Fructivore Investments

In my last article discussing Black Box, part of my positive opinion of the company was its performance in 2009. This led me to consider how far back into a company’s earnings history we should go. Ben Graham in his Security Analysis recommends at least a decade, but that runs into the situation that a company now may not be the same company it was ten years ago. However, it would be equally a mistake to take last year’s earnings as representative of a company’s earnings power. Behavioralists call that the recency bias, the tendency to overweight the most recent information, and I attribute much of this bias to the fact that financial websites tend to report only the current figures (current book value, P/E based on most recent 4 quarters of earnings, etc.), and to get historical data you have to do more digging. Not that I mind digging, of course.

The effect is particularly disturbing with cyclical companies. Nothing is more dangerous than valuing a cyclical company at the peak of its cycle. Consider the US Gypsum takeover of 1987; the company received a leveraged buyout offer from a takeover artist, and the Board knew immediately from reading the offer that they were valuing the company at its cyclical peak, as though it was a noncyclical company that could always go on earning at that level. The Board had no choice but to issue a counteroffer with slightly less leverage involved, but sadly even maneuver this was unable to prevent a subsequent bankruptcy.

The trouble is there is a balance that has to be struck. Go back too far and you start incorporating data that is not directly comparable because the company was different at the time, but go back not far enough and you risk missing a cyclical issue. Some businesses have a reputation for cyclicality (US Gypsum, for example, which made drywall and is therefore exposed to the cyclical construction industry).

Obviously for these companies you have to look back into history to determine the average level of earnings and profit margins. And yet, even cyclical companies can change over time. By way of illustration, I give you International Paper (IP), the leading manufacturer of corrugated cardboard in the United States, as well as printing paper, packaging, and other things to do with paper and pulp. The firm’s current market cap is $13.5 billion, or $10.8 billion net of excess cash. The company owns 20 paper and packaging mills, 144 converting and packaging plants, 19 recycleries, 3 bag making facilities, about a third of which are located outside the United States. The company also owns some land in Brazil and has a joint venture in Russia to both harvest wood and process it into paper.

Our interest in this company comes from its massive restructuring in the last few years. In 2010 for example, the company incurred over $300 million in restructuring charges, and in 2009 the figure was more than $1 billion. Clearly, there is a lot of restructuring going on, and the impact of restructuring on the company’s prospective earnings power cannot be set aside, as you will see from the figures. However, the improved economic situation as between 2009 and now, coupled with the fact that this is a cyclical company in general, gives me concern about how effective this restructuring is.

In presenting these figures, I am treating various restructuring expenses as nonrecurring if they are one-time expenses such as severance, or noncash expenses such as writing off an accelerated depreciation allowance. However, expenses relating to the direct cost of closures I am leaving in because the firm can close and open plants even outside of the context of a restructuring, and with nearly 200 facilities that should be considered simply a cost of doing business.

In 2010, sales were $25.2 billion, operating income as reported were $1430 million, the excess of capital expenditures over depreciation $681 million, certain restructuring charges $280 million, producing operating cash flow of $2391. Interest expense that year was $608 million, leaving pretax cash flow of $1783. After estimated taxes at a 35% rate and adding back in earnings from the joint venture, we have free cash flow to shareholders of $1223 million.

2011 seems to be continuing this trend.  For the first three quarters  sales were $19.7 billion, operating income as adjusted for impairments $1261 million, certain restructuring charges $32 million, excess depreciation $286 million, which leaves $1579 million in operating income.  Interest expense was $403 million, which leaves $1176 in pretax cash flow. After estimated taxes and joint venture earnings we have $914 million, which would be $1219 on an annualized basis.

Compare these results to those of 2009: sales of $23.4 billion, reported operating income $1199 million, certain impairment charges $1154 million, excess depreciation $938 million, producing operating cash flows of $3291 million. However, $2100 million of this amount was the infamous black liquor tax credit, so actual operating income was only $1191 million. Interest expense in this year was $669 million, leaving $522 million before taxes, or $290 million afterwards.

And in 2008, sales were $24.8 billion, reported operating income as adjusted for impairments was $624 million, excess depreciation was $345 million, producing a total of $1097 million. Interest expense that year was $492 million, leaving $605 million in pretax cash flow, or $442 million in after-tax free cash flow. This was also the year in which the company acquired Weyerhaeuser’s packaging business.

Now, if we were naïve enough never to have heard of cyclicality we would assume that the improved performance of 2010 and 2011 relative to the years before were the result of the restructuring, which has apparently been effective because the company’s free cash flow yield  after excess cash is deducted is 11.3%. However, because this is a cyclical company we know that it would be unwise to use these earnings as a baseline of the company’s earnings power.

This presents the difficulty that we cannot evaluate the effectiveness of International Paper’s restructuring in the first place, at least without waiting for another severe recession. We could, however, compare it to how the company was doing the last time it was at the same point in the business cycle, which would probably be around 2002. Again, it is a different company than it was in 2002, but the comparison is better than nothing.

Way back in 2002, sales were $25 billion, operating income as reported was $1154 million, excess depreciation was $582 million (not counting an additional $535 million in divestitures—curiously, International Paper was going through a restructuring then too), leaving operating income of $1736 million. Interest expense that year was $783 million, leaving $953 million, or $620 million after estimated taxes.  So, comparing 2002 and 2012, we see that sales and operating profits have remained roughly flat, and the difference in net income is the result of lower interest expenses. And, since long term debt at the end of 2002 was $13 billion and International Paper’s current long term debt is $7.8 billion, we see that the improvements in free cash flow are largely the result of paying down debt, as International Paper’s interest rates are in fact slightly higher than in 2002. So, we can conclude that the  restructuring at International Paper was effective only at retaining existing earnings power, not improving the company’s prospects.

As a value investor, what should we take away from this? One sensible approach is to average a company’s performance across the entire length of a business cycle and use that as an estimate of earnings power. However, cyclical companies tend to be priced according to where they are in the cycle even if the market knows they are cyclical—even Ben Graham observed that ice companies tend to do better in the summer than the winter. It is also possible to assess profit margins across the cycle and apply them to the current level of sales, as I did above.

However, the wise value investor would do better to avoid risk than to make sure that the risk is compensated. As a result, the most conservative rule would be to avoid investing in a cyclical company unless its free cash flow yield based on the current price would be adequate even at the bottom of the cycle. Domtar, a company I have written up previously, is in just such a situation. Even in 2009, free cash flows were $274 million, not including the tax benefits of excess depreciation, and the company’s current market cap after excess cash is taken into account is $2.75 billion, meaning that free cash flow yields in this bad year were a robust 10%, and of course returns at a better time in the cycle would be quite compelling.

My point is not simply “buy Domtar instead of International Paper,” but to make sure that we use a genuinely representative sample of earnings when trying to compute a firm’s earnings power. As I said in my last article, to paraphrase Hugh Hendry, a good alternate form of stress testing is asking what happened in 2009.

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