International Paper Co (IP) 2006 Q3 法說會逐字稿

Good morning. My name is Christy and I will be your conference operator today. At this time I would like to welcome everyone to the International Paper third quarter 2006 conference call. [OPERATOR INSTRUCTIONS]

I will now turn the call over to Mr. McDonald Vice President of Investor Relations. Please go ahead, sir.

Good morning, everybody and thanks for joining International Papers' third quarter 2006 earnings conference call. This call is being webcast. Our two key speakers this morning, our Chairman and Chief Executive Officer John Faraci, and Chief Financial Officer, Marianne Parrs.

During this call we will make forward looking statements that are subject to risk and uncertainties. These risk and uncertainties are outlined on slide two of the third quarter 2006 earnings slide presentation, and at the end of our earnings press release. Please go to our website at www.internationalpaper.com under the tab marked investors to find copies of the third quarter earnings release, presentation slides, and a reconciliation of nonGAAP financial measures to generally accepted accounting principals. Here is John.

Thanks, Brian. And good morning, everybody. This morning Marianne and I will do a couple of things, review the third quarter earnings and results performance of our individual businesses. We'll talk about the fourth quarter outlook and we'll also update you on our transformation plan.

Overall we had a solid third quarter in our platform businesses. Principally driven by strong North American paper and packaging results. In fact it was record quarter for our North American paper business and our best North American packaging earnings since 2000. For North America paper and packaging combined operating earnings improved $80 million, and importantly operating margins improved to combine 250 basis points during the quarter. Product pricing also improved versus the second quarter across all pulp, coated paper and packaging grades as a number of IP announced price increases were fully implemented. Through nine months our price is now improved more than our costs, and that's the first we've been able to say that in several years.

Global manufacturing operations again performed well in the third quarter. Third quarter volumes were solid, and I'd say unbalanced comparable to the second quarter. We do, however, continue to be challenged by high input costs especially-- driven to a large degree-- hello? Operator?

Ladies and gentlemen, we are experiencing a slight delay in today's conference. Please hold and the conference will resume momentarily.

Oh.

Sir, you may proceed.

Okay. I think I'll start the summary of the third quarter all over again just to make sure everybody catches it. We had a solid third quarter in our key platform businesses driven by a strong North American paper and packaging results. In fact it was record quarter for our North American paper business and our best North American packaging earnings since 2000. For North American paper and packages combined operating earnings improved by $80 million and operating margins improved by 250 basis points during the quarter. That's very important.

Product pricing improved in the second quarter across all pulp uncoated paper and packaging grades as the number of previously announced IP price increases were fully implemented. And through the first nine months our prices have now improved more than our cost. That's the first time we've been able to say that in several years. Third quarter volumes were about comparable to the second quarter so I'd say they were solid. We continue to be challenged, however, by very high input costs especially freight and distribution which is driven a lot by energy. Wood product performances in the third quarter were down sharply, reflecting lower prices associated with the weaker housing market.

So I'm now on slide six for those of you who were following the slides. And you can see our diluted earnings per share from continuing operations before special items which was restated to-- also restated to reflect the sale of the coated papers business which was sold September 1st, was $0.39, about equal to the second quarter of 2006. Earnings were impacted though on a quarter-to-quarter basis by $0.08 a share due to the sharply lower pricing in our wood products business. So absent that we would have had quite a good quarter, in fact the best quarter in over four years.

We're not satisfied at all with the absolute level of earnings. But we are very encouraged by the continued supply demand balance in our North American uncoated papers and Industrial Packaging business. As well as our across the board strength in manufacturing operations. We're also making real progress on all elements of our transformation plan and I'll cover that after Marianne goes through the third quarter in some more detail.

Thanks, John. Okay thanks, John. And good morning to everyone. If you turn to slide seven, you can see we're comparing third quarter results with those of the second quarter. So moving from left to right, higher price realization for our paper and packaging grades improved earnings by $0.09 per share. Solid volumes across our business resulted in a $0.01 per share improvement. Outstanding manufacturing operations increased earnings by $0.05 a share. Now higher raw materials prices and distribution costs did reduce earnings by $0.03 a share. Corporate items impacted earnings by $0.06 per share primarily due to benefit related expenses and other favorable adjustments in the second quarter which did not repeat in the third quarter.

We continue to expect our full year Corporate expense to be in line with our previous outlook probably toward the upper end. Traumatically lower prices and slightly reduced volumes for wood products reduced earnings by $0.08 per share. Lower earnings from coated paper, reflecting the sale of this business on August 1st, reduced earnings by $0.03 per share. The tax rate in the third quarter was 27%, versus 34% in the second quarter. And this change increased earnings by $0.04 a share. The decrease in the third quarter tax rate reflects changes in the projected U.S., nonU.S. mix of earnings and the impact of recent transactions in Brazil. For the fourth quarter we expect our tax rate to be 31%. I also want to point out the cash generation in the third quarter, like the second quarter, continued to be strong reflecting higher average price realizations during the quarter, and an improved working capital position.

Slide eight compares diluted earnings per share from continuing operations and before special items, for the first nine months of 2006, versus the same period in 2005. Again, moving left to right, paper and packaging prices were higher on average in 2006 versus 2005, and this added $0.40 per share. We've now improved our prices greater than our cost increases for the first time this year. Higher volumes increased earnings by $0.19 in 2006, due primarily to increased uncoated paper, liner board, corrugated box and coated paper board shipments as well as improved revenue from xpedx.

