International Paper Company

Good morning, and thank you for standing by. Welcome to today's International Paper Third Quarter 2020 Earnings Day Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, you will have an opportunity to ask questions. To ask a question, press star 1 on your telephone keypad. To withdraw a question, press the pound key. I'd now like to turn today's conference over to Guillermo Gutierrez. Vice President, Investor Relations.

Thank you, Maria. Good morning, and thank you for joining International Papers Third Quarter 2020 Earnings Call. Our speakers this morning are Mark Sutton, Chairman and Chief Executive Officer, and Tim Nichols, Senior Vice President and Chief Financial Officer. There is important information at the beginning of our presentation on slide two, including certain legal disclaimers. For example, during the call, we will make forward-looking statements that are subject to risks and uncertainties, including the impact of COVID-19. We will also present certain non-U.S. GAAP financial information. A reconciliation of those figures to U.S. GAAP financial measures is available on our website. Our website also contains copies of the third quarter 2020 earnings press release and today's presentation slides. Relative to the Illum joint venture and graphic packaging investments, slide two also provides context around the financial information and statistical measures presented on those entities. I will now turn the call over to Mark Sutton.

Thank you, Guillermo, and good morning, everyone. We'll begin our discussion on slide three. International paper delivered solid results and robust cash flows in a dynamic environment. We generated $1.6 billion of free cash flow through the first three quarters as we continue to demonstrate the strength and resilience of our company. We're on track to generate $2 billion in free cash flow this year through our early actions and strong execution. Relative to demand, recovery trends continue to vary by business and by end-user consumer segments. Demand for our corrugated packaging accelerated in the third quarter, and that momentum continues in the fourth quarter. In flood pulp, as expected, we experienced seasonally lower demand and destocking across most regions. In papers, we're in the early stages of recovery as offices and school activities begin to restart. Against this backdrop, our commercial, supply chain, and manufacturing organizations are executing at a high level to ensure we meet our customers' changing needs, leveraging the scale and flexibility of our system and optimizing our costs. The company's solid performance in the third quarter reinforces our financial strength and commitment to our capital allocation framework. Turning now to slide four, which shows our third quarter results. Operating earnings were $0.71 per share, which included an unfavorable ILIM foreign exchange non-cash impact of $0.14 in the quarter. Sales improved sequentially and came in higher than our expectations, driven by strong demand in our North American packaging business. EBITDA increased by nearly $100 million sequentially even as planned maintenance outage expenses stepped up by about $80 million. As already mentioned, we generated robust free cash flow in the third quarter, which we continue to apply in a manner consistent with our capital allocation framework. During the third quarter, we reduced debt by about $800 million, bringing year-to-date debt reduction to $1.1 billion. Earlier this month, the Board of Directors approved the fourth quarter dividend, bringing the full-year authorizations for our dividend to $800 million. Moving to slide five, as I reflect on our performance this year, it reaffirms my admiration and appreciation for our 50,000 employees worldwide who continue to perform at a high level by taking care of each other and our customers. I'm especially grateful to our frontline teams in manufacturing and converting facilities around the world. We remain absolutely committed to our COVID-19 principles and we'll continue to focus on what we need to do to further strengthen the company for all of our stakeholders in the short term and in the long term. Now I'll turn it over to Tim, who will cover our business performance and our fourth quarter outlook. Tim?

