international paper Q2 2005 10-Q

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international paper Q2 2005 10-Q

  1. 1. UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended June 30, 2005 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From _______________ to _______________ Commission File Number 1-3157 INTERNATIONAL PAPER COMPANY (Exact name of registrant as specified in its charter) New York 13-0872805 (State or other jurisdiction of (I.R.S. Employer incorporation of organization) Identification No.) 400 Atlantic Street, Stamford, CT 06921 (Address of principal executive offices) (Zip Code) Registrant’s telephone number, including area code: (203) 541-8000 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No _____ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2) of the Exchange Act. Yes X No _____ The number of shares outstanding of the registrant’s common stock as of July 29, 2005 was 490,498,543.
  2. 2. INTERNATIONAL PAPER COMPANY INDEX PART I. FINANCIAL INFORMATION PAGE NO. Item 1. Financial Statements Consolidated Statement of Operations - Three Months and Six Months Ended June 30, 2005 and 2004 1 Consolidated Balance Sheet - June 30, 2005 and December 31, 2004 2 Consolidated Statement of Cash Flows - Six Months Ended June 30, 2005 and 2004 3 Consolidated Statement of Changes in Common Shareholders' Equity - Six Months Ended June 30, 2005 and 2004 4 Condensed Notes to Consolidated Financial Statements 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 18 Financial Information by Industry Segment 34 Item 3. Quantitative and Qualitative Disclosures About Market Risk 36 Item 4. Controls and Procedures 37 PART II. OTHER INFORMATION Item 1. Legal Proceedings 38 Item 2. Unregistered Sale of Equity Securities and Use of Proceeds * Item 3. Defaults Upon Senior Securities * Item 4. Submission of Matters to a Vote of Security Holders 39 Item 5. Other Information 40 Item 6. Exhibits 41 Signatures 42 * Omitted since no answer is called for, answer is in the negative or inapplicable.
  3. 3. PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS INTERNATIONAL PAPER COMPANY Consolidated Statement of Operations (Unaudited) (In millions, except per share amounts) Three Months Ended Six Months Ended June 30, June 30, 2005 2004 2005 2004 $ 6,229 $ 12,367 Net Sales $ 6,514 $ 13,064 Costs and Expenses Cost of products sold 4,630 9,250 4,893 9,797 Selling and administrative expenses 472 986 498 1,020 Depreciation, amortization and cost of timber harvested 375 753 390 782 Distribution expenses 260 518 264 531 Taxes other than payroll and income taxes 60 122 57 120 Restructuring and other charges 107 137 31 97 Insurance recoveries - - (35) (35) Net (gains) losses on sales and impairments of businesses held for sale 36 27 (19) 60 Reversal of reserves no longer required, net (5) (12) - - Interest expense, net 184 380 166 345 Earnings From Continuing Operations Before Income Taxes and 269 110 206 Minority Interest 347 Income tax provision 15 46 180 198 Minority interest expense (benefit), net of taxes 33 47 12 (5) 62 113 Earnings From Continuing Operations 77 154 Discontinued operations, net of taxes and minority interest 131 153 - - $ 193 $ 266 Net Earnings $ 77 $ 154 Basic and Diluted Earnings Per Common Share Earnings from continuing operations $ 0.13 $ 0.23 $ 0.16 $ 0.32 Discontinued operations 0.27 0.32 - - Net earnings $ 0.40 $ 0.55 $ 0.16 $ 0.32 488.2 487.8 Average Shares of Common Stock Outstanding - Assuming dilution 487.4 488.0 $ 0.25 $ 0.50 Cash Dividends Per Common Share $ 0.25 $ 0.50 The accompanying notes are an integral part of these financial statements. 1
  4. 4. INTERNATIONAL PAPER COMPANY Consolidated Balance Sheet (Unaudited) (In millions) June 30, December 31, 2005 2004 Assets Current Assets Cash and temporary investments $ 2,596 $ 1,251 Accounts and notes receivable, net 2,994 3,195 Inventories 2,718 2,830 Assets of businesses held for sale 229 61 Deferred income tax assets 470 422 Other current assets 312 272 Total Current Assets 9,319 8,031 Plants, Properties and Equipment, net 13,432 13,150 Forestlands 3,936 3,927 Investments 679 644 Goodwill 4,994 5,012 Deferred Charges and Other Assets 1,857 1,782 $ 34,217 Total Assets $ 32,546 Liabilities and Common Shareholders' Equity Current Liabilities Notes payable and current maturities of long-term debt $ 506 $ 571 Accounts payable 2,279 2,197 Accrued payroll and benefits 492 453 Liabilities of businesses held for sale 82 50 Other accrued liabilities 1,513 1,330 Total Current Liabilities 4,872 4,601 Long-Term Debt 14,132 12,812 Deferred Income Taxes 1,697 1,769 Other Liabilities 3,714 3,771 Minority Interest 1,548 1,497 Common Shareholders' Equity Common stock, $1 par value, 490.5 shares in 2005 and 487.5 shares in 2004 487 490 Paid-in capital 6,562 6,593 Retained earnings 2,562 2,470 Accumulated other comprehensive loss (1,357) (1,452) 8,254 8,101 Less: Common stock held in treasury, at cost, 2005 - 0.1 shares - 5 Total Common Shareholders' Equity 8,254 8,096 $ 34,217 Total Liabilities and Common Shareholders' Equity $ 32,546 The accompanying notes are an integral part of these financial statements. 2