Our mills have run very well in 2006 with manufacturing costs in mix $0.22 per share favorable versus 2005. Now together the combined $0.41 per share or 276 million for volume, cost and mix, shows us making solid progress against our targeted average 400 million for three year improvement-- profit improvement goal.

Higher raw material and distribution costs continue to be a significant factor in 2006 reducing earns by 250 million or $0.38 per share and I'll give you more detail in a moment. Lower forest land sale reduced earns by $0.02 per share versus 2005. Higher corporate expense unfavorably impacted earnings by $0.20 per share and this is primarily due to higher pension expense, incentive compensation, benefits-related expenses and supply chain cost. And of course the supply chain project benefits are reflected in the business results.

Interest expense was favorable at-- by $0.08 per share as we continue to strengthen the balance sheet. Other was $0.03 per share favorable. Wood products primarily driven by prices was lower in 2006 versus 2005, and this reduced earnings by $0.22 per share. The tax rate was $0.04 per share unfavorable due to the higher tax rate of 31 % for nine months 2006, versus 28% for nine months 2005.

Turning to slide nine, we break out the 250 million or $0.38 per share of higher raw material and distribution costs for the nine months 2006 versus the same period last year. Distribution costs represents a largest change period-to-period and this is due to rising rail and truck rates as well as fuel surcharges. Chemicals and energy represented the next most significant change period-to-period as year-over-year comparables continue to be unfavorable. For more information on input cost you can see slides 32 to 35 in the appendix.

Turning now to how our businesses performed in the third quarter on slide 10, printing paper sales were 1.7 billion versus 1.9 billion in the second quarter. However, if you exclude our U.S. coated papers business and remember we sold that effective August 1st, sales were 153 billion, compared to sales of 148 billion in the second quarter, or off about 5%. Green paper had record earnings in the third quarter. Now you see here earnings improved slightly to 249 million from 247 million however, if you exclude coated papers the numbers would have been 231 million compared with 198 million in the second quarter and the improvement is due primarily to strong results in U.S. uncoated paper.

In fact U.S. uncoated papers earnings grew by 25 million in the third quarter and this was due to higher price realizations and improved manufacturing operations. Volumes were again strong but flat with second quarter levels. Pulp earnings were up in the third quarter and this was due to higher price realizations and good manufacturing operations partially offset by lower shipments and that's because we did have-- we had lower inventory levels. European papers earnings were solid flat quarter-to-quarter with improved volumes from our eastern European ramp-up offset by planned outages and somewhat higher distribution costs. And IP Brazil's earnings were down slightly, and that's due to the absence of a favorable second quarter tax settlement. Mix in volumes, however, were strong.

Slide 11 shows industrial packaging earnings increasing to 138 million in the third quarter from 100 million in the second quarter, and this was driven by strong results in U.S. operations. Now I should note that third quarter earnings do include a $13 million gain on the sale of property in Spain and this was treated as a special item. U.S. earnings were driven by strong mill operations, and higher containerboard and corrugated box prices, and this resulted from the full implementation of our previously announced price increases. IP U.S. box shipments were down 3% in the third quarter but only 1% on an average day basis. Third party containerboard sales volumes were higher in the third quarter, and this was due to outstanding mill production.

Turning to slide 12, the result of IP's cost position customer base and technology, is a return on sales performance in our North American paper business that continues to improve and clearly outperform the competition. Our Industrial Packaging business in North America also continues to improve and now ranks second in return on sales and we've got a clear path and ability to earn very good returns. Our focus in fact will be to continue to strengthen those returns.

Turning to slide 13, our consumer packaging earnings improved to 64 million in the third quarter from 41 million in the second quarter, and that was due primarily too higher earnings in U.S. coated paper board with some improvement in Shorewood Packaging as well. U.S. coated paper board benefited from excellent operations, price improvement in pulp and general folding grades, partially offset by higher costs and some unfavorable mix. Looking at the converting businesses, Shorewood Packaging results improved seasonally, although we do continue to be impacted by delayed gain launches by our customers. I also want to mention that Shorewood Packaging second quarter results were negatively impacted by an $8 million asset write off. Beverage packaging and food service earnings were essentially flat quarter-to-quarter.

On slide 14, our distribution business reported record third quarter operating profits of 34 million. Now this compared all-time record operating profits in the second quarter of 36 million. A solid business environment resulted in higher revenues but margins were down slightly due to rising product costs.

Turning to slide 15, our Forest Product earnings of 129 million in the third quarter were down from 184 million in the second quarter, due to sharply reduced earnings in wood products. Forest Resource earnings were up slightly quarter-to-quarter due to higher harvest income and lower operating expenses. Land sales were flat quarter-to-quarter. Wood products results were down 61 million quarter-to-quarter resulting in a loss of 37 million, and this was due to significantly lower prices for lumber and plywood. Our belief is that lumber prices were nearing the bottom by the end of the third quarter.

Second quarter specialized-- third quarter special items and discontinued operations are detailed on slide 16. Special items after tax in the third quarter of 2006 totalled a loss of 75 million or $0.16 per share including a charge of 56 million and that includes 35 million of transportation-- transformation planned costs and 21 million of legal charges relating to hardwood siding reserve. A loss of 19 million for divestitures which includes impairments of the wood products business of 165 million and the beverage packaging of 82 million, and an additional loss of 23 million to complete the coated paper sales. These losses were partially offset by gains from transformation planned land sales of 185 million. The recognition of a previously deferred gain of 68 million related to a 2004 sale of forest lands in Maine, and 2 million net of other small charges.