Thank you, Mark. Good morning. Moving to the quarter over quarter earnings bridge on slide six, third quarter operating earnings were better than we expected, driven by strong commercial and operating performance, as well as outstanding cost management. Higher volume contributed to improved fixed cost absorption in the quarter, which is captured in operations and cost. Third quarter performance also benefited from one-time items, which favorably impacted operations and cost. Looking at the bridge, price and mix was essentially flat. Volume was favorable, driven by strong demand for corrugated packaging in North America, and improved demand for printing papers across all regions. Operations and costs benefited from improved fixed-cost absorption on higher volume. The businesses continued to do an excellent job managing costs and delivered strong operational performance to mitigate the impact of hurricanes in the quarter. As mentioned earlier, one-time items contributed favorably to operations and costs, adding about $30 million or $0.06 per share, with each business seeing about $10 million in benefits. As expected, maintenance outage costs were a drag in the third quarter, which is our highest planned maintenance outage quarter this year. I'll remind you that in response to COVID-19, we made significant adjustments to the scope and timing of our maintenance outage plan. We now expect the full year maintenance outage expense to be $450 million compared to $585 million in the original forecast that we shared with you at the beginning of the year. Input costs were favorable, mostly due to lower recovered fiber costs. We did experience higher energy and distribution costs as we exited the third quarter, which we see as a positive sign of an improving economy. Corporate expenses were lower than expected, benefiting from about $20 million in foreign currency adjustments. Tax expense was lower by 7 cents per share in the third quarter with an effective tax rate of 19% compared to 26% in the second quarter. Most of this was related to adjustments to our federal tax provision after finalizing our 2019 tax return. Equity earnings includes a non-cash foreign exchange loss of 14 cents in the third quarter for ILM as compared to a 9 cent gain in the second quarter. Turning to the segments and starting with industrial packaging on slide seven, the business performed well, driven by strong commercial and operational performance. Across the segment pricing mix was stable. Volume improves sequentially across all regions with strong demand in North America, where demand accelerated in the third quarter in just about every segment. We're seeing the benefits of strong at-home consumption, and we're in the early stages of a recovery in food service. We continue to see very strong double-digit growth in e-commerce with increased consumer reliance on e-commerce as a buying channel. More recently, we're seeing better performance for industrial and durable goods across a broad spectrum of the end-use segments, especially those linked with construction and home improvement. Our export container board shipments were lower in the third quarter due to the strong demand in North America and the impact of weather events. With that said, underlying demand in our export channels picked up as we entered the seasonally stronger fourth quarter. Our mills and converting facilities performed well. We managed direct and indirect costs well, while fixed cost absorption improved on higher volume, all of which helped mitigate the impact of precautionary downtime related to the hurricanes. Maintenance outage costs were lower than expected as we de-scoped and shifted some outage activity to the fourth quarter to better support customer demand in the third quarter. Input costs were favorable, driven by lower recovered fiber costs. We did see higher energy and distribution costs as we exited the third quarter, along with a sharp increase in natural gas costs from the COVID-related lows as economies reopened. Lastly, an update on Riverdale 15, the white top liner board conversion, the ramp up is progressing. Ahead of schedule and qualification activities are advancing rapidly through our box system. As a reminder, this investment benefits our box customers who value high impact graphics and strengthens our container board offerings. Moving to slide eight, we've also talked about how we're investing to enhance our capabilities. And while that is often associated with investments we make in our mills and box systems, another important investment we're making is around innovation and enhancing customer-specific solutions. It comes back to the fundamental notion that boxes are tailored to meet each of our customers' unique needs. We're accelerating innovation to further our advantages in faster-growing box segments. We developed eBoss, a software platform that enables our teams of experts – to work with our e-commerce customers to determine the optimal design and suite of boxes to minimize packaging waste and reduce their freight costs. For our protein customers, we developed a recyclable moisture barrier that allows poultry, beef, and pork boxes to complete the fiber cycle. For our fresh produce customers, we provide a full-service machinery platform that's tailored to meet each customer's packaging needs. These are just a few examples of how we provide value to our customers to ensure they have the right box with the right support services for each particular application. If we look at slide nine, a quick update on the demand outlook for container board exports. Demand improved as we moved through the third quarter and customer inventories are currently normal to the low side. We're seeing an expected seasonal pickup in the Mediterranean region with an especially robust citrus season in northern Africa and a solid start in Spain. We're also seeing a nice pickup in demand in China for industrial production recovers. And in Latin America, favorable weather conditions are supportive to continued solid demand for banana and pineapple boxes. Our export container board channels provide good insight to box demand expectations across key regions, given a typical 60-day lead time. If we turn to global cellulose fibers on slide 10, price of mix was favorable on price flow through. Volume was stable with a mix of about 75% fluff and specialty pulp. Operations and costs were impacted by unabsorbed fixed costs, which was partially offset by about $10 million of favorable one-time items, including higher seasonal electricity sales. Maintenance outage costs