  5. 5. INTERNATIONAL PAPER COMPANY Consolidated Statement of Cash Flows (Unaudited) (In millions) Six Months Ended June 30, 2005 2004 Operating Activities Net earnings $ 266 $ 154 Discontinued operations, net of taxes and minority interest (153) - Depreciation and amortization 753 782 Deferred income tax expense, net 14 110 Restructuring and other charges 137 97 Payments related to restructuring and legal reserves (111) (90) Insurance recoveries - (35) Reversal of reserves no longer required, net (12) - Net losses on sales and impairments of businesses held for sale 27 60 Other, net 168 101 Changes in current assets and liabilities Accounts and notes receivable (309) (118) Inventories (17) (123) Accounts payable and accrued liabilities 4 (243) Other (72) (116) 695 Cash Provided by Operations 579 Investment Activities Invested in capital projects Continuing operations (558) (506) Businesses sold and held for sale (4) (15) Acquisitions, net of cash acquired - (181) Proceeds from divestitures 604 280 Other 110 42 152 Cash (Used for) Provided by Investment Activities (380) Financing Activities Issuance of common stock 110 19 Issuance of debt 2,033 559 Reduction of debt (3,148) (1,761) Change in book overdrafts (65) 1 Dividends paid (242) (246) Other (57) (17) (1,369) Cash Used for Financing Activities (1,445) 21 Effect of Exchange Rate Changes on Cash (99) (501) Change in Cash and Temporary Investments (1,345) Cash and Temporary Investments Beginning of the period 2,363 2,596 End of the period $ 1,862 $ 1,251 The accompanying notes are an integral part of these financial statements. 3
  6. 6. INTERNATIONAL PAPER COMPANY Consolidated Statement of Changes in Common Shareholders' Equity (Unaudited) (In millions, except share amounts in thousands) Six Months Ended June 30, 2005 Accumulated Total Other Common Common Stock Issued Paid-in Retained Comprehensive Treasury Stock Shareholders' Shares Amount Capital Earnings Income (Loss) Shares Amount Equity 487,495 $ 487 $ 6,562 $ 2,562 $ (1,357) 16 $ - $ 8,254 Balance, December 31, 2004 Net issuance of stock for various plans 3,004 3 31 - - 126 5 29 Cash dividends - Common stock ($0.50 per share) - - - (246) - - - (246) Comprehensive income (loss): Net income - - - 154 - - - 154 Change in cumulative foreign currency translation adjustment (less tax of $17) - - - - (101) - - (101) Net gains (losses) on cash flow hedging derivatives: Net gain arising during the period (less tax of $10) - - - - 26 - - 26 Less: Reclassification adjustment for gains included in net income (less tax of $9) - - - - (20) - - (20) Total comprehensive income 59 Balance, June 30, 2005 490,499 $ 490 $ 6,593 $ 2,470 $ (1,452) 142 $ 5 $ 8,096 Six Months Ended June 30, 2004 Accumulated Total Other Common Common Stock Issued Paid-in Retained Comprehensive Treasury Stock Shareholders' Shares Amount Capital Earnings Income (Loss) Shares Amount Equity 485,162 $ 485 $ 6,500 $ 3,082 $ (1,690) 3,668 $ 140 $ 8,237 Balance, December 31, 2003 Net issuance of stock for various plans 901 1 (13) - - (3,662) (140) 128 Cash dividends - Common stock ($0.50 per share) - - - (242) - - - (242) Comprehensive income (loss): Net income - - - 266 - - - 266 Change in cumulative foreign currency translation adjustment (less tax of $13) - - - - (101) - - (101) Net gains (losses) on cash flow hedging derivatives: Net loss arising during the period (less tax of $3) - - - - (7) - - (7) Less: Reclassification adjustment for gains included in net income (less tax of $7) - - - - (14) - - (14) Total comprehensive income 144 486,063 $ 486 $ 6,487 $ 3,106 $ (1,812) 6 $ - $ 8,267 Balance, June 30, 2004 The accompanying notes are an intergral part of these financial statements. 4
  7. 7. INTERNATIONAL PAPER COMPANY Condensed Notes to Consolidated Financial Statements (Unaudited) NOTE 1 - BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and, in the opinion of Management, include all adjustments (consisting only of normal recurring accruals) that are necessary for the fair presentation of results for the interim periods. Results for the first six months of the year may not necessarily be indicative of full year results. It is suggested that these consolidated financial statements be read in conjunction with the audited financial statements and the notes thereto included in International Paper's (the Company) Annual Report on Form 10-K for the year ended December 31, 2004, which has previously been filed with the Securities and Exchange Commission. Financial information by industry segment is presented on page 34. Beginning with the 2005 first quarter, Industrial Packaging and Consumer Packaging are reported as separate industry segments. Prior period segment information has been restated to reflect this presentation. See Note 12 for required pro forma and additional disclosures related to stock-based compensation awards. Certain reclassifications