Looking ahead the forest land sale to TimberStar for 1.1 billion in cash and notes closed this week. Plus the forest land sales to RMS for approximately 5 billion in cash and notes is expected to close very soon. Together these will result in an estimated special fourth quarter pre-tax gain in excess of $4 billion.

Slide 17 shows how you get from the $0.39 of diluted earnings from continuing operations and before special items, to the $0.42 per share that we reported this morning. This concludes my remarks and I'll now turn it back to John, who will review the fourth quarter outlook and provide an update on the transformation plan.

Thanks, Marianne. Let's take a look at the fourth quarter first. We expect volumes to be seasonally slower toward the end of the year as they always are. And too soon to say what October was, but there's no question when we get to, after Thanksgiving through Christmas, things will get seasonally slower. For North America to the end of the third quarter we realized all of our previously announced paper and packaging increases, and as I said or Marianne said, we believe we're close to the bottom on wood product pricing. As probably all of you know yesterday we communicated to our customers a $40/ton liner board increase effective January 1st, and there's still some pulp price increases, although modest ones, out there.

We're making continued progress on improving performance of our global manufacturing operations, that'll be somewhat offset by planned maintenance down time we'll be taking in the fourth quarter, there'll be more of that than there was in the third quarter. In North America input cost remain high but we do see some signs of-- some favorable signs of improvement on the horizon, particularly in the energy and chemicals area. Although freight is going to remain high.

We expect lower interest expense due to additional interest income from the installment notes we will receive as the forest land sales close, and they are closing now and over the next several days. So taking this all in we expect earnings from continuing operations and before special items to be slightly lower than in the third quarter. However, as we move into 2007, our interest expense savings from debt reduction, a lower number of shares outstanding, and continued improvement on-- in our platform businesses, will continue to drive improved results.

Turning to slide 19, let me take a minute and give you a brief update on our transformation plan. As part of the plan we continue to focus on improving our key operations. That's paper and packaging on a global basis. Employing what we called a fewer, bigger, better strategy, putting capital to realign our coated-- our uncoated and packaging mill operations in North America, we'll be lowering our cost and improving our product offerings, and a lot of that is going to be happening in 2007.

The biggest element of that will be the closure of Pensacola as an [inaudible] sheet mill and it's conversion to a light weight liner board mill. We will again target an annual average of about $400 million of nonprice improvement as Marianne indicated, we're on track to deliver that this year. Our asset divestiture program is on track with announced deals of $9.7 billion we think at the end of the day it is going to be turn out to be 11 billion, when they're all completed so we'll get more proceeds faster.

The cash is coming in from the Timber sales. The-- this week and next week. We've completed the sale of our credit papers business in the U.S. and our Brazilian coated papers business during the quarter, and we hope to be able to update you on beverage packages and [wood] products by the end of the year. Arizona chemical is a little bit behind that.

And as [inaudible] all of you know our Board's authorized a $3 billion share repurchase plan and we recently completed a dutch tender on 39 million shares for about $1.4 billion so half of the announced share repurchase. And we're continuing to take the steps necessary to strengthen the balance sheet. We expect to have cash in hand, as I said, from the forest land sales over the next couple of weeks and Kraft papers in the fourth quarter.

Turning to the other element of the transformation plan which is selective reinvestment, we continue to look again selectively at opportunities, our recently announced asset swap with VCP in Brazil where IP gains the Luiz Antonio and uncoated free sheet mill, we believe to be the second lowest uncoated free sheet mill in the world and our potential joint venture with Ilim in Russia, as well as the recently closed joint venture in bleach board in China, are examples of selective reinvestment we believe are important. Important elements of a stronger, more valuable IP and all three of those will be immediately accretive to earnings.

Yes. let me take a moment now and I'm going to slide 20, and I'm going to take a little more time here, but-- and the reason I'm going to do that is because I was in Russia last week and I know many of you were unable to be on the call that we hosted on the potential Ilim joint venture, so I want to take a couple of minutes to speak to that. And just as a reminder for those of you who were on the call we did sign a letter of intent last week that's subject to more due diligence and approval by the Board of Directors to form a 50/50 joint venture. I'm really excited about this partnership.

Ilim is the leading integrated pulp paper company in Russia with significant capabilities in terms of assets, products, people, and access to market, enjoys really strong positions in Russia, China, eastern Europe. All important growth markets for the International Paper, and all important growth markets for the businesses we're in, paper and packaging.

Ilim is profitable today with an EBITDA of about $250 million. And the strategic rational is compelling as the joint venture fits right in with what we're doing. It strengthens our paper and packaging business in Russia and China, and it improves our returns in [secretive earnings]. IP's been operating in eastern Russia since 1992, that began with Poland. Since 1999 in Russia, that was the Svetogorsk acquisition, both of those businesses have been successful, and earned greater than cost to capital returns. And in fact we're currently finishing off a $300 million investment program with Svetogorsk [equipment] which substantially completes our current build out plan on those two sites.

So this joint venture would create additional platforms for profitable growth, again, in key products, paper and packaging, and in key regions, Russia, eastern Europe, and China. And I'm excited about the cost competitiveness of the joint venture, as it would be one of the lowest cost set of assets delivered to it's target market. And if you look at slides 39 to 44 in the appendix, you'll see how these facilities are credible and show up on the global cost curve to delivered markets. And they are all at the low, low end of the cost curve.

