International Paper Co (IP) 2018 Q2 法說會逐字稿

Good morning, and welcome to the Second Quarter investor relations conference call. (Operator Instructions)

Mr. Guillermo Gutierrez, you may begin.

Thank you, Sarah. Good morning, and thank you for joining International Paper's Second Quarter 2018 Conference Call. Our key speakers this morning are Mark Sutton, Chairman and Chief Executive Officer; and Tim Nicholls, Senior Vice President and Chief Financial Officer.

There's important information at the beginning of our presentation on Slide 2, including certain legal disclaimers. For example, during this call, we will make forward-looking statements that are subject to risks and uncertainties. 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 second quarter 2018 earnings press release and today's presentation slides.

Relative to the Ilim joint venture and Graphic Packaging investments, Slide 2 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 3. International Paper delivered a very strong second quarter performance and year-over-year earnings growth. We had outstanding commercial performance with volume growth and accelerating price realization across our 3 businesses. Operationally, we performed well in another heavy maintenance outage quarter, and we have now completed 75% of our planned maintenance outages in 2018.

Input costs and transportation remain a headwind, which we view largely as a reflection of a healthy underlying global demand environment. The only notable exception is recovered fiber costs, which decreased sequentially and continues to be affected by China policy changes. Overall, we continue to see healthy demand and good fundamentals across our global businesses.

Turning to the financial results on Slide 4. Revenue increased by more than 8% year-over-year, which, again, reflects healthy underlying demand, strong commercial performance and a focus on profitable growth. Our North American Industrial Packaging business outperformed industry shipments through the first 2 quarters of 2018. It's a reflection of really great customers in growing segments.

In our Global Cellulose Fibers business, we delivered record fluff pulp shipments during the quarter.

EBITDA improved by 23% year-over-year, driven by margin expansion across all of our businesses as well as a continued focus on commercial and operational excellence. Many of those initiatives are internal initiatives unique to International Paper.

Our equity earnings were $70 million in the quarter, which includes $57 million from our Ilim joint venture and $15 million from our ownership interests in Graphic Packaging. We also received a $6 million cash dividend from Graphic Packaging during the second quarter.

Our cash from operations in the second quarter improved by about $160 million year-over-year, reflecting the strength of our earnings. Free cash flow for the quarter is essentially flat, and that's just due to the timing of CapEx spending in 2018.

Also, during the quarter, we purchased $300 million of IP shares. Tim will provide additional details on those purchases as well as our broader capital allocation framework later on the call.

I'm excited to be working with Tim in his role as CFO. Many of you know him from his previous roles, most recently, leading our North American Industrial Packaging business.

I'm now going to turn the call over to Tim to cover the performance across our businesses as well as our third quarter outlook. Tim?

Great. Thanks, Mark, and good morning, everyone. I'm very happy to be back in the role and able to share our second quarter performance with you.

So let me begin on Slide 5 of the presentation, which shows our quarter-over-quarter operating earnings per share bridge. Operating earnings improved $0.25 sequentially, driven by strong commercial performance and price realization across all businesses. Our operations performed well in what was another heavy outage quarter. And as Mark mentioned, we've now completed 75% of our planned maintenance outages in 2018.

Input costs were favorable, mostly due to lower recovered fiber prices in the second quarter. Distribution costs continue to trend higher on a very tight truck and rail availability as well as higher diesel fuel cost. We expect the distribution environment to be an ongoing challenge and continue to work aggressively to mitigate its impact.

Our corporate expenses and taxes came in largely as expected, with a 25% effective tax rate in the quarter. And lastly, equity earnings were lower sequentially, due to the non-FX charge on Ilim's U.S. dollar-denominated net debt, which works out to be about $0.09 deduction to our EPS. All in, a very strong performance across the company.

So on Page 6. I'll turn to Industrial Packaging. Industrial Packaging, the team turned in very strong performance in the quarter and delivered quarter EBIT of $569 million with an EBITDA margin of 23% in North America. We continue to see good demand across all channels and realized about 50% of our recent box price increase as we exited the second quarter. We've also completed approximately 75% of the planned maintenance outages in the first half of the year.

Operations and cost in the second quarter includes higher LIFO inventory revaluation charges related to the recent price increases. And on input costs, we saw the favorable impact of lower energy and recovered fiber costs, which was partially offset by higher distribution costs across the system.

In our European packaging business, we continue to see compressed margins on our nonintegrated business. But having said that, the Madrid mill start-up is in process. And we expect to have paper on the reel in the coming days. Once up and running, it will materially improve our margins, improve our cost position and our product range. Again, we're very pleased with the business fundamentals and our strong performance in the North American Industrial Packaging business.