have been made to prior year amounts to conform to the current year presentation. NOTE 2 - EARNINGS PER COMMON SHARE Earnings per common share from continuing operations are computed by dividing earnings from continuing operations by the weighted average number of common shares outstanding. Earnings per common share from continuing operations, assuming dilution, are computed assuming that all potentially dilutive securities, including quot;in-the-moneyquot; stock options, are converted into common shares at the beginning of each period. In addition, the computation of diluted earnings per share reflects the inclusion of contingently convertible securities in periods when dilutive. Furthermore, as required by the Emerging Issues Task Force of the Financial Accounting Standards Board (FASB), the computations of diluted earnings per share for all prior periods have been restated on this basis. A reconciliation of the amounts included in the computation of earnings per common share from continuing operations, and earnings per common share from continuing operations, assuming dilution, is as follows: Three Months Ended Six Months Ended June 30, June 30, In millions, except per share amounts 2005 2004 2005 2004 $ 62 $ 113 Earnings from continuing operations $ 77 $ 154 Effect of dilutive securities - - - - $ 62 $ 113 Earnings from continuing operations - assuming dilution $ 77 $ 154 485.6 485.0 Average common shares outstanding 485.9 486.0 Effect of dilutive securities Performance share plan - - 1.2 1.2 Stock options 2.6 2.8 0.3 0.8 488.2 487.8 Average common shares outstanding - assuming dilution 487.4 488.0 $ 0.13 $ 0.23 Earnings per common share from continuing operations $ 0.16 $ 0.32 Earnings per common share from continuing operations - $ 0.13 $ 0.23 assuming dilution $ 0.16 $ 0.32 Note: If an amount does not appear in the above table, the security was antidilutive for the period presented. 5
  8. 8. NOTE 3 - RESTRUCTURING AND OTHER CHARGES During the second quarter of 2005, a pre-tax charge of $31 million ($19 million after taxes) for organizational restructuring charges, and a pre-tax credit of $35 million ($21 million after taxes) for insurance recoveries related to the hardboard siding and roofing litigation were recorded. The organizational restructuring charges included $17 million before taxes ($11 million after taxes) recorded in the Printing Papers business segment for severance and other charges associated with the indefinite shutdown of three U.S. paper machines, and $14 million before taxes ($8 million after taxes) in the Forest Products business segment for costs associated with relocating the business headquarters to Memphis, Tennessee from Savannah, Georgia. Additionally, a $94 million increase in the income tax provision was recorded, including approximately $91 million for deferred taxes related to earnings repatriated during the quarter under the American Jobs Creation Act of 2004. During the first quarter of 2005, other charges totaling $66 million before taxes and minority interest ($36 million after taxes and minority interest) were recorded. Included in this amount were a $24 million charge before taxes ($15 million after taxes) for losses on early extinguishment of high-coupon-rate debt and a $42 million charge before minority interest ($21 million after minority interest) for the impairment of goodwill arising in connection with Carter Holt Harvey’s (CHH’s) purchase of Wadepack Limited. Also during the 2005 first quarter, a $19 million reduction in the income tax provision was recorded reflecting the favorable settlement of a tax matter. During the second quarter of 2004, restructuring and other charges totaling $107 million before taxes and minority interest ($63 million after taxes and minority interest) were recorded. Included in this charge were $42 million before taxes and minority interest ($23 million after taxes and minority interest) for organizational restructuring programs and $65 million before taxes ($40 million after taxes) for losses on early extinguishment of debt. The $42 million restructuring charge included $20 million of severance costs covering the termination of 431 employees and other cash costs of $22 million, and included: Printing Papers - $1 million, Industrial Packaging - $1 million, Consumer Packaging - $2 million, Forest Products - $1 million, Distribution - $2 million, Specialty Businesses - $11 million and Corporate - $24 million. In addition, a $5 million credit before taxes and minority interest ($3 million after taxes and minority interest) was recorded for the net reversal of restructuring and realignment reserves no longer required. Also, a $5 million net increase in the tax provision, after minority interest, was recorded reflecting a $32 million charge for an adjustment of deferred tax balances and a $27 million credit from the reduction of valuation reserves for capital loss carryovers. During the first quarter of 2004, restructuring and other charges totaling $30 million before taxes ($19 