Turning to slide 22, the economics of the investment are as follows. The enterprise value of the joint venture is $1.3 billion, IP would invest $400 million for 50% interest in the joint venture, the debt of the joint venture's going to be recoursed to the joint venture only. I think this is a very attractive option for growth in Russia and China. It's $520/ton, our partners mills are lower costs than we can do with any kind of Greenfield opportunity in that part of the world. We expect there'll be a $1.2 billion plus or minus capital plan which will result in some new capacity, lower operating costs, improved quality and the mix of products. Basically, the things that we've done at [inaudible] and Svetogorsk over the last six years, as the markets have grown and required new capacity to come on.

Financial returns to total investment are expected to be well above the cost of capital for Russia, and at the outset this will be a true joint venture with equal representation on the Board. Ilim will name the Chairman, IP will nominate the CEO and the CEO will appoint the key positions. International Paper's operating experience in Russia is deep and has been successful. And the fact that it's a joint venture allows us to step into a business already operating, with an experienced management team, really significant it reduces the execution risks, versus any other growth options for us in Russia which we'll do on our own.

As I said, we've been operating profitably in Russia since our first year, which is 1999. We've got employees, we've got customers, we understand how to work with the local government officials. All of that has been a contributor to our success. And over the last two to three years we've been talking to the political leadership in Russia as well as other global companies, who have sizable investments in Russia, and the government is supportive of what we are doing. And as I compare notes with other CEOs in other industries who have invested in Russia, I'm confident that if we go ahead we'll know the things we need to know to make this successful.

The International Paper and Ilim Management teams have known each other for over 10 years. And our future partners have an impressive record. They founded the company in 1992. And since 2000 have increased capacity by 80% and revenues by 90%. And our decision to take on a partner was not made lightly or overnight but after a lot of discussions and a lot of years of contacts. I personally have made numerous trips to Russia and engaged in a lot of dialogue with both our future partners and senior officials ata the top of the Russian government. And I feel very comfortable about our, our decision.

We also know that joint ventures are different than 100% ownership positions, but I think in this case the joint venture route is the way to go. We're currently in the due diligence process. We're encouraged by what we see in the mills and in the forest. There's a map on page 38 which-- 538 which shows you where the facilities are. All the-- three of the facilities ar up for, are all scale facilities. [Cutlass] is close to 900,000 tons. [Bragst] is--[Cutlass] is in Northwest Russia. [Bragst] and [Usalance] which are in eastern Russia, are about 700,000 tons all these facilities have good scale and we can improve on that. The assets been well maintained and modernized. They have a lot of opportunity ahead of them, but the assets are in pretty good shape.

The said their low cost delivered to their target markets right now, and we know we can improve on that. But what really excites me is we've identified with the Ilim people some attractive opportunities to lower cost, improve product quality and where we need it add capacity, each mill where they can be more productive and improve their cost position, and that's the $1.2 billion I talked about.

Turning to the forest assets, that'sthe JV Oil and Wood concession, that's 5.1 million hectors, which translates into 7.5 million cubic meters of sustainable harvest. This is more than 50% of the joint venture's fiber needs and that can be met from itself own forest lands that Ilim has developed in substantial harvesting operations. The wood consumption in the area where the joint venture operates is less than 25 % of the allowable cut. So this is both in northwest Russia and in eastern Russia, wood baskets where there is a lot of supply, which means we have low cost fiber and ample room to grow to support our plans for each of these-- each of these mills.

As you can see on the slide here, the value creation, really more than half of it comes from paper packaging cost and mix, there is quite a bit of pulp opportunity and we'll take advantage of that as those markets in that part of the world grow. Ilims' current production, I'm now on slide 23, of 2.5 million tons breaks out as follows. There's about 1.5 million tons of pulp, most os that is soft wood pulp, but there is some hard wood pulp. And the pulp is made at all three locations [Cutlass], [Bragst], and [Usalance]. There's about 750,000 tons of packaging board. Most of that is liner board and then there's some folding box board as well. Those products are made at [Cutlass] and [Bragst] and there's some folding box board made at a St. Petersburg facility. And there's about 250,000 tons of Sat Kraft and [inaudible] sheets made of [inaudible].

The division we have as a joint venture is really going to replicate what IP's done before in the region. It will transition to higher value products, improve the quality and value to western standards, reduce the operating costs and debottleneck to add capacity, and I said the value created in the capital plan is more than 50% driven by mixed cost and paper and packaging volume improvements.

So we think this is the right growth platform with the right cost structure with the right partner at the right time and targeted at the right markets. I really look forward to updating you on the path forward as we get into the beginning of next year.

So let's go to the questions now, and I'm sure you have some. But before I do that I just want to emphasize that the leadership of International Paper is absolutely focused on executing the transformation plan, all elements of it, which means improving the existing businesses, paying down debt, returning value to shareholders, and selective reinvestment. And again, we look forward to updating you on that in the coming months, and we have an investor day coming up in December, which I hope most of you can make where we'll be talking a lot about this year but more importantly what's ahead of us in 2007. So with that we'll open up the line for questions.

[OPERATOR INSTRUCTIONS] Your first question comes from Claudia Shank with J.P. Morgan.

Hi, good morning. Thank you. Just wanted to ask, first on-- if you could just give us a specific update on your cost reduction program and supply chain initiative? Where are you in terms of savings, and what should we expect in terms of sort of a trajectory for savings going forward?

Let me talk about the cost reduction, the $400 million, Claudia, then I'll ask Marianne to jump in on the supply chain. We're about, I think Marianne mentioned this, about $275 million of the 500 million-- of the 400 million through the first nine months, so we're on track to get to the $400 million level. There's still a lot of input cost that's eating away at that, but you can see if you look at the water fall charts on the earlier slide, slide eight, you can see how we're doing there. Marianne do you want to talk about the supply chain?

