be the answer to I can run with a lot lower inventories. Some of our shipments, as Tim mentioned or alluded to, We shipped a little more than we expected partly because the supply chain velocity improved a little bit as you paraphrase.

Speaker 2

Quarter. We don't know for sure if that's permanent or if that was just in the Q3. We hope it's going to get better because it will help us lower our cost. But we still have quarter. For example, China's market is still semi closed with some of the lockdowns.

Speaker 2

We think the inventory situation is going to remain strained, meaning low for finished products throughout the value chain quarter for the coming several quarters. And so, we think that the demand is stable. It could improve if China figures out Their vaccine and all that strategy and maybe opens the economy a little more. But right now, what we see is stable demand going forward, quarter. A lot of commercial improvements that will flow into 2023 and the ability with a little bit better supply chain to really start to take cost out of our system that we get to keep.

Speaker 2

Thank you, Mark. Thanks, Stuart.

Operator

Thank you. Our next question comes from Citi in the line of Anthony Pettinari. Please go ahead.

Speaker 5

Good morning. Just following up on inventories, maybe on the containerboard side, how would you characterized customer inventories here in October as well as your own inventories. And to the extent that there's maybe an overhang still in the channel. Like how long do you think it might take to work through that?

Speaker 2

So I think there's quarter. If you go back to the slide Tim showed, Anthony, with the yellow and red segment descriptors, Those that were the demand declined more than the average demand. Those are the customers in those segments. And we had very big customers, national type accounts and we had very small customers inside of each of those little segment descriptors. Those that were greater than the average, a big portion of their commentary to us on their order pattern was too much inventory.

Speaker 2

And we think they think best they can tell from the consumer, I watched a few of their earnings calls earlier this week, quarter. That's a 4th quarter unwinding process, but maybe not terribly much beyond that. If you look at the other part of that chart, Where our decline in some cases, we didn't break it out, but in some cases, we had customers inside of segments that the demand didn't decline at all. They're very big and important customers to us. And they would say their inventories are a little high, but we'll see what happens with Q4 consumer demand.

Speaker 2

They're predicting a little less of a holiday pickup, any pickup at all, and they'll feel like they're in great shape. So it's really a tale of those segments on that chart we showed. But even in the worst case, we think most of our customers believe that this is a working through the 4th quarter process. Quarter. Obviously, you hate to make a prediction because there seems to be so many variables that come up and inflation is so persistent and high.

Speaker 2

Consumer can be fickle after the holiday period and spending a lot of money on services. What happens to the goods market in the Q1? I think that is what a lot of us quarter.

Speaker 5

Okay. That's very helpful. And then just with the updated CapEx guidance, Can you remind us kind of how you think about normalized maintenance versus growth versus regulatory CapEx to the extent that you're maybe trimming some of that, maybe where is that coming from? And then understanding you're not giving guidance on 23, just kind of directionally, are there capital needs for the business that might cause CapEx to go higher next year? Could it go lower?

Speaker 5

Do you think you're kind of in a good position year. Just any incremental thoughts on CapEx?

Speaker 3

Yes, great. Thanks, Anthony. It's Jim. So over time, longer quarter. We look to have capital investment around the level of depreciation that can be a little bit higher in some years.

Speaker 3

What usually drives that is not so much maintenance and regulatory. We try to keep that fairly consistent. We look over a 5 year period. We have 5 year plans about how we're going to do maintenance schedules. What tends to drive it up and down a little bit on the margin tends to be more of the strategic projects, Whether it's building out capability or more recently adding capacity in our converting operations.

Speaker 3

So but the $900,000,000,000 to $1,000,000,000 is not necessarily us actively pulling back capital. Quarter. It's just coming to the realization this close to the end of the year that as hard as we've tried all through the year, supply chain has It's been a limiting factor about how much capital you can have installed and have it be productive in a given period of time. So that's the reason for the adjustment, just acknowledging that we're not going to get as much done as we thought we were earlier in the year. Quarter.

Speaker 3

And longer term, we'll try to be around depreciation, but where there's either good cost reduction projects or Strategic Needs Building Out Capability. It could be a little bit higher than that in given years.

Operator

Thank you. Our next question comes from Bank of Montreal and the line of Mark Wilde. Please go ahead.

Speaker 6

Thanks. Good morning, Mark. Good morning, Tim.