Turning to Global Cellulose Fiber on Slide 7. Delivered $69 million of earnings in the second quarter. The 2 big drivers were the acceleration of price realization and lower planned maintenance outages. On the last point, you may recall that we moved some outages to help meet strong customer demand in the quarter. Global pulp demand is healthy, and demand in the fluff segment continues to grow at 4% to 5% annually. During the second quarter, we delivered record fluff pulp shipments, which represent about 75% of our pulp mix. Overall, we're pleased with the progress that the business is making on the commercial side and the optimization initiatives that they're bringing to the bottom line.

Moving to Printing Papers, on Page 8. We continue to see improved demand globally, and North American mill operating rates have improved significantly since last year. As such, we're realizing price increases across all the regions that we operate in. Volume improved sequentially despite the truckers' strike in Brazil and the lingering effects of the incident at the Kwidzyn mill, which returned to normal operations earlier this month. The impact of the truckers' strike of $7 million was offset by favorable FX.

Operationally, we did perform well. And we've now completed 85% of planned maintenance outages for the year. And although input costs were essentially flat, distribution costs remained elevated, particularly in North America. We're pleased with the improved earnings and the runway in our Paper business.

As you can see on Slide 9, all 3 businesses continue to show strong year-over-year profitable growth. At a high level, you can see that we came out of a weaker 2016 with consistent revenue growth quarter-over-quarter. In our North American box business, we're ahead of industry volume growth through the first half of this year, on what is certainly a tough industry comp.

In our business, we are well positioned in segments that are benefiting from strong secular growth trends. We are also progressing well on our recent box price increase that was announced earlier this year, with 50% realization at the end of the second quarter. And looking forward to the third quarter and year-end, we should be at a 90% realization as we exit the third quarter with full realization by year end.

As I mentioned earlier, the pace of price realization in our Global Cellulose Fibers business accelerated in the second quarter. We are also making good progress with new product introductions in our fluff pulp segment, which is one of the reasons we have expanded fluff pulp to about 75% of overall pulp mix. In Papers, we are seeing improved demand and have value propositions in global brands to capture profitable growth.

Turning to Slide 10. The Ilim joint venture delivered record operating EBITDA of $307 million in the second quarter and an EBITDA margin of 44% before foreign currency charges. IP's equity earnings were $57 million and were impacted by a noncash foreign exchange charge on Ilim's U.S. dollar-denominated net debt, of which IP's after-tax portion was $39 million.

Taking a look at our third quarter outlook on Slide 11. In the Industrial Packaging business, we expect to see a $50 million benefit from continued realization of our recent price increases, mostly in North America. Mix is expected to be a $10 million headwind, mainly due to geographic mix. Also, note that North American has 1 less shipping day in the third quarter. We also expect $5 million of incremental expenses related to the Madrid mill start-up during the quarter. The mill is in the start-up process as we speak, and we expect to ramp up to 1,000 metric tons per day by the end of the year and to run at full capacity of 400,000 metric tons within 1 year from start-up.

Staying with Industrial Packaging. Outage expenses will be $55 million lower, while input costs are expected to increase by about $25 million. In our Global Cellulose Fibers business, we expect to see a $15 million benefit from our recent price increases and improved mix. Volume is expected to increase seasonally with a benefit of $10 million as we continue to run our system full to meet customer demand. And outage expense will be $14 million lower.

In our global Printing Papers business, we expect to see a $20 million benefit from our recent price increases and mix. Volume is expected to improve sequentially on stronger seasonal demand in Brazil with an expected benefit of $10 million. Also within Printing Papers, operations are expected to improve $15 million, partly offset by higher input costs of $10 million, mostly related to wood in Brazil, Europe and Russia. And outage expenses will be $43 million lower.

Under equity earnings, you will see the outlook for our Ilim joint venture and investment in Graphic Packaging. And lastly, in other items, we include corporate and interest expense and our estimated effective tax rate for the third quarter.

Looking at Slide 12. I want to take a moment to share with you our capital allocation framework and more specifics on how we will maximize value creation with our strong and sustainable cash from operations. We will maintain a strong balance sheet and investment-grade credit rating, which we view as foundational to the strength of International Paper and provides us with the financial flexibility to maximize value creation. Specifically, we will target debt-to-EBITDA of 2.5x to 2.8x on a Moody's basis. With regard to our pension plan, we feel very good about where we are today, with no funding requirements on the horizon. Going forward, we will continue to assess if there are attractive opportunities to further de-risk the plan on a structural basis.