increased as planned, and input costs increased on higher wood and energy costs. Taking a closer look at slough pulp demand in the quarter, we experienced seasonally weaker demand and destocking across most regions. This follows a rather strong pull forward in demand during the first half of the year, Overall demand is stable going into the fourth quarter, with improved fluff demand offset by weak demand for printing and writing grades. Tissue demand remains healthy. If we turn to slide 11 and look at printing papers, demand improved in just about every region from COVID restriction lows in the second quarter, but remain well below prior year levels. Across the segment, price and mix decreased primarily due to lower export pricing in Latin America and lower pricing in Europe. Volume improved across all regions, with year-over-year demand improving from about minus 30% in the second quarter to about minus 15% in the third quarter in our key regions. Operations and costs benefited from improved fixed cost absorption as economic downtime decreased by 225,000 times sequentially across all regions. We also benefited from about $10 million in one-time items, primarily related to COVID subsidies and green energy credits in Europe. The business continues to generate meaningful cash flows by focusing on cost management and working capital. We exited the quarter with our inventories at our target range based on the current demand environment. As we think about recovery, we saw a meaningful improvement in demand in the third quarter. We know uncertainty remains while COVID restrictions persist. However, we do expect the recovery to accelerate as economies fully reopen. Looking at the EL results on slide 12, we had an equity loss of $33 million in the quarter. This includes a non-cash foreign exchange loss on ILM's U.S. dollar-denominated net debt, of which IP's after-tax portion was $55 million, or 14 cents a share. Volume improved sequentially and year-over-year, driven by higher softwood pulp exports to China. However, price and mix decreased on lower pulp pricing. Operations were solid and maintenance outages were well-executed. The third quarter was ILM's highest maintenance outage quarter in 2020. Turning to slide 13, we'll cover the outlook. We continue to operate in a dynamic environment with demand trends varying by business and in-use customer segments. As mentioned, demand for corrugated packaging accelerated in the third quarter, and that momentum continues in the fourth quarter. Demand for fluff pulp is normalizing following the inventory destocking which occurred in the third quarter. In printing papers, we're seeing a modest recovery, although demand challenges persist. Taking a closer look at industrial packaging, we expect price and mix to be stable. Volume is expected to decrease by 5 million, with strong box demand mostly offsetting the impact of three less shipping days in the fourth quarter. operations and costs are expected to lower earnings by 15 million dollars including the non-repeat of one-time benefits in the in the third quarter staying with industrial packaging maintenance outage expense is expected to decrease by 45 million dollars and input costs are expected to increase by 20 million dollars mostly due to higher energy and transportation costs in cellulose fibers we expect price and mix to decrease by $5 million. Volume is expected to be stable. Operations and costs are expected to lower earnings by $20 million, which again includes the non-repeat of favorable items in the third quarter. Maintenance outage expense is expected to increase by $4 million, and input costs are expected to be stable. Turning to printing papers, we expect price and mix to be stable. Volume is expected to improve $20 million on higher seasonal demand in Latin America. Operations and costs are expected to lower earnings by $25 million, mostly due to the non-repeat of one-time benefits in the third quarter and higher seasonal energy costs. Maintenance outage expense is expected to decrease by $16 million, and input costs are expected to increase by $5 million. Lastly, under equity earnings, you will see our outlook for the Illum joint venture. Turning to slide 14, as Mark said in his opening remarks, we're on track to generate $2 billion in free cash flow in 2020. In our first quarter earnings call, we highlighted the company's financial flexibility and some of the cash levers we had available to enhance our cash generation in what has been undoubtedly one of the most uncertain environments we've faced. Given the economic uncertainty at the time, we chose to pull some of these levers, including capital spending. In addition, COVID-19 changed the way we worked in 2020, and choices were made around our planned maintenance outages and other spending priorities, which we expect will contribute about 15% of our free cash flow this year. Our early actions and strong execution across the company are enabling us to deliver another year of strong free cash flow generation, reflecting the resilience of international paper. Turning to slide 15, I want to take a moment to update you on our capital allocation choices in the third quarter. Debt repayment is a priority. During the third quarter, we reduced debt by nearly $800 million, which brings debt reduction to $1.1 billion through the third quarter. We've essentially eliminated all bond maturities through the end of 2021 and improved our maturity profile over the next decade. I'd also note that we've reduced annual interest expense by nearly $60 million on debt reduction activity through the third quarter. You can expect additional debt reduction in the fourth quarter with an expected debt to EBITDA of around three times at year end on a Moody's basis. Returning cash to shareholders is a meaningful part of our capital allocation framework. Our board of directors authorized the fourth quarter dividend earlier this month. With this decision, we will have returned about $800 million to shareholders through the fourth quarter. Looking at investments, we're on track with our $800 million capital spending target in 2020, which includes the Riverdale conversion as well as other funding priorities to ensure we have the right capabilities in our U.S. box business. With regard to our investment in graphic packaging, we received $250 million in cash in the third quarter related to the second transaction. This is the maximum amount permitted for each period under the agreement. Our ownership position is now approximately 14.8%. And with that, I'll turn it back over to Mark.