Speaker 3

Quarter. Mark, I wanted just

Speaker 6

to start out, you took a lot of economic downtime in the 3rd quarter, And you're suggesting more in the Q4. I just wondered given that level of downtime and coupling that with 3rd. Are there some more efficient ways to adjust your capital base over the next 12 to 18 months, whether it's some permanent moves or maybe moves like we saw at Valiant several years ago when they just mothballed 1 of the machines? Quarter. Or is just continuing to take kind of rolling downtime across the system, is that the optimum approach?

Speaker 2

It's a great question, Mark. I think the variables we looked at, of course, we don't know what the demand environment is going to be over the next year or 2, and we don't know exactly what the ramp of the new capacity you mentioned will be. So there's a lot of variables. The other thing that's a little different and quarter. Natural gas costs, which changed the competitiveness of your recycled mills.

Speaker 2

And we have a few that are 100% recycled. The flip side of that is you got a very expensive and congested supply chain. So An IP example would be our large recycle mill that's up in the Midwest might be a candidate to scale back for 3rd quarter. So one of the reasons you see us doing more of, as you described, rolling, so not Fully shutting down, but adjusting the output of multiple plants is to try to make all of that balance, Get our integrated mills to be as close to energy independent as possible and our non integrated mills, which tend to be Located physically in places and they were built for that reason to be close to the end use market and they're beyond a lot of their real choke points to get those to serve as much As things change, as supply chain costs change, as energy changes, it will lead us to different conclusions. So that's how we make that decision on how much we run to our order book and where we do it.

Speaker 3

Okay. And I wanted to

Speaker 6

just turn to cellulose. I know that this whole strategic effort in cellulose over the last few years. It has a number of different elements.

Speaker 7

And so just quarter. If we look at

Speaker 6

the pulp price charts right now, they're at the highest levels any of us have ever seen. So can you just help us on this call Get confidence that if pulp prices start to roll over, you're actually going to be able to maintain those caustic capital returns going forward in cellulose. It is not just the market that's gotten you there at this point.

Speaker 2

Yes. I think if you look at a couple of indicators, one of the things we've tried to do with our value proposition is to make Arrangements with customers. Tim, you used the word moving to strategic arrangements versus just contractual volume for price. And 2, how we participate in the different regions of the world, given the nature of product and what requirements a customer has from the standpoint of substitution and making sure we get paid for that. And so you can see some evidence in certain charts in certain regions where that phenomena has already started to occur And there's no impact on our absorbent products economics.

Speaker 2

And the reason for that is Our strategy adjustment has been to work with our customers and to basically have the effect of decoupling that as much as quarter. But your point is well taken. We will see how that plays out as we go through a normal business cycle. Quarter. We're very comfortable that we've made structural changes in the way we go to market.

Speaker 2

And I'm not saying you won't see any cyclicality, but I think you will begin to see a different spread over time than you've seen in the past. But the proof will be in the coming quarters. Quarter. I'll take you back, Mark, to what I said over a year ago. Investors can expect with the changes we're making for Global Cellulose Fibers to quarter after quarter after quarter that we will be at the cost of capital returns in the second half of 'twenty two And that you could expect the business as we enter into 'twenty three to be a value creating business.

Speaker 2

And so far, That's the track we're off. So let's keep talking about it quarter after quarter. I think your point is a great one and I think We'll learn a lot more about whether or not our strategy adjustments have resiliency and sustainability as we move 23. I believe they do.

Speaker 6

Okay. That's helpful, Mark. I'll turn it over to some other questions.

Operator

Thank you. Next from Seaport Research Partners, Mark Weintraub. Your line is open.

Speaker 8

Thank you. Quarter. So I'm just trying to think through and work out the downtime, the magnitude of downtime that you guys took in the 3rd quarter, obviously acting quickly to Adjust to the Demand Environment. And I think your North American system order magnitude is 13,500,000 tons, so roughly 3,500,000 tons a quarter. And just the economic downtime itself was about 400,000 tons, which if I'm doing my math right and I'm not missing something is suggesting you're kind of in the 85%, 90% range in terms of operating rates.

Speaker 8

Quarter. And basically, containerboard production presumably was down by 10% plus quarter. So I have 2 questions on that. 1, are you actually are you have you been bringing containerboard inventory down in your system during this quarter. And then you also made the comments that you if I understood correctly that in the Q4, you're probably going to be taking out much or maybe more.

Speaker 8

Did I hear that right?