We will invest to create value. Our investments will be selective and disciplined, and they will be grounded on clear, strategic and financial logic. We will start with a commitment to maintain our safe and sustainable world-class operations with low-cost advantaged assets. We will also invest in cost-reduction projects with high returns and quick paybacks, and in strategic projects with a meaningful spread above cost of capital in our core businesses, Industrial Packaging and Global Cellulose Fibers, all of which further enables us to grow our free cash flow.

M&A will be disciplined, selective and compelling and must align with our strategy of advantaged positions in attractive markets and create compelling value for our shareholders with clear financial targets: EPS and free cash flow accretion within the first 2 years, and returns above cost of capital within the first 3 years.

We will return cash to our shareholders through a sustainable dividend and systematic share repurchases. Our dividend policy is clear. We're committed to a competitive and sustainable dividend of 40% to 50% of free cash flow, which we will review annually as earnings and cash flow grow. We will also make share repurchases with a minimum threshold to offset dilution from our compensation plans. And we will continue to evaluate our free cash flow and intrinsic value to ensure that additional share repurchase opportunities are weighed against other capital allocation options, with a commitment to maximize value creation. As Mark alluded at the opening, we did repurchase $300 million of shares at an average price of $57.32. And we have $600 million remaining on the current authorization.

With that, let me turn it back over to Mark.

Thanks, Tim. We're very pleased with our strong performance in the quarter. It's our best second quarter in more than a decade. But more importantly, we're pleased with the momentum we carry going into the second half of the year. We continue to see profitable growth across our 3 businesses, with a healthy demand backdrop and high mill operating rates. We're monitoring the tariff situation carefully, and although we do not see any near-term impact to our business, it's certainly difficult to predict the timing and potential impact of evolving trade policies. But we're watching it very closely and are involved in the public policy debate.

Our team is focused on delivering on our earnings commitments. And that starts with commercial and operational excellence. We believe taking care of our customers and running safe, efficient operations creates sustainable value. We also have internal catalysts to further accelerate our performance, such as the Madrid mill, which fundamentally changes our business model in Europe as we move from practically 0 integration to about 60% integration on recycled container board. And in Global Cellulose Fibers, the team continues to optimize the business and is bringing innovative solutions to our customers as we grow together in the absorbent pulp market. Looking ahead, we are confident in our commitment to deliver a second consecutive year of more than 15% EBITDA growth.

With that, we'll open up the call for questions.

(Operator Instructions) Your first question is from the line of Brian Maguire with Goldman Sachs.

Thanks for all the color on the capital reallocation strategy. Just wanted to ask, Tim, if you marked for the pension, to kind of current rates, how close to that targeted 2.5x to 2.8x range you think we are today? And sort of related to that, for the right acquisition, how high do you think you'd be willing to go with that leverage level?

Yes. So currently, we are roughly a little bit below 3x. So I don't think we're far off. But I don't want to talk about what we might do and when, but the target is to be consistently in a 2.5x to 2.8x leverage multiple. And it'll be a combination of debt that we pay down and earnings performance.

And Brian, I could just add on the question about how high. I mean, fundamentally, we will remain an investment-grade company. And so there's a lot of -- that goes into that the statement. But one of the things is managing, even in the event of any acquisition, number one, how high; and number two, how fast you get it back to the level that we're targeting. And that's just not, in our mind, not negotiable. We think it's important. As Tim said, the word foundational is what it is for International Paper.

Okay. And on the share repo in the quarter, obviously $300 million is the most it's been in a while. Just wondering if you -- philosophically, is that just more of an opportunistic thing in the quarter? Or obviously, you want to offset dilution from equity issuance through the year. And this seems like it will pretty much do it. But should we -- is the messaging and the communication here that this is going to be more of consistent ongoing thing? Or should we take it as -- this kind of it for the year and more of an opportunistic thing, too?

Well, I wouldn't forecast what we might or might not do in the year. The commitment is that we're going to be systematic about share repurchases, and at a minimum, we will repurchase shares on an annual basis to offset the dilution from our compensation plans. So we thought we had an opportunity in the second quarter. We bought some shares. As I laid out, all of these things are related. And there's a number of actions that we could take around capital allocation, whether it's balance sheet, share repurchases, dividends. It's something that we look at annually. So I see them as all related. And we'll be reporting back as we do them after the fact.

Okay. One last one for me, just touching -- to the base business. With the elevation in U.S. freight rates that's been pretty well publicized, just wondering, do exports look more attractive to you these days? Has your kind of thoughts on where you want to be putting your tons between the domestic and export market changed much because of that? And where -- maybe you can kind of just update us on where that mix stands today?

Yes, it really varies by business. So if you look at Global Cellulose Fiber, it's mostly an export business. Our markets are in other regions of the world as well as North America. For the container board business, we look at it as a strategic part of our mix. We obviously value our integrated box channel, and so we make sure that we are managing the customer demand here in North America and as well as balancing that out with exports. But your question around just margin structure of 1 region versus another, we still see good margin structure here in North America, even on a marginal basis, with the transportation costs as they are.