million after taxes) were recorded. Included in this charge were $14 million before taxes ($9 million after taxes) for organizational restructuring programs and $16 million before taxes ($10 million after taxes) for losses on early extinguishment of debt. The $14 million charge covered the termination of 202 employees and included: Printing Papers - $1 million, Industrial Packaging - $4 million, Consumer Packaging - $1 million, Forest Products - $4 million, Distribution - $2 million and Corporate - $2 million. In addition, a $7 million credit before taxes ($4 million after taxes) was recorded for the net reversal of restructuring and realignment reserves no longer required. During the last two quarters of 2004, restructuring and other charges totaling $74 million before taxes and minority interest ($42 million after taxes and minority interest) were recorded. These charges included an $18 million charge before taxes and minority interest ($11 million after taxes and minority interest) for a corporate-wide organizational restructuring program, a $35 million charge before minority interest ($18 million after minority interest) for the impairment of goodwill arising in connection with CHH’s purchase of Plantation Timber Products, a $10 million charge before taxes ($6 million after taxes) for legal settlements and an $11 million charge before taxes ($7 million after taxes) for losses on early extinguishment of debt. In addition, credits of $123 million before taxes ($76 million after taxes) for net insurance recoveries related to 6
  9. 9. the hardboard siding and roofing litigation and $23 million before taxes and minority interest ($15 million after taxes and minority interest) for the net reversal of reserves no longer needed were recorded. NOTE 4 – ACQUISITIONS On April 28, 2005, International Paper’s 50.5% owned subsidiary, CHH, announced the completion of its acquisition of Tenon Limited’s structural timber business for a purchase price of approximately NZ$165 million (approximately U.S. $120 million). In the first quarter of 2005, CHH completed the previously announced acquisition of Wadepack Limited, an Australian carton business, for approximately $65 million. In connection with this acquisition, CHH recorded approximately $42 million of goodwill. Since International Paper wrote off all CHH goodwill in 2002 under a newly adopted U.S. accounting standard, the goodwill arising in subsequent CHH acquisitions must be evaluated for impairment in International Paper’s consolidated financial statements. Accordingly, at March 31, 2005, this newly recorded goodwill was evaluated for impairment and written off. NOTE 5 - BUSINESSES HELD FOR SALE AND DIVESTITURES Discontinued Operations: In July 2004, International Paper reached an agreement to sell its Weldwood of Canada, Ltd. business. This transaction was completed in December 2004. Additionally in the first quarter of 2004, International Paper’s 50.5% owned subsidiary, CHH, announced that it had entered into an agreement to sell its Tissue business. The sale was completed in May 2004. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” International Paper has restated all periods prior to these transactions to classify these businesses as discontinued operations. Revenues associated with these discontinued operations were $293 million and $636 million, respectively, for the three-month and six-month periods ended June 30, 2004. Earnings and earnings per share related to these operations were as follows: Three Months Ended Six Months Ended June 30, 2004 June 30, 2004 In millions, except per share amounts Earnings from discontinued operations Earnings from operations $ 56 $ 94 Income tax expense (13) (26) Minority interest expense, net of taxes (2) (5) Earnings from discontinued operations, net of taxes and minority interest 41 63 Gain on sale of CHH Tissue business 268 268 Income tax expense (69) (69) Minority interest expense, net of taxes (109) (109) Gain on sale, net of taxes and minority interest 90 90 Earnings from discontinued operations, net of taxes and minority interest $ 131 $ 153 Earnings per common share from discontinued operations Earnings from operations, net of taxes and minority interest $ 0.08 $ 0.13 Gain on sale, net of taxes and minority interest 0.19 0.19 Earnings per common share from discontinued operations, net of taxes and minority interest $ 0.27 $ 0.32 7