Speaker 2

So Mark, that's a multifaceted question. Let me just take you back quarter. So the containerboard system has a certain capacity. It's a little higher than the number you mentioned. And the way we run it is not by quarter.

Speaker 2

I We have to do what we have to do in a single quarter. The way we think about our system is we have a certain amount of output capability. We strategically target about 3% of that and you can look at our earnings calls quarter. How much volume we take out for planned maintenance ends up being around between 3% and 4%. Then there's another 3% to 4% that we tend to average Just in terms of being flexible for customer service, for unforeseen problems.

Speaker 2

And so every once in a while, to match quarter. A change in demand, like 2019, we'll adjust our output to match a reduced demand environment. And that, Again, it has multiple variables. It depends on how strong the export market is during the same period of time. Sometimes the markets are connected, sometimes they're not.

Speaker 2

That number as a percentage of our total capacity in 2019 was probably 6%, 7% of our total capacity once In a multiyear period. And I don't know what it's going to be. We don't forecast. We're just trying to match up the principle call. We're going to make the containerboard we need to serve the order book we have and to maintain what is much healthier inventories for our supply chain.

Speaker 2

Quarter. And those numbers, as you know, for almost every industry are a little higher in this kind of supply chain environment. But that's the way you should think about it. Think about it big picture, not in a 60 or 90 day period. There's a system, there's maintenance, there's flexibility time and occasionally there's an adjustment.

Speaker 2

Quarter. And that's the kind of way it's going to play out, roughly the percentages I gave you if you annualize. What's unique about this and I've mentioned it in the prior answer quarter. A, the market slowdown in quarters that normally the market is not slowing down and for IP, quarter where we don't have any other maintenance outages that would normally be taking production offline like we had in the first half of the year. So That's the difference is that's what adds to the cost mitigation challenge.

Speaker 8

Thank you. Helpful. And just to clarify, I guess what I'm trying to ascertain is whether or not the amount of downtime you took and I appreciate all the talk about maintenance and levels along those lines, etcetera, having and impact. But were you was there almost some catch up down if we were to remain in a down 6% type of demand environment. Would you anticipate continuing to take this level of downtime?

Speaker 8

Or was there the degree of downtime on the Board side of things was even more than what the box shipment type of environment would have indicated.

Speaker 2

So again, Mark, the way you need to think about the answer to that question is Any downtime we take is a product of doing the analysis of our North American order book, our export order book. Any maintenance outages that would already take production offline. And I think Tim mentioned it, how well we're running in the moment. So we're running really, really well right now, I. E.

Speaker 2

We're making too much containerboard, which is where you want to be. That's what we've worked on to be reliable. What that means in plain speak quarter. The lack of reliability interruptions in the quarter, which is a good thing, but not in a quarter where you necessarily Don't need the production, so you end up slowing back, but at least you didn't have a repair cost. So it's impossible to answer the question without knowing the answer to all four of those variables Glensky.

Speaker 8

Understood. That's really helpful. And I get it, I think, basically, you have improved your system. You can actually make more products. You could continue like this, Which I guess would then sort of go back to Mark Wilde's question a little bit.

Speaker 8

Does that then give you a little bit added flexibility to think about your footprint on a different basis too, if you've actually is that a fair observation?

Speaker 2

I think it's fair to Think about the way I answered Mark's question is, in the moment where you're considering, which let's take right now, you look at the other variables like And you make the decisions for production at the lowest, I think Tim used The words, the lowest marginal cost operations. And that could change in a month because of a hurricane that wet the woodlands and now you've got So my point is not to be evasive. It's a dynamic set of variables We make those decisions not real time, but in a 7 to 10 day period. So if the answer to the question, How do we make the production we need at the lowest cost involve some of the examples you and Mark mentioned, and then that's what we would do. Quarter.

Speaker 2

Right now, with the variables we have with supply chain and energy, that's not the most cost effective way to do it. Thanks very much.

Operator

Thank you. Then our next question comes from Truist Securities and the line of Mike Roxland. Please go ahead.

Speaker 7

Quarter. Thanks. Hi, Mark, Tim. Thanks for taking my questions. Just wanted to follow-up, I guess, on your inventory as well, just quarter.

Speaker 7

Following up on Mark's question, Anthony's question is about the overall or the aggregate level of your inventories during the quarter. Can Can you give us a sense of where they stand? I mean, I remember last quarter you mentioning that your continued board inventories are now back to sufficient level. Quarter. Well, with demand slowing aggressively it has, given the economic downside you've taken, given some of the slowbacks, would it be fair to say that your inventories have declined sequentially and relative to your comments from last quarter.

