Silicom (SILC) Blows a Tire at 100mph; International Paper (IP) Slowly Gathers Speed
My Q2 earnings season is off to an eventful start with Skyworks (SWKS) once again blowing the doors off of its consensus estimate and guiding 15% above consensus for Q3. At this point, that’s routine for that company. And then on the other hand, Silicom (SILC) missed its Q2 consensus estimate by 14% on Tuesday and issued full year guidance that was 30% below consensus. In the earnings call, Silicom management did its best Alfred E. Newman impersonation (‘What, us worry?’) politely pointing out that they had lost a customer that comprised 30% of its revenue due to not having a product developed on time for the latest round of design bids. The stock dropped from $39/share on Monday to $27/share to end the week.
The announcement on Tuesday ended a five-year winning streak for Silicom over which time they could do no wrong and grew operating earnings at an astounding annual rate of 69%. Earnings in 2014 are now expected to decrease by 19% YOY. I sold the stock last week because looking at it now, SILC in no way resembles a stock I want to own. It certainly violates my guideline that both forward and current earnings growth rates should be in excess of the forward PE ratio.
However, I still find the business model interesting and it is possible that the stock could regain momentum in 2015 due to a number of new products in the pipeline (partnership with Intel on ColetoCreek and time stamping products). The rest of 2014 looks like uninterrupted bad news though, and considering the circumstances around losing their largest customer, I think it’s going to take SILC management at least several quarters of solid execution to regain credibility with the investment community. So I’m staying away at least for a while.
The silver lining to selling SILC is that I very quickly found another stock to buy - International Paper (IP). IP made news on Thursday when Perry Capital disclosed in a letter to investors that it had taken a position in numerous paper companies because it believes they can convert at least some of their assets to an MLP structure. Doing so would of course allow them to avoid taxes on the income generated by those assets. An MLP would also attract a much higher earnings multiple. For instance, IP trades today at an EV/EBITDA multiple of 6.2x. Perry Capital estimates that an MLP containing IP assets would trade at 9.7x EBITDA. Perry estimates that IP would be worth between 46% and 67% more in a sum-of-parts if an MLP were to be issued.
IP has said through a spokesperson that they have been aware of the possibility for some time and have been analyzing the many relevant considerations and complexities of the MLP structure. They have not requested a private letter ruling from the IRS, which would be the first official step in creating the MLP. IP reports Q2 earnings on Tuesday and it will be highly interesting to hear any relevant comments.
The letter from Perry Capital is what drew my attention, but what surprised me most about IP is that even without an MLP, it’s a great looking investment. For starters, it meets my guideline that earnings growth, both current and future, should be greater than forward PE. At $50/share, the forward PE is 12x. Earnings growth in 2014 is expected to be 12%, even with a very soft Q1 due to weather issues. Earnings growth next year is expected to be 21% and the five-year estimated growth rate is 14%.
IP has been on an upward trajectory since 2006 when John Faraci assumed the CEO position. His strategic moves look like the best kind of strategic moves – brilliant but with a certain ‘common sensical’ theme. For starters, in 2006 Faraci sold off $11B worth of operating units that he considered to be non-core such as wood products, chemicals and beverage packaging. He used $6B of the proceeds to reduce debt and the rest to invest in core assets in BRIC countries and to return to shareholders. Today, IP is a highly focused company with basically three operating units: Industrial Packaging (64% of 2013 EBITDA), Printing Paper (24%) and Consumer Packaging (10%). (The remaining 1% is a distribution business which is being spun off and merged with a competitor.)
IP has been a very successful consolidator in a rapidly consolidating industry. In 2008, IP purchased the packaging assets of Weyerhauser and in 2012 it purchased one of its largest competitors, Temple-Inland. The paper and packaging industry is now dominated by four large competitors that account for 79% of the containerboard market in North America (up from 43% in 1995). IP is the largest.
Consolidation in the paper industry has led to outstanding capacity control in what is in some respects a declining market. For instance, in 2014 the unfinished free sheet (UFS) paper market in the US is expected to decrease by 3% YOY. Fortunately for IP and the rest of the industry, capacity is expected to decrease at a much greater 9% rate YOY. That sort of capacity discipline and the resulting pricing gains has been one of the key profitability drivers for the paper industry in recent years.
The above strategic moves and industry trends have resulted in outstanding financial performance. From 2005 to 2007 IP generated $0.4B in free cash flow per year on average. From 2010 to 2013 IP generated $1.7B in free cash flow per year on average.
Management has been focused on returning the cash flow to shareholders. In September 2013, IP announced a $1.5B stock repurchase program. Through April, they had repurchased $1.0B under that program. Earlier this month they announced a further $1.5B in planned repurchases, bringing the total authority to repurchase shares to almost 10% of IP’s equity market value. IP currently pays a quarterly dividend of $0.35/share and management has expressed a desire to increase that to between $0.40/share and $0.50/share starting in Q4. S&P estimates that IP will increase its dividend by 10% per year for the next five years.
In summary, we have a very reasonable valuation for a company with a proven earnings growth strategy, favorable industry trends and propensity to aggressively return money to shareholders. I like it even without the MLP option and it fits well into my portfolio right now, which could use a little less volatility (except the good kind, of course, which is when GTAT and ABGB start going back up!). With the MLP option, this could be an outstanding buy and hold over the next couple of years.
Happy hunting everyone!