  10. 10. Other Divestitures: During the second quarter of 2005, the Company completed the sales of its Fine Papers and Industrial Papers businesses and Papeteries de France for approximately $61 million, $180 million and $14 million, respectively. The accompanying consolidated statement of operations includes a $19 million pre-tax credit ($12 million after taxes), including a $25 million credit before taxes ($15 million after taxes) from the collection of a note receivable from the 2001 sale of the Flexible Packaging business, final charges related to the sale of Fine Papers and Industrial Papers, as well as net adjustments of losses from businesses previously sold. In addition, interest income of $11 million before taxes ($7 million after taxes) was collected on the Flexible Packaging business note, which is included in Interest expense, net. In June 2005, International Paper announced that it will explore strategic alternatives for its 50.5% stake in CHH. Many of International Paper’s original plans for investment in CHH have changed, and the Company has decided to reassess the role of CHH in its global portfolio. International Paper hopes to identify acceptable strategic alternatives for its shares before the end of 2005. In March 2005, International Paper announced an agreement to sell its Fine Papers business to Mohawk Paper Mills, Inc. of Cohoes, New York. A $24 million pre-tax loss ($13 million after taxes) was recorded in the first quarter to write down the net assets of the Fine Papers business to their estimated net realizable value. Included in the sale were the Hamilton, Ohio paper mill with an annual production capacity of approximately 65,000 tons; the Saybrook, Ohio converting center; and the Westfield, Massachusetts artist papers converting operation. The sale also included the Strathmore®, Brite Hue®, VIA ® and Beckett® brands. Also in March 2005, International Paper announced that it had signed an agreement to sell its Industrial Papers business to an affiliate of Kohlberg and Company, LLC. A $49 million pre-tax loss ($35 million after taxes) was recorded in the first quarter to write down the net assets of the Industrial Papers business and related corporate assets to their estimated net realizable value. The Industrial Papers business included packaging and pressure sensitive papers and related converting assets. Also in the first quarter of 2005, charges totaling $6 million before taxes ($4 million after taxes) were recorded for adjustments to estimated losses on sales of certain smaller operations. In the second quarter of 2004, a $27 million pre-tax loss ($27 million after taxes) was recorded to write down the assets of the Company’s Anould mill to their estimated net realizable value. In addition, a $9 million loss before taxes and minority interest ($5 million after taxes and minority interest) was recorded to write down the assets of Food Pack S.A. in Chile to their estimated net realizable value. In the first quarter of 2004, a $9 million pre-tax gain ($6 million after taxes) was recorded to adjust estimated gains/losses of businesses previously sold. At June 30, 2005, assets and liabilities of businesses held for sale totaled $61 million and $50 million, respectively, consisting of certain smaller businesses held for sale. Assets and liabilities of businesses held for sale at December 31, 2004 totaled $229 million and $82 million, respectively, and included the Fine Papers business as well as certain smaller businesses. 8
  11. 11. NOTE 6 - SUPPLEMENTAL FINANCIAL STATEMENT INFORMATION Inventories by major category were: June 30, December 31, In millions 2005 2004 Raw materials $ 371 $ 421 Finished pulp, paper and packaging products 1,796 1,770 Finished lumber and panel products 184 208 Operating supplies 351 385 Other 16 46 $ 2,718 Total $ 2,830 Temporary investments with an original maturity of three months or less are treated as cash equivalents and are stated at cost. Temporary investments totaled $953 million and $2.1 billion at June 30, 2005 and December 31, 2004, respectively. Interest payments made during the six-month periods ended June 30, 2005 and 2004 were $392 million and $417 million, respectively. Capitalized net interest costs were $5 million and $7 million for the six months ended June 30, 2005 and 2004, respectively. Total interest expense was $396 million for the first six months of 2005 and $424 million for the first six months of 2004. Distributions paid under all of International Paper's preferred securities of subsidiaries were $8 million and $30 million during the first six months of 2005 and 2004, respectively. The decrease in 2005 was due to preferred securities redeemed in February 2005 and in 2004. The expense related to these preferred securities was included in minority interest expense in the consolidated statement of operations, except for $3 million in 2005 and $19 million in 2004 related to the Trust preferred securities that were deconsolidated in the last half of 2003 and redeemed in February 2005. Income tax payments of $117 million and $113 million were made during the first six months of 2005 and 2004, respectively. Accumulated depreciation was $18.3 billion at June 30, 2005 and $18.2 billion at December 31, 2004. The allowance for doubtful accounts was $116 million at June 30, 2005 and $128 million at December 31, 2004. The following tables present changes in the goodwill balances as allocated to each business segment for the six-month periods ended June 30, 2005 and 2004: Balance Reclassifications Balance December 31, and Additions/ June 30, In millions 2004 Other (Reductions) 2005 Printing Papers $ 2,876 $ 3 $ - $ 2,879 Industrial Packaging 591 31 (a) (5) 617 Consumer Packaging 1,014 5 (b) (4) 1,015 Distribution 299 - - 299 Forest Products 190 1 - 191 Corporate and Other Businesses 24 (13) (c) - 11 Total $ 4,994 $ (5) $ 23 $ 5,012 (a) Reflects the completion of the accounting for the acquisition of Box USA, which resulted in a $37 million increase in goodwill, offset by a $6 million decrease resulting from the sale of the Industrial Papers business. (b) Reflects a $5 million adjustment resulting from the acquisition of minority interest in Shorewood EPC Europe Limited. (c) Reflects the sale of International Paper's Fine Papers business. 9