Speaker 3

Yes. So quarter. We were back where we needed to be part of the reaction that you saw in the quarter. It happened midway through the quarter as Mark referenced. It was really in response to making sure that inventories don't get away from us.

Speaker 3

If we're running to demand, quarter. We're trying to look our S and OP process is trying to look at not only in the moment, but further out in time and what kind of product availability needs we're going to have. So we were able to kind of keep inventories in time with where we want them through the way we ran the system.

Speaker 2

And Mike, again, I'll just reiterate the Decisions that we make are for the what we can see upcoming, but think about the calendar. The other variable as you're taking Adjustments to inventory at this time of year versus in the middle of the year as we enter into the first half of the year, which Our heavy 75 percent of our maintenance outages. So part of our normal operating strategy is to predict how do we make sure we have the inventory we need in the and Q2 of next year, so we don't lose a sale because we did something to inventories in the moment in the Q4 without Looking at what's getting ready to happen. So that's factored into our decisions as well. It's not just about the inventory quarter.

Speaker 2

It probably would be if we were in the 2nd quarter because the outages are done, you got plenty of inventory, you don't have any more mills down, but that's not the case here. We're getting ready Enter into our normal outage season and that factors into what we think we have to run whether or not there was an economic slowdown or not so we can get through our quarter.

Speaker 3

Yes. The other thing I would add is even though we've seen some modest improvement in transit times with ocean vessels, Here on the ground in North America, well and truck, our network, the supply chain has not paid up a lot of velocity. Quarter. So we're still dealing with the extra time it takes to move product in between mills and converting operations.

Speaker 7

Got you. I appreciate the color. Just one quick follow-up. If demand remains depressed through this quarter through the earlier part of next year, Would it be fair to say that and you continue not to, let's say, you could turn up production there slow back. Is that the point at which you would draw down your inventory?

Speaker 7

So, Mark, you mentioned It was 2Q, but would it be fair to say that if you were in early 1Q and demand the overall environment demand volume is minus 6%, you would start to draw down your inventories quarter.

Speaker 2

We would run the system to match the demand that we have. So we don't know what the demand is going to be in the Q1, but as we Get closer to that, we'll have a better idea. And if that results and the supply chain velocities improve, then we don't solve for the inventory level number. We call for making sure we can take care of our customers and that we have the business prepared because what we make today gets used In the future, not today. And so we've already made the ending for it for today yesterday.

Speaker 2

Quarter. So that's why it's difficult to give you a finite period answer. There's again a lot of variables. We need less absolute inventory when the supply chain is Flowing and we do when it's not. And it's a long way from flowing and especially in the rail area, a lot of our mills are in the southeast, deep southeast, Where the rail choke points are not getting any better and the labor situation is not getting a lot better.

Speaker 2

So we're working with what we know right now quarter. And what we know right now says the inventory levels we have, the absolute number matches the slow philosophy of the supply chain. If that changes, we'll adjust our production output to match the fact that the inventory is moving investor. So it's not a matter of will we lower our inventory, it's a matter of all of those variables lead to an inventory number.

Speaker 7

Sasha, appreciate all the color. Good luck in the balance of the year.

Operator

Thank you. Thank you. Then our next question comes from Adam Josephson of KeyBanc. Please go ahead.

Speaker 6

Mark and Tim, good morning. Thanks very much for taking my questions. Quarter. Mark, just one more kind of way of asking that capacity question that I think both marks were getting at is, obviously, you have to hazard a guess as to what long run demand will be to figure out what the optimal level of capacity is. And obviously, there was this exceptionally unusual surge in demand during the pandemic, and now we're starting to see the other side of that.

Speaker 6

So when you're thinking about the right amount of capacity to have long term. How are you thinking about the right level of demand? Obviously, it's near impossible to forecast it, but are you thinking that 2019 levels were kind of normal or and what the long run rate of demand growth will be? Obviously, there's capacity coming that I think Mark Wilde mentioned. So how are you thinking about all those factors when determining what the right level of long term capacity is for you.

Speaker 2

Yes. Again, Adam, I appreciate you coming at it from Different angle. I mean, the long term capacity we think we need is based on what we believe about the markets we serve. And the markets we serve, ex the pandemic, just normalized volume. Unless there's some major change in the structure of the U.