And your next question comes from the line of Gail Glazerman with Roe Equity Research.

Gail?

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percent year-on-year on an adjusted basis. And then, it's a bit slower than we've seen. I'm just wondering, is there anything you're seeing in the business? Are there any end markets that do stand out?

Gail, this is Mark. We didn't hear the first part of your question. If you could repeat it?

Just, industry box shipments in 2Q were

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Somewhat slower than what we've seen. And I'm just wondering, are you seeing any end markets that are slowing down or changing? Or just is there any shift on the demand front?

You cut out just a little bit again, Gail. But I think I got the essence of the question. We felt really good about our box demand in the second quarter. And it was against, I think, the toughest comp of the year, year-over-year. So protein, produce, e-commerce, those segments continue to perform very well for us. And we were really happy with growth, both on a large customer level and our local business across the entire quarter.

Okay. And during the quarter, Ilim announced that they were looking at a large kraftliner expansion in Russia. You guys are working on a large expansion here. There are other producers that are looking at kraftliner on a level that haven't seen in -- probably at least 3 decades, and I'm just wondering how you see that playing out globally? Do you think the fiber balance is there, that we need that much more kraftliner these days?

It's a great question, Gail. The -- specific to International Papers, that -- it's on the Ilim side, the way projects work in that part of the world, you've obviously got to announce that you're going to study and look at something so you can get the different government agencies involved. Forestry is managed differently there. Infrastructure, in this particular case, is in Siberia. And we believe that's an opportunity, much like our pulp business, to serve an underserved market from a fiber standpoint, that being Asia. But it's just that. It's undertaking a project. And a lot of things have to happen for that project to come to fruition. I think that's probably true from some of the other ones I also saw that are not International Paper. And then you take that all the way to something that's certain and sure, like our Riverdale conversion. Our view is kraftliner is growing globally because the box market's growing globally. It is the feedstock for all of the fiber uses downstream. And so it's hard to predict what the markets will look like 3, 4, 5, 6 years from now. But International Paper has first and second quartile high-quality kraftliner. We have the position in the markets that need it and want it and value it. So for us, it makes sense to continue to be looking at investing in that market over time.

And your next question comes from the line of Mark Wilde with BMO Capital Markets.

Mark, I wondered if we could just step back and talk a little bit about the kind of the pricing model in Industrial Packaging. In the past, John Faraci, your predecessor, talked about a willingness to maybe rethink that model at a particular point in time. And I just wondered right now, with the market in pretty healthy condition, whether this is a time you might engage customers to kind of rethink this basis on kind of trade paper pricing.

Yes, Mark, I'm going to let Tim comment, given his closeness to that particular market in Industrial Packaging. But pricing as you know is, at the box level, very unique to the type of customer and the type of packaging. There's a catalyst in this industry in North America for the input material changing. And contracts are designed around that. There's lots of different ways to do it. Customers buy a lot of other inputs that are priced different ways. But for right now and for the foreseeable future, this mechanism, while imperfect, works for the parties in the value chain. And so that's kind of how we look at it. But the pricing discussion is really a conversation between International Paper and individual customers, to some extent, precipitated by some input cost materials -- input cost changes. And Tim might -- you might want to add to that.

No, I think you said it well. The only thing that I would add to it is, the way -- it's inappropriate, first, to talk about what model we might move to. But in the various contracts, it doesn't establish price. It establishes the basis for us to have a conversation about how the contract will perform and how price may move or not move over time. So I don't know that I can add much more than what Mark said. It works at the moment. Our customers find value in it. And it's been around for a long time. And so what we negotiate on actual price is a customer -- our conversation to our customers and agreeing on the basis of supply.

Okay. Fair enough. I had -- as a follow-on, I just wondered, Tim, can you or Mark, talk about the options for fixing that Brazilian packaging business? And maybe whether you're interested in expanding packaging kind of across Latin America more broadly? You're in the 2 biggest markets right now, Mexico and Brazil.

Yes, it's been a challenge, Mark. No question about it. And I think that we like our box plant assets there. We're challenged on the mill cost side, but we have a great customer base. We got pulled in the downdraft of the economy and that hit us harder than we ever expected it would. And we're battling our way back from that. But yes, we're happy with the engagement of the team and the things that they're working on. But it is taking more time and it's harder than we thought, given some of the economic realities on the ground.

Well, I mean, does that mean you need, like, to have virgin fiber mill assets there? Or what does fix this, Tim?