Thank you, Tim, for all the detail. Look, this is our third earnings call under the realities of COVID-19. And as I've said from the outset, International Paper entered this crisis in a position of strength. It really starts with the talent and commitment of our employees. That strong position is reinforced by our capabilities to provide the best solutions for our customers and by our customers themselves. We are partnered with many of the winning customers in multiple segments across our three businesses. And our strong position is supported by our world-class manufacturing and supply chain capabilities, all of which contributed once again to our solid performance and strong cash generation in the quarter. I'm pleased with our performance and really excited about our strong outlook for the fourth quarter and the momentum we're generating, especially in our packaging business. And with that, we're ready to take your questions.

Thank you. As a reminder, to ask a question, press star 1. To withdraw a question, press the pound key. Again, that is star 1 to ask a question. Thank you. We will pause for a moment to compile the Q&A roster. Our first question comes from the line of Gabe Hajji of Wells Fargo Securities.

Good morning, everyone. Hope you and your families are doing well. Thanks, Gabe. First question, Mark, has to do with the global cellulose fibers business. And from my perspective, quite frankly, I don't think you guys are getting much credit for it. So I recognize that where you guys play, this is somewhat of a subsegment of a larger health complex. So I'm curious if there's something unique about kind of this cycle, you know, outside of the obvious COVID impact that we're seeing in printing tissue and towel that is negatively impacting kind of the supply-demand dynamics globally. And then relatedly, I think you guys made a management change here, and given Mr. Hammock's background would seemingly imply more of the fixes might be commercial. But I'm curious if there's anything on the operational side that might be contemplated. You know, we didn't see much in the way of footprint consolidation post-wirehousing.

those are three really good questions about our global cellulose fibers business first one on the cycle i think the there's nothing unique about this particular cycle if you think about 18 it was at the peak of pricing the peak of demand 19 was a somewhat normal reset and then as we were turning the corner in the beginning of 20 prices were moving up volume was moving up covet hit Temporarily, that was a benefit, but now with the demand decline in printing papers, a certain amount of softwood pulp is stranded. So there's a supply issue that's unique to this cycle, but it's really COVID-related, and it's related to the demand decline in printing papers. Some of that softwood pulp is finding its way into absorbent products at the margins, and that's creating what I believe is a temporary structural issue. On the operations, I've talked before about what the business needs to be successful post the combination of IP and Weyerhaeuser. And that is moving the mix to about 85% absorbent products, so fluff and specialties. minimal position but a small position in market Paul to balance the system and then having the cost structure of the best mills which tended to be some of the ones we acquired be the cost structure of most of the mills and some of that is going to take some investment we've developed some of the projects and now it's a matter of timing those investments so improving the mix improving the cost structure, the manufacturing cost structure, and then operating commercially in an excellent way through the normal cyclicality. As far as the management change, you mentioned Tom Hammack. His background suits what the business needs right now very well. He's had tremendous success commercially in different businesses in the company. And after we did the integration, and we put the teams together, which was done very well, he does have the right skill set for where we're going forward. So we're excited about the role he'll play in that business, and we believe in the business long term. We made this investment. If I take you back to the end of 2016, In order to position IP in another fiber-advantaged, growth-oriented market, albeit small market, it was a play for the longer term. And I think as you think about the demand drivers for diapers, adult incontinence, and the other absorbent products, it's got good fundamental demand dynamics around the world. We have to level set and improve our supply position mainly in the ways that I've described previously.

Thank you very much, Mark. I'll try to be brief here with the follow-up as it relates to the industrial packaging segment. Obviously, demand has been somewhat episodic with the COVID impact, but I'm curious if you can share anything, what you're hearing from your customers in terms of inventory levels. We're hearing that things are pretty well depleted, and really we're just seeing the benefits of sell-through right now, but just curious if you have any insight there.

It is by segment, really, Gabe, a story by segment, and we are seeing some very positive trends in areas that were hurt a little bit, and part of it is, I think, inventory depletion. So the center, processed foods center of the grocery store has picked up very nicely. We talked a lot about e-commerce. That's up a lot, and it's staying up a lot. We began to see some improvement as restaurants opened. We have to see what that looks like as we head into the fall and winter, predictable caseload of COVID moving up and what different governments do to deal with that. But really encouraging news across the board sequentially. But even on the year-over-year basis, the e-commerce channel is an order of magnitude different than it has been. We think some of that will stay.

Thank you. Good luck.

Our next question comes from one of Anthony Petanari of Citi.

Good morning. Good morning. You highlighted some of the investments for customer-tailored solutions for e-commerce and protein. I'm just wondering, from a big-picture perspective, if you can talk about the kind of returns you get from those investments, and then for the products themselves, if there's a margin differential or just how you get paid for those solutions when you're on the ground with the customers.

So on the examples that Tim shared are just a few examples of addressing the needs of our box customers. And then that flows back through our value chain all the way to the type of substrates and container board that we would make to make those boxes. And if it's a capital investment, we're always looking at north of 20% returns. But some of them are not capital investments. They're design investments, and that's what we tried to highlight in this particular earnings call, that the talent level of our go-to-market strategy and our designers is coming up with unique, products and unique services that can run on our equipment that we have. So the capital investment's small. Where we see the payoff is two ways. Usually there's a margin benefit if, in fact, it's a total cost of ownership, meaning it lowers the customer's cost. And two, it positions us in a differentiated way in a very competitive market to where we grow our position with a certain customer because we have an offering that's just enough different from the competitive set that it helps us to grow our position.

Okay, that's helpful. And then just sticking with industrial technology, industrial packaging. There's a container board price hike that's been announced. I'm just wondering to the extent that you can, if you could talk about sort of the typical timing of price increases on boxes, you know, how much maybe using history as a guide might show up in a 4Q versus 1Q versus 2Q next year.

Yeah, hey, Anthony. It's Tim. So we see it following a normal path. For us, you know, we might pick up a little bit in the fourth quarter, but it's very minimal. Every contract's different, but most of our contracts allow for a one-quarter lag, and so we start seeing the real benefits in the first quarter and then continuing on in the second next year.

Okay. That's helpful.

I'll turn it over. Our next question comes from one of Mark Weintraub of Seaport Global.