Yes sure Claudia. As you know we've been working on our supply chain for a couple of years now. We have realized probably order of magnitude about $300 million in benefit from the time we started up to today. Our spending this year is going to be a little bit less than we originally expected it to be, probably-- our expense actually, probably closer to 160 to 165 million. We do expect that expense to continue to increase next year in part because we postponed some of the activities we planned this year into next year.

Okay. And then just going through your slide pack, I was a little surprised to see that the September uncoated free sheet price was only flat with the third quarter average. So should we--

What are you looking at Claudia?

In the appendix, where did it go--

For everybody who wants to find it.

Sorry. Towards the back.

We have it Claudia.

You've got it. Slide 31. Yes. And I was just curious, should we expect any further upward movement in prices or are those sort of previously announced price increases pretty much fully rolled through on uncoated?

Well we're not going to try to sit here and forecast pricing, but I would say supply and demand is in balance, inventories are in good shape, our orders are solid. We picked up a little share this year, if you look at the chart you'll see, our shipments are up about 5%, nine months compared to nine months. And that's in a market that's fundamentally flat, and we're going to manage in a market that's fundamentally flat.

And the uncoat free sheet business, as I said has record profitability in the third quarter. That business is returning double-digit returns now on its capital. So we also think we've got -- we're not letting up. We've got more opportunities to improve it without price. And if we get some pricing, we get some pricing.

Okay.

I might mention to that-- on that, also, Claudia if you'll see the increase from the third quarter to the second quarter we got the price implemented in July.

Okay. So it just pretty much all came through then in July?

Yes.

Okay and then just finally, if you could just give an update on the timing of the conversion project at Pensacola. When do things sort of shut down, and when do things start up on the liner board side?

We're relooking at that. The-- Claudia. As the-- well liner board side is pretty fixed.

Okay.

We're going to be starting that up in the third quarter of next year. When we take Pensacola down, it's going to be a function of when we need or don't need the capacity.

Okay.

There's a lot of flexibility there to-- to move quicker if we want and slower if we need to, but the liner board side of that will-- is relatively fixed.

Okay. Perfect thanks a lot.

Your next question comes from Rich Schneider with UBS.

Hi, John.

Hi, Rich, how are you?

Just wanted to check on your outlook for the fourth quarter. You said it would be slightly down from the third quarter. Does that adjust for the sales of the forest product asset?

No, that-- that's got no take-outs for forest products that we're packaging [for Arizona]. And I'm not sure-- we don't try to predict when those things are going to close, and so right now just think of that as steady state. But here we are in the first week of November, we're making good progress in negotiations with all of those with various parties, but we'll have to see when those things close.

I guess I was referring to the $5 billion of timberland that you--

The timberland sales, we closed one earlier this week. We close another one next week so that does reflect that going out.

In your printing papers area, you had $18 million carry over from still owning the coated paper business in the U.S. However, on the flip side, Brazil was in discontinued operations, the coated paper operations you're selling there. Would you be able to give us what Brazil coated paper contributed in the second quarter to sort of balance this thing out?

It was a very small number, Rich, probably less than $0.01 a share.

Okay. And, and just a strategic question, with everything that you have going on right now, share repurchase, interest expense, reductions through-- the reduction in debt, and also these three acquisitions in China, Brazil, and, and Russia, do you feel now that you're at a point where you're offsetting the loss of earnings from the businesses that you are selling?

Well we've got [inaudible], we've got a lot of work to do before we get to the finish line on Russia. There's still more due diligence to do there. We're going to close the VCT exchange or asset swap, February.

And with wood products, obviously having-- their earnings having come down, we're making a pretty good dent in replacing those earnings with those three, but you also got to remember too, that those are on-- in some cases in Russia and China they're joint ventures. So only 50% of the earnings will come initially. So yes we're making good progress, and we'll be able to talk more about that when we get to investor day, so you can kind of see the impact of those-- those businesses going forward in 2007 and beyond, but they are all accretive, which is-- which is important.

Okay. And then just lastly, the $0.03 increase in distribution and material costs going from second to third, a little surprised by that, if you can comment on that. And why corporate expense was up as much as it was due to benefits?

The reason distribution costs are up is, if UBS was in the freight business, you'd know why. You'd have to negotiate with the railroad-- rail rates are up substantially, and ther're fuel surcharges, Rich, that will come off as diesel prices come down, but have not yet, that amount to about-- this is September now-- year-to-date this year versus last year, the fuel surcharges alone are about $25 million. So that's why you are starting to see these rail rates-- a lot of them were effective in the third quarter. And we're looking at $100 increase in transportation costs year-over-year. 100 million.

So that should start coming down in the fourth quarter?

Pardon me.

They should start coming down in the fourth quarter with the surcharges coming down?

Well, not necessarily. They will start coming down, but it's not all going to disappear in the fourth quarter. If we get diesel back to $2 it will.

Okay. And then benefits?

The Corporate other, Rich--?

Right.

Primarily the reason-- the corporate other was up compared with second quarter and to an appreciable extent because we have favorable adjustments in the second quarter that were not repeated in the third quarter. There are a lot of items that flow through Corporate other. I would say probably 150 of them in terms of individual line items. Some quarters everything tends to be plus. Some quarters everything tends to be minus, this quarter a lot of them tended to be minus.

Marianne where are we on Corporate expense relative to our guidance?

We were saying we were going to be between 700 and 750 million for Corporate expense this year, and I think we're going to be at the high end of that range.

And that's down from where we started the year, where we were 750 to 800 million. So we made good progress there.