I think we have the ability to continue ramping up our commercial execution. There's huge leverage there in terms of marginal volume that we put through our box plants. And that will go a long way to restoring margins. There are some cost opportunities, but I think we want to be very careful and very selective about how we think about incremental investments there.

And your next question comes from the line of George Staphos with Bank of America Merrill Lynch.

I was going to ask a different question to start, but just given the way the stocks in the industry have been acting recently, Tim, I know it's ultimately investors' and analysts' jobs to consider valuation. But has the fact that the market's been effectively applying a higher cost of capital on your results, with the stock having come down, change at all the way you think International Paper will think about capital allocation going forward and the returns that you'll require from new investments? Has there been any migration in those views over the last couple of quarters and why or why not?

George, yes. I think it's what I was trying to outline earlier. We're going to be selective. We're going to be disciplined. And we're going to invest in things that support improvement in our core businesses. So I would say no, there has been no change in our thinking, other than to say we are trying to make better and better choices about investment decisions over time.

And I guess a related point -- and I'll ask one more as my two-part and turn it over. With, again, the return that's being applied or discount rate applied to your equity value by the market these days and how it's changed apparently over the last few quarters, does that make buyback any more attractive? You're using a more systematic approach. You've talked about taking in the dilution. But does -- equity hasn't moved up in terms of repurchases, in terms of capital allocation over the next -- the last 6 months, and again, given the way it's performed, why or why not? That's question one. And question two, just as we think about the heat map table or -- Slide 11, are there any other points that we should consider in terms of sequential EBITDA trends? Or are we, basically, looking at -- or whatever the number works out to, I think about $130 million, $150 million sequential pickup EBITDA 2Q to 3Q?

Yes, I'd just say, and Mark may want to comment on it, but I think the businesses are performing very well. And we're set up for a strong third quarter and second half. And related to the first question, I don't want to start forecasting what we're going to do at moments in time. I think we're going to take a broad view. We're going to look at our cash availability, and then we'll make the best decisions across the whole capital allocation framework that I talked about.

And your next question comes from the line of Anthony Pettinari with Citigroup.

Tim, you discussed the leverage target at 2.5x to 2.8x. And I think that's down -- or at least a clarification from the kind of below 3x level that you pointed to recently. And I'm just wondering, to follow-up on George's question, kind of the thought process behind refining that target leverage change. Does it actually represent a shift? And is it based on where you think we are in the economic cycle or discussions with investors? Any color you can give there?

Clarity. Mark said it. We're going to maintain an investment-grade credit rating, and we think that at those leverage targets, it is very supportive of our current rating. No more than that.

Okay. And then just shifting to kind of a bigger-picture question. Mark, the Chinese government has discussed, I think, banning imports of pretty much all grades of recovered fiber, which seems like it could have a pretty profound impact to global supply chain. I'm just wondering how you think that could impact IP over the mid- to long-term in terms of OCC prices domestically or opportunities to send pulp or kraftliner into China or maybe unintended consequences. Whatever thoughts you could share on what this -- kind of what this shift could mean.

That's a great question, Anthony. And obviously, we're spending a lot of time trying to figure out, strategically, different options if you play these statements out to reality. Bottom line, though, is China's got a dynamic economy. It's going to need fiber in the long term. And from an International Paper standpoint, given we have a large position in the new fiber -- virgin fiber, which then becomes, as you know, recovered fiber around the world, we feel very well positioned to be a major player in that value-added fiber. Whether it's in the form of a finished product or semi-finished product like container board, or whether it's in a less finished -- like, for example, our softwood pulp from Ilim. It's hard to see, and I don't pretend to know what the Chinese government's thinking around the puts and takes, if a position like that hurts 1 industry in China but it helps another and helps trade balances. There's a lot of that at play. And we're going to monitor it very well. But I think the big picture is that the world is going to need more fiber for all of these sustainable fiber-based products over time. There'd be dislocations from time to time in where it's generated and where it's used. But I think, from an International Paper business model, we are very well positioned with the world's best fiber to be a major player in providing that fiber need in different stages of the value chain, different levels of product sophistication. We feel good about that. And we'll continue to try to monitor it and be ready to take full advantage of the position we can play.

And your next question comes from the line of Mark Weintraub with Buckingham Research.

I -- one question that's really striking me here is that you just had a great quarter. You're laying out terrific momentum coming into the third quarter. The stock, though, is trading off and it's trading near the low of recent ranges. And certainly, one of the catalysts this morning, probably, is the Cascades announcement that they're looking to go forward with that purchase and intentional conversion of a mill in Virginia. I mean, how concerned are you at this juncture about the capacity that has been announced? And as you overlay what you see happening demand-wise and expect to continue to happen demand-wise, how concerned are you? And are there things that you think are in your capabilities that will help you manage the various scenarios that could play out that you could talk to?