Packaging, obviously, demand really seems to be picking up a lot. If we could get your quarter-date box shipments, that would be helpful. And maybe even more importantly, what do you think is going on? Assuming that you have seen some of this really strong pickup lately that we're hearing from others as well. How sustainable is it? Do you think folks are rebuilding inventories that got very low, and so to a certain extent, what we saw before was understated? Or is it more potentially buyers getting ahead of the price increase? Any color you could give would be helpful.

Yeah, hey, Mark. It's Tim. I don't think it's getting ahead of the price increase. People just don't warehouse boxes. They take up too much space. You know, I think it's somewhat what Mark said earlier. There is some replenishing of supply chains that's going on, but there's also the continued opening of economies as well. We've seen pickups in the third quarter. August was better than July. September was better than August. It's continuing in October. Right now, nearing the end of the month, we're looking at about a 6% increase on a daily basis in our box system. But, you know, it's really strong e-commerce. That continues to grow. And I think it's some of these other segments starting to come back. One thing that we see a little bit of a shift just on durable goods, it looks like people are substituting, you know, travel for durable goods purchases or travel. or maybe making other tradeoffs like that. So we've seen an acceleration as we've come from the third into the fourth. If you look at the market overall on a daily basis, the market's up a little bit over a point year to date. So, you know, in an upset condition, pretty good growth. And I think, like Mark said, it'll vary by segment as we go through the fourth quarter and into next year.

Okay, super. You made that comment that export markets looking strong in general demand, picking up in one area, China, you mentioned industrial getting a bit better. I guess one of the big questions is, how is China going to be dealing with their fiber issues with no OCC going in potentially next year? As you look at it, could China become an increasingly important buyer of Kraft Liner from North America? And how important a factor could this be in the global equation?

Well, so our base case is we take them at their word, and we think all imports of OCC will end like they say it will. It will be a fiber balance equation, as you suggest. I think some of it will get satisfied by market pulp for certain end uses. And yes, I think there could be a step up in not only craft liner purchases, but probably recycled pulp purchases as well. That may take a little bit of time to fully play out. And as to where it comes from, I think it's going to come from a lot of different places.

I would just add... Mark, the highest quality of recovered fiber in the world comes from the U.S. market because of the high concentration of craft liner boxes. And while China may not take any as OCC, it will probably take some of that feedstock as a version of recycled pulp or or, you know, processed one time before it goes to China. And in the region, there are some people doing that, and I think there'll be some people doing that from the U.S. with high-quality recovered fiber, minimal cost input to clean it up, roll it, and then I think it probably qualifies as input fiber to China. But we'll see how that plays out. No one knows exactly how, but the simple math says that there's a tremendous... fiber need for the growing Chinese economy that'll have to come from somewhere.

Thank you.

Our next question comes from one of Neil Kumar of Morgan Stanley.

For the Riverdale project, you mentioned the startup being ahead of schedule. I was just wondering if you could just talk about your plans for ramping volume, particularly with a stronger near-term demand backdrop. And are you seeing any significant differences in the supply and demand dynamics of white top versus traditional line of work?

I think on Riverdale, we're really pleased with the ramp-up once we started up. So the ramp-up of the startup is ahead of schedule. The project itself obviously was impacted in the final stages by trying to finish a large project. construction project during a pandemic. But it's running well. The quality is really, really good. In some cases, exceeding our design expectations. And we will adjust that product, as we've said before, that white top liner into our system in place of some lower quality white top we were making. And then we'll just balance the brown and white. But We don't see any significant demand shifts right now in the need for White Top other than the growth drivers we saw when we approved the project. So we're excited about it. It's going to help our box customers. It's going to help some of our open market customers who make their own boxes. Some of this product goes into the premium segments. premium wines, premium beverages, and there's a pretty strong demand for some of that, and probably some of it's related to the way people are confined to home.

Thanks. That's helpful. And there was also an article recently about Amazon, again, looking to reduce the amount of packaging it uses and some shifting towards padded mailers rather than boxes. E-commerce demand has actually been very strong this year. But I was curious if you were seeing any evidence that mailers didn't share from boxes. And in general, how are you thinking about the efficiency of patching in the e-commerce channel over time and the impact of these types of initiatives?

So we try to look at the solution that the customer needs, whether it's a box or a mailer. We try to obviously steer customers toward the sustainable choice, which is fiber-based. And we see growth in both. Mailers are used for certain type of items where it's the better solution. Maybe some of those items were in boxes before mailers became more effective. But we see growth in the box segment. We see growth in the mailer segment. We participate a bit on the craft paper side of that. And when Tim talked about this e-boss technology, we are proactively helping all of our e-commerce customers optimize their packaging suite. So the right size box, if it's a box, and in many cases a box is definitely the right solution given the supply chain it's got to travel through. But if it's a piece of clothing, maybe a mailer works fine. But we are actively working, proactively, to get the waste down, to make the packaging experience for our customers cost-effective and for the consumer to know that they are doing something that's sustainable. If they recycle that box, and 92% of them are recycled, that that goes back in the stream, and it's just a good overall solution to to commerce. And so we're actively involved in that, Neil, and view it as a positive, not a negative.