  12. 12. Balance Reclassifications Balance December 31, and Additions/ June 30, In millions 2003 Other (Reductions) 2004 Printing Papers $ 2,878 $ (1) $ - $ 2,877 Industrial Packaging 345 5 (1) 349 Consumer Packaging 1,016 (4) - 1,012 Distribution 334 - - 334 Forest Products 190 1 - 191 Corporate and Other Businesses 30 (6) - 24 Total $ 4,793 $ (5) $ (1) $ 4,787 The following table presents an analysis of activity related to asset retirement obligations: Six Months Ended June 30, 2005 2004 In millions Asset retirement obligations, January 1 $ 48 $ 41 New liabilities 2 9 Liabilities settled (3) (3) Net adjustments to existing liabilties (1) (3) Accretion expense 1 1 $ 47 Asset retirement obligations, June 30 $ 45 This obligation is included in Other liabilities in the accompanying consolidated balance sheet. The following table presents changes in minority interest balances: Six Months Ended June 30, In millions 2005 2004 Balance, January 1 $ 1,622 $ 1,548 Minority interest related to sale of CHH Tissue Business 307 - Currency translation adjustment (24) (22) Reclassification of limited partnership interests to debt (163) - Dividends paid (37) (23) Minority interest (benefit) expense 23 (8) Other, net - 2 $ 1,728 Balance, June 30 $ 1,497 NOTE 7 – RECENT ACCOUNTING DEVELOPMENTS In May 2005, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 154, “Accounting Changes and Error Corrections,” which changes the requirements for the accounting and reporting of a change in accounting principle. SFAS No. 154 will be effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. This Statement does not change the transition provisions of any existing accounting pronouncements, including those that are in a transition phase as of the effective date of the Statement. 10
  13. 13. In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations.” This Interpretation clarifies that the term “conditional asset retirement obligation” as used in FASB Statement No. 143, “Accounting for Asset Retirement Obligations,” refers to the fact that a legal obligation to perform an asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement. Uncertainty about the timing and (or) method of settlement of a conditional asset retirement obligation should be factored into the measurement of the liability when sufficient information exists to make a reasonable estimate of the fair value of the obligation. Interpretation 47 must be adopted no later than the fourth quarter of 2005. International Paper is currently evaluating the effects of this Interpretation but believes that it will not have a material impact on its consolidated financial statements. In March 2005, the FASB also issued FASB Staff Position (FSP) FIN 46(R)-5 (FSP FIN 46(R)-5), “Implicit Variable Interests Under FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities.” This FSP states that implicit variable interests are implied financial interests in an entity that change with changes in the fair value of the entity’s net assets exclusive of variable interests. An implicit variable interest acts the same as an explicit variable interest except it involves the absorbing and (or) receiving of variability indirectly from the entity (rather than directly). The identification of an implicit variable interest is a matter of judgment that depends on the relevant facts and circumstances. International Paper has already adopted FIN 46(R) and applied the provisions of FSP FIN 46(R)-5 in the second quarter of 2005, with no material impact on its consolidated financial statements. In December 2004, the FASB issued FASB Staff Position Financial Accounting Standards 109-1 and 109-2 relating to the American Jobs Creation Act of 2004 (the Act). The Act provides for a special one-time deduction of 85% of certain foreign earnings that are repatriated. In the second quarter of 2005, International Paper repatriated approximately $1.2 billion in cash from certain of its foreign subsidiaries, including amounts eligible for this special deduction. The Company recorded income tax expenses associated with these cash repatriations totaling approximately $91 million. In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment,” which will require compensation costs related to share-based payment transactions to be recognized in the financial statements. The amount of the compensation cost will be measured based on the