Great. Thanks.

Big chunk of that this year Rich, is pension expense which will go the other way next year. It will turn favorable on a year-over-year basis as opposed to negative on year-over-year basis.

Your next question comes from Edings Thibault with Morgan Stanley.

Thanks very much. John help me-- talk about the European packaging business a little bit. Clearly, it seems as if you guys are pretty happy and you're demonstrating some fairly significant price moves in the U.S. Europe is seeing a rise in liner board prices you guys have only limited exposure on the board side in Europe. Can you talk about what the impact at higher liner board prices had on your profits there and do you expect to be able to pass those through and in what time frame?

Well our European container business is not doing as well as it did last year for that principal reason. We were--our earnings were up in the third quarter, compared to the second quarter, but a big chunk of that was the-- the real estate sale that Marianne mentioned, and we're getting squeeze by-- by board prices called [delta] [inaudible] margin between sales prices for boxes and boards, they squeeze us in Europe because we're not integrated there. We buy all of our board on the outside market.

We like the business. Demand is up double-digits in Turkey. The Moroccan joint venture is off to a good start. And our business in Spain and Italy is pretty strong. Where we're in fruit and vegetables, but the business is strong. In France and the U.K. it's a little weaker. So that business is not doing as well as it has done because it's a at the margin squeeze part of the cycle.

Our packaging business in, in China, while small, is doing quite well. It's profitable, and it's interesting when we look at at the Sun investment becoming part of China next year, we're going to double sales and triple profits in China with the businesses we have and the ones we're adding.

Got it. And then just looking out-- strategically as well you guys have a lot in place on, on your plate right now, but you've talked in the past about attacking low cost regions in the regions where-- particularly where you combine low cost and growth, i.e. Brazil, China, arguably Russia, and you seem to have a program in place for each market. Are you comfortable with those programs? Is the-- do you continue to see opportunities both in terms of future opportunities as well as kind of what is actually on your radar today for additional investments in those regions?

Well, I'd say in Brazil and assuming we go ahead in Russia, we're going to have our hands full. So-- when I say our hands full, we've got the right people on the ground working on these things. So I think one of the important thing to understand about what's going on in International Paper, how it's organized, the people working on Brazil aren't the people working on Russia. The people working on Russia aren't the people working in North America.

So I'd say that for-- we're going to be focusing in 2007 and 8 on making Brazil and Russia successful. China-- we could-- if something came up there, we could look at that, those are going to be small steps rather than big steps. And in North America we haven't seen anything that looks like it makes sense for us, and so we're doing what we said we would do is rationalizing our facilities here, managing our capacity and just fewer bigger better strategy of fewer mills with a footprint that's sized to the market places, what you'll see us doing.

Got it. And then one final question on the European uncoated business, looks like profits there were essentially flat despite the price increase. Is that an accurate characterization? And then how--?

We have a lot of maintenance outages in the-- in Europe. We had some operating issues in Russia that are-- we think are behind us, so-- while profits are flat there, we would expect them to move up in the fourth quarter.

And how would you characterize the-- the-- probably the western European rather than the Russia uncoated free sheet market, given some of the recent capacity announcements?

The markets okay. The profitability's lousy. The profitability in eastern Russia. The markets are good and the profitability is good. It's tough to make money in western Europe.

Got it. Thanks very much.

Your next question comes from Mark Connelly with Credit Suisse.

Hi, Mark.

How are you? Just-- just two things. John, can you talk about the U.S. containerboard market a little bit in terms of your own box plant system and the changes and progress you've made there? And maybe give us a sense of what the utilization rates are?

Well, our box business is up if you look at the appendix, is it release-- our volume is up around 2% year-over-year and about 2%-- on a year-to-date basis-- and that's 2% quarter-to-quarter. Third quarter last year and third quarter this year. And even that business is always a lot of churn, but with our target accounts we've got a good pipeline of additional business coming on, and so it's-- I think good steady progress there, no, no major changes. In containerboard what we're doing is we're going to size the containerboard system to meet the demand requirements, and we've got a lot of options there, as we bring on Pensacola to figure out what to do with-- in our other facilities.

John, do you have specific targets for box plant utilization the way some of our other competitors now do?

No. We-- there's plenty of box plant capacity, and what we're doing is we're trying to, and we've been very successful [inaudible] the acquisition of taking more of our containerboard out of the export market and selling it domestically, both to our independent box customers, they're an important part of IP's going to market equation, and our own box plants.

So that's the principal objective and then to get the containerboard mills-- get them low cost and keep them low cost and make every box plant profitable, on a stand alone basis. Because we don't just run it as an integrated system. We want these assets to be profitable. We've probably closed, oh, a dozen box plants over the past two years. We don't have utilization targets for box plants, we have lots of operating metrics are improving box plants efficiency and cost.

That makes a lot of sense to me. Just, just one more question on that with, with respect to, to the target customer base, has there been material changes in mix in the last, say, six months or so, coincident with all of the other stuff you're doing?

In the box business?

Yes.

No. We've got a segment focus in the markets. It's fruit and vegetable in Europe. In the U.S. it's poultry. It's bulk. It's agriculture. And then every box plant has got some local business that is important to it. And the-- we're also making some good progress into some of the-- some of the food categories. But again--

That's helpful.

On a very selective basis.

And just one more question, with respect to the Russian JV you've given a fair amount of detail, do you have at this point estimates of when Ilim would actually start to distribute cash? Just trying to geet a sense is it-- long term investment plan doesn't mean there isn't going to be cash, but do you have expectations of when you might see cash coming off of that joint venture?