Mark, that's a loaded question with a lot of potential directions it can go in. But let me just say the way we look at this. We just had a recent period where a couple of million tons of container board, various types of container board, were going to be added to the U.S. market. And the underlying box demand, the products that worked versus the products that didn't, I think we navigated through that pretty well. This is another potential, in a global sense, in the future. We believe fiber-based packaging is growing. We don't know how many of these projects are going to actually come to fruition and what type of end product quality. We think it starts with our customers that buy the packaging. And so that's why we spend so much time saying things like commercial excellence. There's a lot behind those 2 words. And by having the customer relationships and having the best value chain, from tree to box and the recycled fiber in between, we believe we'll be well positioned -- better positioned than anyone, really, to really benefit from that. So I think that it's a robust market. It's a resilient market. And I think we have some very recent history that we can look at and draw some parallels to. And we're going to always make the container board in our system that we need for the box orders we have. And right now, you've got container board systems, in the case of International Paper, basically running wide open and full, which is actually not sustainable with respect to customer service and the flexibility we need beyond just when you take mills down for maintenance. So hard to predict the future. Some of this is way out to 2021 and 2022. But we are very confident in our position. We're confident in the role that we're playing, in some of the capacity that might -- that will come on. And we're very, very confident in our ability to serve customers on the box end. Because that's what really matters in all of this is, are you a preferred supplier for the actual package?

And just as a kind of a follow-on. For instance, with the Riverdale project, if the uncoated free sheet market continues to perform quite well as it is now, is that type of -- where maybe you have flexibility and you do that a little bit slower, and you wait for that card and box demand growth to absorb the capacity? Or are those things that are sort of set and that gets done at the timing that's been laid out?

I'll ask Tim to comment on that, given it's a near-term project. And it's a unique product, given it's got the white top component.

Yes. So the Paper margins are important, but we're really looking at what our Industrial Packaging customers are requiring. And we're investing in better capability to supply a better product to them through our integrated channels. So this gives us options for better white top product, more brown container board in the geographies where we need it and in the grades and basis weights that we need. So we would see that project continuing on a time line that we laid out when we announced it, targeting mid-2019.

Your next question comes from the line of Mark Connelly with Stephens Inc.

You mentioned that you're seeing improved demand in white paper. Obviously, the quarter was [up]. So can you give us a little bit of a sense of what you're seeing shifting there? And also, was there a negative mix shift in paper? Because the results were obviously excellent. The costs were fantastic. But I was surprised that the price realization wasn't even a little better.

Yes. So no, on the demand side, we were hit by 2 things. We had the operational issues in Europe around Kwidzyn, the fire, and then reliability issue that's since been corrected. And then we had the truckers' strike in Brazil, which obviously impacted supply chains for a period of time. In North America, it's really been the performance of our customers. Stronger year-over-year sequential demand of our product from us. So those are the main reasons, Mark.

Okay. And then just one other question. Can you give us a sense of where your pulp mix can go from here and what -- the time line you're expecting? And also, what kind of an operating rate you've got in pulp right now?

Well, we're running the system flat out. In fact, we're -- one of the challenges in the quarter was just product availability, given how much demand we have. And so we don't see that really changing as we're in the third quarter and going into the fourth quarter. The goal -- we're 75% today, and the goal is to keep as much as we can, adding to our fluff and specialty pulp mix, which could approach 85% at a point in time.

And Mark, there's just one thing on the pulp. We do have -- a part of our capacity is the NBSK asset in Canada. So there's kind of a base load of non-fluff. It's a very good product. It's high quality and very profitable. The plan would not to be to convert that, obviously, to fluff. But I think Tim's comment about probably 85% in the absorbent markets, and then some of the specialty markets that are not exactly absorbent end uses would be where we think we can get to.

And your next question comes from the line of Steve Chercover with D. A. Davidson.

So just to start, I mean, obviously, great quarter on Industrial Packaging. But clearly, Brazil and Europe are still challenged. Will Madrid be enough to get you to where you want to be? I mean, the integration level, I think you said, would be 60%. But will it get you to cost capital returns or do you need something virgin over there as well?

This is Tim, Steven. We are already integrated on a virgin basis with our operations here in North America. So we think we have that piece covered for our European converting business. Will Madrid take us all the way to cost of capital? It will get us darn close. It's a big factor in terms of product availability for the basis weights and grades that are growing the fastest. And so as Mark referenced earlier, it gets us to 60% integration on recycled. And we think in the range of -- for the integrated business, converting and mill, gets us mid-teens on EBITDA margins, but with a lower capital base. So it should get us pretty close to cost of capital over time.