grant-date fair value of the equity or liability instruments issued. In addition, liability awards will be remeasured each reporting period. Compensation cost will be recognized over the period that an employee provides service in exchange for the award. This Statement will apply to all awards outstanding on its effective date, or awards granted, modified, repurchased, or cancelled after that date. In April 2005, the Securities and Exchange Commission (SEC) deferred the effective date of this Statement until the first fiscal year beginning after June 15, 2005. International Paper believes that the adoption of SFAS No. 143 will not have a material impact on its consolidated financial statements. See Note 12 for a further discussion of stock options. In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4,” which requires that abnormal amounts of idle facility expense, freight, handling costs and wasted material be recognized as current-period charges. This Statement also introduces the concept of “normal capacity” and requires the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. Unallocated overheads must be recognized as an expense in the period in which they are incurred. This Statement will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. International Paper believes that the adoption of SFAS No. 151 will not have a material impact on its consolidated financial statements. 11
  14. 14. NOTE 8 - COMMITMENTS AND CONTINGENCIES International Paper has established reserves relating to certain liabilities associated with exterior siding and roofing products manufactured by its former Masonite subsidiary, which were the subject of settlements in three nationwide class action lawsuits. These lawsuits, which were settled during 1998 and 1999, are discussed in detail in Note 10 to the Financial Statements included in International Paper's Annual Report on Form 10-K for the year ended December 31, 2004. The following table presents an analysis of the net reserve activity related to these lawsuits for the six months ended June 30, 2005. RESERVE ANALYSIS Hard- Omni- In millions board wood Woodruf Total Balance, December 31, 2004 $ 158 $ 97 $ 4 $ 259 Payments (64) (12) (3) (79) Balance, June 30, 2005 $ 94 $ 85 $ 1 $ 180 The following table shows an analysis of claims statistics related to these lawsuits for the six months ended June 30, 2005. CLAIMS STATISTICS In thousands Hardboard Omniwood Woodruf Total No. of Single Multi- Single Multi- Single Multi- Single Multi- Claims Pending Family Family Total Family Family Family Family Family Family December 31, 2004 38.9 5.0 2.4 0.4 0.9 0.3 42.2 5.7 47.9 20.4 5.3 2.1 0.3 0.3 - 22.8 5.6 28.4 No. of Claims Filed (17.1) (2.2) (2.1) - (0.2) - (19.4) (2.2) (21.6) No. of Claims Paid (9.8) (1.8) (0.1) - (0.1) - (10.0) (1.8) (11.8) No. of Claims Dismissed June 30, 2005 32.4 6.3 2.3 0.7 0.9 0.3 35.6 7.3 42.9 While additional reserve balances may be required for future payments under the Woodruf Lawsuit, International Paper believes that the aggregate reserve balance for claims arising in connection with exterior siding and roofing products, described above, is adequate, and that additional amounts will be recovered from its insurance carriers in the future relating to these claims (described below). International Paper is unable to estimate at this time the amount of additional charges, if any, that may be required for these matters in the future. The lawsuit commenced by International Paper and Masonite against certain of their insurance carriers for recovery of amounts paid by International Paper and Masonite to property owners and others in connection with the settlement of the hardboard siding class action lawsuit (the Indemnification Lawsuit) is discussed in Note 10 to the Financial Statements included in International Paper’s Annual Report on Form 10-K for the year ended December 31, 2004. In March 2005, the Court in the Indemnification Lawsuit issued a preliminary decision that resolved a number of legal issues relating to the allocation of liabilities to the various insurance policies involved. Based on this decision, the Company has asked the Court to enter a judgment allocating damages, plus interest, to each of the carriers who have not settled with the Company. It is difficult to predict when the judgment will be entered. The judgment will be subject to appeal. Because of the uncertainties inherent in the litigation, the Company is unable to estimate the amount that it will ultimately recover against its insurance carriers. See also Note 13. 12