It would be after the build out plan, Mark.

Okay.

I think the build out plan is four or five years-- or four to six years. Now all of this is a function of what the cycle is, I mean--

Sure.

Ilim is doing quite well now because we're-- liner board prices and pulp prices are good. So--but as we looked-- kind of modeled this out, we're assuming that most of the cash that comes out of the joint venture will be reinvested in the-- back into the business to build out these sites, but again that's also going to be driven by-- on the capacity side whether the capacity is needed. And we're talking about the possibility of dividends as well, so, but they're not-- they won't be substantial. So don't think of this as a big cash machine to the U.S. right now. Think of it as building a platform for cash generations and earnings growth to come, but-- while you're talking about cash, if you look at our cash flows-- you don't have any-- Marianne-- if we had looked at our cash flows--

We'd love to take a look at them by the way.

Which will be next week.

If you look at our second and third quarter cash flows, taken together, we're generating over $1 billion a year annualized free cash, that's after CapEx and after dividends, so we're in pretty good shape.

Okay. Very helpful. Thanks, John.

Your next question comes from George Staphos, Banc of America Securities.

Hi, everyone. Congrats-- pretty good quarter. I just want to come back to the outlook for the fourth quarter. Are you referring to earnings at a pre-tax level, John? Or are you referring to EPS? Because obviously the share counts been declining.

EPS, George.

Okay.

The share count really doesn't start to decline, does it Marianne until next year?

It'll be down a little bit in the fourth quarter.

Okay. Fair enough. Now, second question we had was in the papers business you've continued to do very well on manufacturing cost--

Just to go back to the fourth quarter for a minute, one of the--

Oh, sure.

We don't forecast, but we know from experience the markets are going to be seasonally slow and if we have to take downtime, we're going to take downtime in the fourth quarter to manage our capacity and not build inventories. So just for that reason alone, you-- you could anticipate the-- if everything stays the same, nothing else changed, we could be taking some downtime if we need to.

Okay actually since you are on that topic, that was one of my questions. At this juncture do you have a view on what the maintenance downtime might look like for the quarter especially in containerboard or in papers?

I don't have it on the tip of my fingers here but as you call Brian he can probably get it for you later.

Okay.

We don't forecast market downtime but we've got maintenance outages we can quantify that for you.

Okay fair enough. Back to manufacturing you again had a very good quarter in papers and by my numbers you saw sequential improvement, having said that by my math and also looking at your year-to-date and your quarter waterfall charts, it looks like the progress slowed a little bit. Would you agree with that? And what are the next areas where you think you can improve your cost per ton in the uncoated business? And do you think-- longer term do you think you can get back to peak levels of profit per ton in that business?

Well we're at, I mean we're at record levels right now, but we think we've got other ways-- more levers to pull to improve that business without price. I think one of the reasons you saw the sequential profitability slow is, as Marianne pointed out, we got most of our price increases and that could appreciate early, so what you're seeing in volume was about flat quarter-to-quarter. So what you're seeing flow through there is just cost. Which is-- that's very, very good because we're seeing continued cost improvement in that business both at the manufacturing cost level and at the supply chain level, and that's where the supply chain benefits are showing up, the cost are in another part of the P&L.

Okay.

The other thing that's coming, of course, too John is when we switched Pensacola over to liner board next year, that's going to be a big benefit to our papers business in terms of lower cost.

That alone is I think worth about $30/ton. All those rationalizations in a uncoated free sheet.

[inaudible] magnitude.

Got you. Got you. I don't have my sheet in front of me, but have you updated your thoughts on any of the other liner board mills that may or may not leave the system as you-- as you switch on Pensacola? I think it was Pineville and [Tarahoat]?

Yes, not yet. We'll do that at the time, and as I said we've got a lot of flexibility when Pensacola goes down. We don't have as much flexibility about when it comes up on liner board. But as we get into next year we'll have-- we'll be making our decisions about what we're going to do there.

Okay last question, I'll turn it over. You talked earlier and you referred to this in the past about how you and box USA become more vertically integrated and over time move production out of external markets, either domestically or into your own box network. Yet, in quarter it looked like-- and you're not the only company here, who reported this way. External production was up. Can you give a sense in terms of why that was the case and if in fact we did our math right on that? And how do you see that playing out over the next two or three quarters? Thanks, guys.

Well box demand was, was slightly down in aggregate. I think it was basically-- pretty close to flat on a per day basis, when you look at it. And we had strong liner board-- strong liner board demand for both our domestic customers, and our offshore customers and that enabled us to run full. Our inventories are still very good shape and industry inventories are in good shape. So I think part of it is just a function of what your mix of business looks like in the box business, and our mix of business is not the same as everybody else's. So I don't think there's anything structural there that's going on. I would expect box demand to be up kind of on a year-over-year basis for us about 2%.

And exports still pretty good, John? At this juncture?

Pardon me.

Exports still pretty solid for you at this juncture?

It, is yes.

Okay, thanks guys. Good luck in the quarter.

Your next question comes from Mark Wilde with Deutsche Bank.

Good morning, John.

How are you?

Good. Question on the consumer packaging business, can you help us understand with paper board prices essentially flat and volume flat, is the-- the lift in earnings there, which looks like about $15 million on an adjusted bases, is that just a seasonal demand in the downstream packaging? Or what really drove the earnings improvement? If it wasn't price or volume.

Costs. I mean in coated and Bleach board our costs are down $15 million quarter-to-quarter.

Okay. All right and--

It's real, Mark. You can't take costs out.