Speaker 2

S. Economy, it's been a 1% to 2% growth market for boxes. Quarter. And the open market is similar because we're selling to people who make boxes in the same market. And global containerboard, virgin containerboard to service The rest of the world and to create recycled fiber has been a 2% to 3% growth.

Speaker 2

And we've typically tried 3rd And so I'd say right now, Again, with those numbers in mind, over time, not here in the moment, but over time, we're good on containerboard. Quarter. We just made the Riverdale investment in 2020. That was another good chunk of high quality white top. We made small project investments across the North American system in the years prior to that.

Speaker 2

And I think we've got the containerboard capacity we need. We're working on different grades, lighter Weight, different things like that. But I think that's how we think about the containerboard capacity. We back it into what do we need in containerboard based on what we think the end use markets are going to need for box, which is the biggest, and then the actual open market we sell in North America and export. And those are the numbers we we didn't change our strategy because of the pandemic demand.

Speaker 2

What we did is We realized we can't run as close to the full capacity that we were running in our converting operations, meaning quarter. You can always use a little labor to get some extra capacity by working some overtime, but you can't do that forever because there's people and they can't do that forever. So you do need to Have a better asset strategy, and we learned that through the pandemic demand, but we didn't change our strategy on what we look at long term growth of containerboard and its uses.

Speaker 3

No, just I think part of what you were getting at, Adam, is the pull forward that's maybe some other industry saw quarter. Primarily around durable goods, but durable goods is a small segment, small for us, a small in total. And a lot of what people are buying are consumable items. So it's not like I don't maybe in some cases, quarter. There's demand pull forward a little bit, but I don't feel like that's the bulk of it.

Speaker 3

It's just I think that we have seen the shift that Mark talked about between goods and services and that will normalize at some point too.

Speaker 6

Yes. Quarter. I appreciate that. And just Tim, one on the dividend. So your balance sheet, you've done a lot of work to get it in much better shape than it used to be and kudos to you for that.

Speaker 6

When I think about the dividend payout, so just in light of what you're guiding to for this year, the $900,000,000 to $1,000,000,000 if if I assume that you sell or do something with your Ilim stake, that would mean that you wouldn't get that $200,000,000 ish of cash dividends next year and thereafter for that matter, such that ex Ilim, you'd be paying out, I think, what, 90% of your free cash flow this year. And obviously, you have a view of where trough cash flow is, a normalized cash flow, peak cash flow. How are you thinking about the dividend payout in light of what you're guiding to for this year, in light of what you're hoping to do with Ilim, etcetera?

Speaker 3

Quarter. Yes, it's a great question, Adam. I mean, the way we think about it is and we say 40% to 50% free cash flow that in our minds and I think we've said this before, but that's not in every moment of quarter. That is through the cycle. And there have been moments when our dividend payout has been higher than that and it's been right down on the bottom end of that at times quarter.

Speaker 3

So I think we're in a moment, but we still believe that the dividend is structured. We have bought a heck of a lot of quarters at the same time. It's still perfectly situated in that 40% to 50% of free cash flow and we call.

Speaker 2

Yes. I think it's important to know, Adam, that what Tim said is really, really important, 40% to 50% over a cycle, which means it's going to be at the upper end and it could be the number you just gave and it could be much lower and be at the lower end. It is even dipped into 30 something percent of free cash flow. The dividend is really important to us. It's really important to our investors.

Speaker 2

That's what we hear from investors. Quarter. And it is important for us to make sure that it's not a tactical thing that we calculate free cash flow for quarter. And then we say, oh, 50% of that. It's not how we do it.

Speaker 2

It's 40% to 50%. It's an overall guideline through a cycle. And a lot of things happen to converge in trough conditions, which you might describe as low demand with all its negative impact, usually followed by quarter. Lower cost environment unwinding of working capital. Cash, as you know, has many components, but that's the way for people to think about our dividend.

Speaker 2

It's not a calculation in the moment, pick your moment, quarter, half year, year. It's through a cycle. And I just want to be really clear about that.

Speaker 6

Quarter. Thanks so much, Mark.

Operator

Thank you. Then our final question for today comes from Deutsche Bank and the line of Kyle White. Please go ahead.

Speaker 9

Hi, good morning. Thanks for taking the question. I was just hoping to get some more details on demand. I know you've talked about a lot, Quad. Just trying to understand the 2 large dynamics impacting demand here, the destock impact and now inflationary pressures on consumers.