All right. Thank you.

Our next question comes from one of Adam Josephson at KeyBank.

Markington, good morning. Can I ask you? Mark, one question on the free sheet business. You took a good bit of downtime in your North American papers business this quarter, as you did last quarter. If you assume that current demand levels stay roughly where they are, how much oversupply would you say you have? And after having just converted Riverdale are you more inclined to potentially convert another paper machine to container board or to shut a machine if you eventually decide that you need to take more capacity actions in that business?

Hi, Adam. That's a lot of hypotheticals in terms. Well, first of all, we don't think paper demand will stay at the level it's at. It will recover, probably not 100% of what the COVID impact did to it, but some of it will recover as schools and offices open to some degree more than they are now. You're right. We took Riverdale out not knowing that this was coming, but it actually was a benefit because it reduced our supply in the face of a real big demand decline. I've said this before, and it'll continue to be our guiding principle. On container board conversions, we'll only make investments in container board production, whether it's a conversion or a greenfield or anything else, based on the box and container board market. We won't do that based on the issues in another product line, like Uncoded Free Sheet in this question. Sometimes the timing doesn't match up perfectly, and you don't want to make a bad decision with an asset. But that's really what would drive it. So right now, we've got the ability. We haven't done it in a while because we typically run Uncoded Free Sheet relatively full. But we have the ability to throttle that business with the same techniques we use in our container board business so that we can adjust our output to the demand we have. And obviously, if you never thought the demand was coming back, you would make some more permanent decisions than carrying the cost of economic downtime, as we call it. But we'll cross that bridge when we come to it. But what you need to know, though, is the principle for making more container board is about making more boxes, not about another asset that needs something to do.

Sure, and I appreciate that, Mark. And just one on the box business. So, you have this slide in your presentation in which you compare economic indicators to box demand. Obviously, the tightest correlation is with non-durable industrial production. And as you know, CPG volumes this year have been extraordinary because of COVID. I think P&G had 16% U.S. sales growth, which is almost unheard of. And we've seen that all year. So I'm just wondering what you would extrapolate from this year's experience in terms of box demand, if anything. I mean, obviously, consumer's behavior has been so unusual lately. in so many ways that I find it hard to extrapolate much of anything into future years unless we continue to be stuck at home for years to come. What are you extrapolating into next year from this year's experience?

A couple of things on the non-durables. I think correlation still holds. I believe box performance is outperforming non-durables because so much of the non-durable collection of market segments is not box intensive. Some of those non-durable items are actually down and the box intensive portions of non-durable goods is up a lot. I think the correlation is going to hold. I hope and I think we're not going to be locked in our homes. So some of this demand and channel movement will settle out. A couple of takeaways, though, just sitting here today. I do think we've been at this long enough, and some of our customers are saying this, that some consumer behavior changes will be pretty sticky. I think people are going to eat and go out a little different. So I think some of the demand and shifts in the food channel are going to Stay with us, maybe not 100%. And then secondly, you have a lot of first-time new adopters to doing business in an e-commerce kind of way. And I think those people have had good experiences, largely. And some of the retail channel will continue to be in an e-commerce space. kind of channel. And for us, for IP, given the investments we've made and the position we have, we believe that's a positive. The rest of it's tough to call. Probably it settles out to something like we had before, but given this wasn't a one-month or two-month issue, I think behaviors and habits are beginning to change, and it'll probably last a while.

Thank you, Mark.

Our next question comes from the line of George Steffens. of Bank of America.

Thanks for the details. Thanks for taking our question. My first question was kind of a tag on to Adam's question. You know, what we've been trying to push companies on during earnings season so far is what change in behavior has occurred that will be sticky, to use your term smart, on a going forward basis? specific to e-commerce because of COVID. And so I don't know that you're in a position at this juncture six months into this to determine what the incremental pickup might be from this change behavior. But if you had any initial goalposts that your customers are sharing with you, or again, if you could affirm where you think this increase in demand will be most likely to stay at this new normal level, that would be great. And then I had a quick question on operations.

Well, as George and Tim said, when you take everything into account, box demand in a bit of a crazy year is up a percent. If the year wasn't so crazy, maybe the normal correlations are there and box demand is up about the same amount or half a percent or a percent and a half, the range we've seen in the last couple of years. I think if some of this e-commerce activity does remain, and we believe it will because of what I said about first adopters and people buying things they never bought before, that tends to drive some incremental purchases in some cases. I think the big unknown is how fast, if ever, do people fully return to the way they spent money before and the things they spent money on. fuel, heavy travel, the service industry, that discretionary income tends to be now flowing into consuming goods, whether it's home improvement goods, luxury items or basic necessities of food and supplies for your home. And that is a much more box-intensive way to spend money from our perspective. And we believe that our level of that will continue well beyond when the all-clear is sounded.