Yes. John, I was a little surprised at that only $2 increase in the coated board prices because some of the other players in the business are reporting larger increases. Can you comment on that?

Well, our to that-- our mix of board business is aseptic, tobacco, cup, and folding. Cup has a lot of contracts on it, reopeners, at, on certain integrals, so we've a big chunk of cup business, which is getting, we'll get price increases but they are not all coming-- kind of at the same time price increases get announced. Tobacco's typically got contracts on it. Folding is the area where there have been price increases announced. Some-- some have gone in-- I'd say at the converting end, though, it's-- there's been a lot less flow through of folding carton prices into converting than there has been of containerboard prices into boxes. [inaudible] containerboard into boxes has been probably 90%, and it's not that-- not the case in folding carton.

Okay. Turning to Russia for a minute, you've got a lot of spare equipment here in the U.S. Is there a potential to take advantage of that in both converting and in terms of mill equipment through Ilim now?

There could be in converting. It's difficult to get the math to work to move paper-- paper-- paper mills around the world. And if we had a paper machine or a board machine we could look at that. And we'd just have to evaluate that against the cost of buying something-- buying something new or debottlenecking or rebuilding what we've got. And that may be, when we get into this, that may be a lot of what we do is rebuilding what we have as opposed to throwing it away and buying something new.

Yes. Okay.

But on the converting side the-- that clearly is something we can look at. In fact we've been looking at that in China. In China it just happens-- so happens you can build new for a fraction of the cost of building new in the U.S. And so it usually makes sense to put something made in China in when we are adding capacity as opposed to moving from the U.S.

Okay and then finally on-- back to price for a minute. I notice that the containerboard price in September was down just a little bit from the third quarter average.

Yes, that's mix.

That's just a mix issue.

Yes.

Okay. All right. Very good thank you.

Okay. Mark.

We do have time for one last question. And your last question comes from Peter Ruschmeier with Lehman Brothers.

Thanks, good morning.

Hi, Pete.

Question on the Forest Product segment, if I could. Can you comment on the amount of harvest income that's included in the third quarter that will be pro forma basis, no longer there with the sale of the timberlands?

I could if I knew what the answer was.

532 is the-- is the document to which is-- is the data to which you're referring. The land that we'll continue to hold for future sale after we complete the big transactions really isn't a major source of harvest income for us. So for all practical purposes, we'll have a little bit of harvest income in the fourth quarter and then the harvest income will go away.

Okay. But was there much in the third quarter?

Look at slide 32.

It has been flat, Pete.

I'm sorry slide 32.

Yes, $[63] million.

Got it. Okay.

That's a good question, Pete because I mean, as we talk about this transformation plan, as we sell assets, improve our business and find select reinvestments, not all of these things happen to totally match up quarter-to-quarter. So what we're after here is how do we build a earnings platform from the International Paper both with what we had and what we might reinvest in, that creates shareholder value and builds sustainable earnings. And it's--in some quarters may be a little lumpy as we sell something, and there is-- we haven't reinvested it yet either in the existing businesses or in something new or pay down debt.

Okay. And how much visibility do you have on that real estate sale going forward? I mean if you have I believe about 800,000 acres or so left of some pretty rich real estate that I think you plan to sell over time, can you give us some indication as to the time frame? Is it three years? Five years? A longer period that you expect to sell that out? And how predictive-- how much predictive power do you have on that?

Well we haven't completed the work we need to do to figure out whether that's going to be more short term or longer term, Pete. That's exactly why we're taking some time. There're close to 500 parcels here. And obviously if we thought the value was 100 and we could get 95 for it now, we wouldn't take three years to do it. But if the value is 100, we're not going to sell it for 50 today. We aren't going to get in the real estate development business. So that's not where--not headed down that path, but we're looking at various options for how that land would get monetized, and it's likely to be over a couple of years, but it could be soon if the right opportunity comes along.

Okay. That's helpful.

I want to clarify something for you on property too--

Sure.

I should have said this when I pointed you to that slide in the first place. You see the recreational income, you also see a line that says forest land expense, a significant portion of the forest land expense is incurred on the harvest. So you--

Got it.

You can net some expense against that.

Okay. And just lastly, if I could, you talked a lot about Pensacola, am I correct, John, in understanding that you haven't yet fully decided as to what the net change is going to be. And we know there's about 0.5 million tons of containerboard coming on, but it sounds like we don't know yet if you're going to take 0.5 million tons out from [Tarahoat] and Pineville?

Well to be clear, we're going to size our footprint to demand. If we don't need the capacity, we're not going to run the equipment. We haven't figured out exactly how we do that. We've got some other options of taking machines down or running facilities differently as well it's just-- it's not just [Tarahoat] and Pineville, but we are not looking to grow our liner board business domestically with capacity if the market doesn't need it.

Okay. And in the white paper business, the 350,000 tons that's coming out, is there-- is that the net change? Or are reinvestments in other U.S. mills going to take up the slack so that net, net there's really not much change?

We can take-- we'll take out as much as we have to to size our footprint to demand. We've got lots of flexibility there if you take out more capacity than just Pensacola. So don't for a minute think this is, okay we're going end up with net the same capacity if we don't need it. And if we need the same capacity, we're going to have a problem, because Pensacola is going to-- it's going to be converted.

Got it. Super, thanks, John.

Okay well I think that was the last question and ends the conference call. Thank you very much, and we'll hopefully see you in December.

And just a reminder, I know we had a long queue today, so I'm available to answer questions after the call. Thank you.

Thank you for participating in today's International Paper's third quarter 2006 conference call.