Yes, I think Tim said it right. When you -- it's a little bit of a unique business model, because as we've described the channels to market, we make the kraftliner in North America. We ship it, in this case, over the ocean. And we convert it in Europe. So you can draw sort of a box around that part of the channel. And then we were buying on the open market all of our recovered fiber, except for a small mill in the Moroccan business. Now we're going to be 60% integrated. There is still 40% of the recycled paper that we don't make or won't make. But we're a pretty good buyer. And where our geographies are, we should be able to buy that economically. And then there is virgin medium, in the European context, the semi-chemical medium, which we do not make. But we're a very good customer of the premium suppliers. So when you put all that together, that channel to market, from board to box, is going to be cost of capital. It's just not measured the same way as a single geography would be. Because, as I said, the container board that's virgin is actually captured in the North American Industrial Packaging results.

Got it. And then one other question. If, in fact, China is permanently out of the OCC market, and by extension, reemerges as a virgin board buyer, which mills in your system are well suited to serve that market? And I guess, that would exclude Ilim, which is obviously close.

Would exclude Ilim -- I don't get that point.

Well, I mean, I'm sure you'll say, well, Ilim is adjacent to China, so that's our conduit into China. But do you have -- if they need board from North America, are any of your mills appropriately situated? Or would you wish you had something in the West Coast?

We do.

No, we do. We have a mill on the West Coast, and it does ship product to China and other parts of Asia. But we also have southern mills that are positioned very close to ports and have product capability, and they ship as well. And Ilim today has a small amount of capacity around kraftliner boards that they do ship into Northern, Central China and supply that part of the market. So I think we're well equipped across a number of geographies for supply to China if we need it.

And your next question comes from the line of Adam Josephson with KeyBanc.

Mark, just a follow-up on, I think, it was Mark Weintraub's question earlier. How do you think about the relationship of -- between the level of North American container board industry margins and how much competition they attract? It seems as if margins have reached a level that have clearly attracted a number of companies. And given that, how sustainable do you think the current margins are?

I think the -- it's a good business. So there's always going to be interest in a good business. But the absolute container board margins aren't really the final equation. The final equation is the box and having the ability to address all the various needs of the box customers. And so I think there's going to be a pretty resilient value chain for a company like International Paper that makes both steps of the value chain, the container board from very competitive softwood fiber all the way through to the box. And I think that's going to continue to be the hallmark of that business. It's just -- it's a lot more -- and I think, again, I just refer us back to just a couple of years ago. There's a lot more than just adding container board capacity and having that really work out in a sustainable way as an investment. You've got to see it all the way through to the box customer.

And just one on the China situation again. I think RISI reported that, of the 10 lowest-cost mills in the country, now 7 were 100% recycled in the second quarter. Obviously, China is not changing its policy or doesn't appear to be doing so, which is why all these Chinese companies are building mills that touch or are outside of China. Do you have any reason to expect the current state of affairs in terms of virgin versus recycled mills, and which one is cost advantaged versus the other to change any time soon in the U.S.?

Any time soon, I think that, that would depend obviously on, primarily, the recovered fiber price. And it is a wild card to figure out exactly where China's end game is on this because that's the big lever. And then the rest of the inputs, energy, and primarily, natural gas, that would be the other input that you would have to track. And then at some point, you just look at the fiber balance, and I think it's dislocated right now because of China, but if any growth in recovered fiber comes at the expense of virgin fiber, you can quickly do the math. And then you're now creating less generation of recovered fiber for every ton that you, theoretically, would displace a virgin. So it ends pretty quickly.

And your next question comes from the line of Chip Dillon with Vertical Research.

Tim, welcome back to the CFO role. My question, first question, has to do with CapEx. I noticed that it was a bit higher than it was year-to-date last year, of course, without the consumer -- well, that's taken out. But the point being, are you still looking for around $1.5 billion CapEx? Or have you rethought that, especially given some of the tax deductibility? And maybe you found some projects that you didn't have otherwise?

No. The plan hasn't changed. It's just a function of timing, Chip. Given outage schedules and project schedules, it just disproportionately fell into the first half of this year. So we're 60%, 60-plus percent complete on the capital plan for the year.

Got you, got you. And then following up on the whole discussion about China. We know last week that their environmental ministry is possibly looking to cease all waste paper imports, which suggests to me, they would basically have to re-footprint about [80 million tons], which is like half our industry. That would also seem to suggest that OCC does stay down while board prices, because of the shortage there, stay up. I didn't know if that was any of your thinking when you were thinking of getting much bigger in Europe in a hurry, because it looks like that they're going to benefit for years, while we see how China re-footprints itself. And even leaving that aside, are there other thoughts you might have about how your strategy could change if we do see a scenario where China basically needs to re-footprint a very major amount of container board on a global scale?