Speaker 9

Quarter. We kind of knew about the destock impact hitting into the quarter, but you mentioned that demand saw sharper decline midway through. So it seems like inflationary pressures are now taking over and having a larger impact on demand going forward. So should that not carry kind of forward into 2023 such that we could see mid single digit declines in the first half of twenty twenty three or just how what are you seeing now and how are you thinking about that for next year?

Speaker 2

Quarter. Kyle, I think it's a really great question. That's the kind of conversations we're having with customers. Our business doesn't have that long of a cycle. So We got some visibility into the Q4.

Speaker 2

It's really there's really not a lot of visibility other than algorithms and analytics into the Q1. But what I think our customers said, what they saw and then hence we saw is as inflation remains persistent, customers had to make choices. And you look at the time of year we're in, approaching holidays, a little more travel, they're making choices to spend money on services or save money for a future airplane flight over the holidays and backing off with some discretionary things. So fast forward through the Q4 and you flush out all that service spending. Where does the consumer find themselves in the Q1?

Speaker 2

I think it has a lot to do with whether this quote slowing market and slowing economy actually creates different policy, interest rates. How does the consumer feel? You listen to the bank CEOs and they have a general view that the consumer is still in pretty good shape. And that's true looking at bank balances and all that, but that won't stay that way if inflation remains at 9%, 10% and rents are high and all the other things. That's the real variables we're watching and our customers are watching.

Speaker 2

But we'll deal with whatever the environment is in the 1st part of next year. But I think we have to see what does the consumer do as They work their way through, at least in this part of the world, a very heavily service oriented holiday spending pattern. And will they make choices that are different? It looks like they're making choices on less goods, more services. But After the services are all spent, will the goods replenishment, as Kim said, some of this is consumables, will that regain a normal cadence in the first quarter.

Speaker 2

It's a great question. We're watching it. We'll know a lot more obviously as we go through the Q4 and when we're talking to all of you at the end January with our full year. We'll be in it. So we'll have a lot better view on that.

Speaker 9

Got it. That's very helpful. And then what's the latest on Ilim, understanding you can't share all the details, but just curious what you can on a call like this regarding the timing of central sale that you think could happen there. And then also curious, do you expect to receive any additional dividends from Ilim next year or in the future?

Speaker 3

Yes. We're not forecasting dividends into next year. We're in the middle of the process. Quarter. And you're right, there's not a whole lot more we can say about it, but we feel good about where we are.

Speaker 3

We have made progress and we're pushing hard.

Speaker 2

And it's I made a couple of comments in prepared remarks, Kyle, that we're not where we were at the beginning of the quarter. We're much more advanced, but it is a complex process. Quarter. It makes it a more time consuming and more complex process. But we have advanced along that process timeline quarter.

Speaker 2

Quite a bit. So I'm really pleased, but we're not there until we're there. So that's why we're not getting out over our skis on where we are on it. But

Operator

quarter. Thank you. Then I'd like to turn the call back over to Mark Sutton for closing comments.

Speaker 2

Quarter. Thank you, operator. I'd just like to close by really saying thank you to all the International Paper team members, employees around the world. What they're doing every day for our customers and what they're doing every day for each other to stay safe and to operate in environments that I don't think any of them ever thought quarter. I'd just like to close by reiterating a couple of comments I made.

Speaker 2

We think the half of this year is clearly transitory. We're taking the actions we need to take, pulling the levers we need to pull to make sure International Paper gets through this period in a very good way, and I'm really pleased with the kind of financial underpinnings we have entering into any type of economic environment. Quarter. We have a lot of opportunity and flexibility even at lower demand levels. And in some cases, there could be a silver lining in the fact that it allows us to get some of our The strong balance sheet gives us options so we can continue to make organic investments in structural cost reduction and in strategic capacity and capability.

Speaker 2

In the past, we would have probably had to stop some of that just to manage the balance sheet. There's no meaningful debt for the foreseeable future that we need to deal with. So quarter. We've got a lot of risk off the table. We're built for this type of environment and we're built for a strong environment.

Speaker 2

And I feel good about our ability to get quarter.

Operator

And ladies and gentlemen, thank you for your participation in International Paper's Third Quarter 2022 Earnings Call. You may now disconnect.

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Earnings Conference Call
International Paper Q3 2022
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