Understood. We'll keep evaluating. You mentioned some of the things that you're investing in earlier in the presentation. Are there... Areas that you can share at this juncture, capabilities that you need to further invest in to continue to participate and lead in this new world relative to corrugated? Again, maybe it's additional printing capability. Maybe it's more, I don't know how the small box initiative worked on e-commerce, but maybe it's more investments like that. Is there anything that you feel from a platform standpoint and really more in converting that that you need to invest in. And then on the mill side, you know, we've seen a dramatic drop-off in demand and then a dramatic resurgence in demand. You're not alone. Other companies have also pulled in some of their maintenance, probably because you can't get people to facilities because of COVID. What are you doing now to make sure that, especially on the mill side, you keep the unplanned outages because this is a lot of stress on a very, very capital-intensive and important portion of your business.

So, George, those are two great questions. Let me hit the investment opportunity. You basically said it. It's almost all in converting. It has a lot to do with small box and e-commerce configured plants. The physical profile of an e-commerce blank for a box is smaller, so most efficiently run on the right size machines. So we've actually evolved to a percentage of our several hundred box plants are becoming e-commerce oriented plants, and they look different. And if we ever build a new one from the ground up, which I think we probably will, it'll look different physically as well, building size. And you'll have more of those located right near the fulfillment centers. And that's where our investment opportunity is. There's always an opportunity, and we continue to see it, to improve printing capability. And we were investing in that. And then sometimes it's just pure capacity. We don't have enough box-making capacity in a certain region of the country, and we have to add it organically or inorganically. And you've seen us do it both ways. With respect to the investment question in the mills, we are blessed to have 16 container ward mills. Now 16 and a half if you take half of Riverdale. We have a big system that's flexible. It is going to be wide open sometimes like 2018, and it'll be less than that like it was in 2019. We're always going to try to keep that balance right. So we're going to look at it over a several year period and decide whether we have too much or not enough capacity. Investing in the reliability, you set aside the recycled mills which don't have the complexity of a pulp mill and a power generation unit. Those are pretty easy to manage your reliability spending. It's mostly about reliability in the paper machine, and we do that through largely non-capital investments. On the integrated mills that take in wood, make their own energy, and pulp the wood, That's where the big maintenance capital is, and that's where the risk management is. So we have a hierarchy process where when we cut back on maintenance, we don't cut back on the maintenance that could result in multiple days down. Usually that's in power generation or in pulping. And so we would do that work and we would forego some work that's in the paper machine area that even if it failed, our teams can get it back up and running with a repair, albeit maybe costly, but a repair within 24 hours or so. So that's how we approach that so that we just have a risk management framework that doesn't leave our mills subject to major large outages.

Mark, that's great. I appreciate the thoughts. Good luck in the quarter. I'll turn it over.

Our next question comes from one of the short presence of DA Davidson.

It's similar to what Gabe led off with. So you guys used to talk a lot about industry structure and behavior in the context of container board. And I think the results demonstrate how important that is in generating good returns. And I would also think that the structure in fluff pulp or absorbent fibers is equally compelling. So when you hit your 85-15 target mix, do you think the returns in cellulose will be similar to what you're doing in industrial packaging?

Steve, I think our goal is to get the cellulose fibers business to the cost of capital. The industrial packaging business has probably got higher returns and probably always will. There's a couple of differences, though. The market in industrial packaging is a lot bigger. Fluff pulp is a smaller market, so it's residing in a very large pulp ecosystem of softwood market pulp, hardwood pulp, and then specialties at the top and pure commodities at the bottom. It's got a lot of activity around it, so inside of that segment, the structure looks really good, but outside of the segment, there's a lot of activity. That will play out over time. But our goal is to get it solidly to the cost of capital through a cycle. That's part margin on the revenue and profit side on the top, and that's part on just reducing our cost, and then finally the right mix, as you mentioned, on the 85-15. We see a path to getting it there. That will correspond to some level of EBITDA. There's opportunities for us to work on the footprint, as I think Gabe asked as well, and we have plans to do all of that.

Well, I thought that IP had evolved to the point where earning a cost of capital wasn't enough. You had to be generating in excess for it to be compelling.

Yeah, that's correct. We believe the best value creation, if you look at S&P 500 companies that perform the best and have first quartile TSR, they tend to have a 200 basis point spread from their cost of capital. So we did that with the entire company. If you followed us for a while, international paper as a whole wasn't at its cost of capital. So the first goal is get it there, and then you build the spread, and we fully expect to be able to do that. And by the way, we have a spread to our cost of capital in the entire company now, and that's our goal in each component of the company. But it won't be democratic and linear. There will be some parts of the company that have a five- or ten-year run well above cost of capital, and there will be others that are right at cost of capital. But you've seen us take action on businesses and parts of businesses that we've concluded we don't think – we're the right owner to get it there.

Sure. And then switching to container board, I was just wondering if you could quantify the financial impacts, and I know that they're already calibrated to the guidance, but how much of those hurricanes and that derecho in Iowa hurt you in the second quarter, or sorry, in Q3? You know, how would you characterize your inventories? And finally, all container board, Are you, would you say that you're growing faster than the market, or are you still walking away from some suboptimal business?