So I think, Chip, the first part of your question, was that a factor in our interest in building a bigger business in Europe? No, not really. That was -- the interest in Europe was we believe it's a good market, and we could build a competitive operation by what we were trying to do. And obviously, the things that affect the price of the raw material like recovered fiber matter, but you have to believe they're going to change structurally over time. And if you just do the mass balance of fiber, it's hard to find scenarios that really structurally change that for a long period of time that you would justify an investment on. As far as whether -- what China is trying to do, I think it's very difficult to predict. I mean, it's extremely popular right now for trade positions, by countries, to take a very extreme position, see what kind of effect you have. And we seem to be doing it in our trade discussions. I think others are taking positions that, to all of us, look illogical on the surface. But there may be an actual end game in mind or a position that's somewhere south of that extreme position that ends up being where they really want to go. And I think we just have to game it out, think it through and be ready for different scenarios. And that's what we're doing.

Okay, got you. And real quickly on fluff pulp. You mentioned the growth rate and how you're up, I think you said, to about 75% of your mix. Do you see a situation, as the market grows, where you might need to make a capacity change in the next 3 to 5 years there? Or do you think you can just, instead, not add any capacity and just transition more of your paper grade into fluff?

Yes. What we're doing, Chip, and what we will do is look at the customers we have, the demand they have. And we're going to work hard, whether it's through capacity additions or optimization, to make sure that we can supply them the product they need.

And your next question comes from the line of Scott Gaffner with Barclays Capital.

This is John Dunigan on for Scott. So realizing we're a bit late in the call, I'll just keep my questions to one for right now. You held onto the 15%-plus EBITDA growth rate for the year again, obviously. But do you believe free cash flow can grow at that same clip? Or is there anything either positive or negative that could cause free cash flow to dislocate from the EBITDA growth?

I think over time, we should expect to see free cash flow grow as we generate more cash from operations. The comment I made about the quarter was simply, as Tim just reiterated, CapEx timing. But no, our expectation is to grow free cash flow because we're growing cash from operations. We're not -- that's not automatically going to result in incremental CapEx. But as part of our capital allocation, we should be able to show the returns for that incremental CapEx that's in cost reduction and in the strategic category of capability, and in some cases, some capacity debottlenecking. And -- but we want to lift the entire cash flow equation from cash from ops as well as free cash.

And your last question comes from the line of Debbie Jones with Deutsche Bank.

Two quick questions: one, on Paper; and with the other, clarifying on guidance. There was just some trade articles about producers in Brazil sending offset to Mexico and avoiding duties. I was just wondering if that has a financial impact on IP. Or any thoughts on an impact to trade flows, going forward? And then I'll move on to the guidance aspect.

Debbie, it's Tim. No, we don't see any impact on anything that we have done up to this point. It's hard to speculate on what might happen going forward, but any change that did happen would not be retroactive in any way.

Okay. And then on guidance, you did note an uptick in Paper volumes in Brazil. I think last year, they actually went down sequentially. Am I missing something there? And then I don't think I caught your inflation guidance for Industrial Packaging. I'm not sure if you gave an exact number on that.

Inflation guidance for...

Just on the sequential bridge that you gave, just kind of an uptick in freight and logistics cost.

Yes. We didn't break it out. But you can follow up with Guillermo. But in general, Industrial Packaging in North America, we have usually between $110 million and $130 million, on an annual basis, of inflation in the business. And then I'm sorry, I forget the other question that you had.

You just mentioned in -- or you put in the guidance that you would expect Brazil volumes to be higher sequentially, I believe. And I just -- when I look last year, that pattern doesn't hold. So I just wanted to know if there was something there that...

Okay. We do expect them to be up. I don't remember if there was some unique circumstance last year. But from second to third, we expect them to be up slightly.

And this does conclude our question-and-answer session. I would now like to turn it back over to Guillermo.

Thanks, Sarah. And thank you again for joining our second quarter earnings call. As always, Michelle and I will be available for your follow-up questions.

Let me now turn it back over to Mark for some closing remarks.

Thanks, Guillermo. Just to wrap up. As you've heard from our remarks, we're very pleased with our second quarter, a very strong performance. International Paper employees executed very well in a very strong economic environment, running our operations close to full. We're very excited about the great outlook that we see for the rest of the year across all of our businesses. I think we're hitting on all cylinders right now. And we have a balance of really good commercial performance with our customers and our product offerings as well as we're running very well. So we appreciate your interest in our company, and we look forward to speaking with you again next quarter. Thank you.

And this does conclude our conference call for today. We thank you for your participation and ask that you please disconnect your lines.