Yeah, so on inventories, we're pretty low at the moment, and I think we referenced that in some of the prepared remarks, just in terms of how we manage the channels during the quarter, where we had to, we pulled back in some areas around export because we had such strong demand in North America, and And now we've given the flexibility of the system and the ability to recover. We're on a better footing, and so we're increasing volume to the export channels in the fourth quarter, which is good because it's seasonally stronger anyway. On the first part of your question, just in terms of the storms, through all of our operations and everything and being able to flex back and forth and move outages around, we feel like we offset most of the impact. So on a net basis, not much.

And the final question was, were you walking away from some business that's just not lucrative enough?

We always manage our mix. We don't talk about how we handle, you know, segments or customers. But, yeah, we're always trying to improve the quality of our mix across all of our businesses.

Great. Many thanks.

Thank you. Our next question comes from one of Mark Wildy of Bank of Montreal.

Great. Good morning, Mark. Good morning, Tim. Mark. I wondered, you know, could either of you just help us in kind of unbundling sort of what the activity in your box business has been by different markets this year, and in particular, I guess, you know, how much that e-commerce business has grown for IP year to date?

Well, Mark, we don't give absolute numbers on that, but if you remember what I said last quarter, it was a cumbersome way to say it, but I think I said orders of magnitude, double-digit growth. So we were growing in double-digit percentages, you know, with a one in front of it before 2020, and we are significantly higher than that in growth. And that number or that range that I talked about in the second quarter on the second quarter call continues to be in the same range and a little bit stronger. So it's This is a significant uptick from, let's say, 19 and 18 and 17, where we were at double-digit levels. And it's just several times that.

OK. Just on supply in both container board and boxes, can you talk about how you're managing particularly that Newport, Indiana milk? Because I think I had heard that you might be shifting that out of container board and back to gypsum facing vapor. And then also just where you're at on the box capacity. Because I'm getting some reports from people who say, you know, IP is so full right now that they're farming out business to independent converters.

I'm going to ask Tim to cover some of that detail. It's a pretty dynamic environment. Your memory is pretty good on Newport. Tim, why don't you take us through that?

Thanks, Mark. Mark, Newport was a facility that produced not only recycled white top liner, but also gypsum facing board. So if you remember when we decided to make the investment in Riverdale, not only did we get a better sheet, a virgin sheet, better brightness and color and smoothness, but it frees up the Newport facility to, over time, be dedicated to the gypsum product fully. And we like that market. We really appreciate the customers we have in it, and we think it's good business for us.

On your question about the box business, as you know, Mark, we provide container board primarily to our own box system, but also to the open market where we have long-term partners whether they're making sheets and then feeding the sheet plant network. And so if that's what your farming out comment makes, that's not new for us. We have partners in every type of channel that ultimately gets to a box. And I would say all of those channels are very busy and very strong right now for us. So that may be what you're picking up. I'm not sure.

Okay. That last one for me, Mark, just to help us with modeling as we think about this price increase. Is it reasonable to assume that all your corrugated volume has some links to the pulp and paper week indexes? And if not, what percent of the business might be on other mechanisms?

Yeah, there's a big part of it, Mark, that is linked to our references. It's not direct, but references movement in the published priceless or index. But, you know, we don't talk publicly about what those percentages are. We have a variety of customers where prices, it's set on a time increment basis. And contracts are written around those types of price mechanisms. So not 100%. It varies by customer and sometimes by segment as well.

Okay. That's helpful, Tim. I'll turn it over.

Thanks.

And ladies and gentlemen, our last question comes from the last line of Mark Connolly of Stevens.

Thanks. I'll try to keep these quick. You mentioned the higher wood and energy costs in the pulp segment. Was the wood cost mostly weather related or was there something else there?

No, I think it was mostly weather, Mark.

Okay. Okay. And then just very last question. I'm just trying to do a little bit of math. In North America, did your container board system run full if you exclude the impacts you had with hurricane and maintenance?

Yeah, I mean, like I said, inventories are on the low side right now, and we're working hard to cover customer commitments. We even pulled back and redirected from the export channel where we could. So, yeah, we're running as hard as we can right now.

That's perfect. Thank you very much.

Thanks, Mark.

And, ladies and gentlemen, that was our final question. I'd like to turn the floor back over to Chairman and CEO Mark Sutton for closing remarks.

Thank you, Operator. What I'd like to do just to wrap up is first thank everyone for joining the call today. I really want to thank our employees, as I mentioned earlier, especially our frontline employees who are showing up every day taking care of themselves, each other, and our customers. I'm pleased with our performance in the third quarter, and I'm really excited about our strong outlook and the momentum that we're building as we finish up 2020 and we start to look into 2021. So, again, thank you for your interest. an international paper and have a great day.

Thank you for participating in today's international paper, third quarter 2020 earnings day call. You may now disconnect.