  15. 15. In addition to the Indemnification Lawsuit, the Company is seeking indemnification from other insurance carriers in arbitration proceedings as required by the applicable policies. As of June 30, 2005, International Paper had received an aggregate of $274 million in settlement payments from certain of its insurance carriers. An alternative risk-transfer agreement with a third party, under which International Paper received $100 million at December 31, 2001, and a settlement of the parties’ rights and obligations with respect to that agreement, are discussed in Note 10 to the Financial Statements included in International Paper’s Annual Report on Form 10-K for the year ended December 31, 2004. Between January 1, 2005 and June 30, 2005, International Paper paid approximately $9 million to the third party under the settlement, for total payments to date of approximately $41 million. International Paper is also involved in various other inquiries, administrative proceedings and litigation relating to contracts, sales of property, environmental protection, tax, antitrust, personal injury and other matters, some of which allege substantial monetary damages. While any proceeding or litigation has the element of uncertainty, International Paper believes that the outcome of any of the lawsuits or claims that are pending or threatened, or all of them combined, will not have a material adverse effect on its consolidated financial statements. NOTE 9 - DEBT In June 2005, International Paper used approximately $400 million of cash to repay a portion of a subsidiary’s long-term debt with an interest rate of LIBOR plus 62.5 basis points and a maturity date of June 2007. In February 2005, International Paper redeemed the outstanding $464 million aggregate principal amount of International Paper Capital Trust 5.25% convertible subordinated debentures originally due in July 2025 at 100.5% of par plus accrued interest. Other reductions in the first quarter of 2005 included early payment of approximately $295 million of principal on notes with coupon rates ranging from 4% to 7.875% and original maturities from 2006 to 2015. Pre-tax early debt retirement costs of $24 million related to first quarter 2005 debt reductions are included in Restructuring and other charges in the accompanying consolidated statement of operations. In June 2004, International Paper reclassified $168 million of limited partnership interests in Georgetown Equipment Leasing Associates, L.P. and Trout Creek Equipment Leasing, L.P. from Minority interest to Current maturities of long-term debt. These partnership interests were repurchased in August 2004. Also in June 2004, an International Paper wholly-owned subsidiary issued $650 million of long-term debt with an interest rate of LIBOR plus 62.5 basis points that can vary depending upon the credit rating of the Company, with a maturity in June 2007, which refinanced $650 million of long-term debt with an interest rate of LIBOR plus 100 basis points with a scheduled maturity date in August 2004. In March 2004, International Paper issued $600 million of 4.00% notes due in April 2010 and $400 million of 5.25% notes due in April 2016. The proceeds from these issuances were used to retire approximately $1.0 billion of 8.125% coupon rate debt in April 2004. Pre-tax early debt retirement costs of $65 million related to the retired debt were included in Restructuring and other charges in the accompanying consolidated statement of operations. In January 2004, approximately $1.0 billion of debt with an 8.05% blended coupon rate was retired using $1.0 billion of proceeds from 4.875% coupon rate debt issued in December 2003. Pre- tax early debt retirement costs of $16 million related to the retired debt were included in Restructuring and other charges in the accompanying consolidated statement of operations. 13
  16. 16. Also in March 2004, International Paper replaced its maturing $750 million bank credit agreement with a five-year, $1.25 billion bank credit facility maturing in March 2009. Concurrently, an existing three-year bank credit agreement maturing in March 2006 was reduced from $1.5 billion to $750 million. The holders of International Paper’s zero-coupon convertible debt have the option to require the Company to repurchase these securities on June 20, 2006, at a price equal to the accreted principal amount of $1.2 billion plus interest. The repurchase may be settled in International Paper common stock or cash, or a combination of both, at the Company’s option, in an amount equal to 57% of each debenture’s principal amount at maturity. The Company anticipates using a combination of cash from operations, from divestitures and from new debt issuances if this repurchase in 2006 is required. At June 30, 2005 and December 31, 2004, International Paper classified $1.25 billion and $87 million, respectively, of tenderable bonds, commercial paper and bank notes and current maturities of long-term debt as Long-term debt. International Paper has the intent and ability to renew or convert these obligations, as evidenced by the credit facilities described above. Maintaining an investment-grade credit rating is an important element of International Paper’s finance strategy. In July 2005, subsequent to the Company’s announcement of a plan to transform its business portfolio to concentrate on two key platform businesses (see Note 13), Standard & Poor’s (S&P) reaffirmed the Company’s current long-term credit rating of BBB (negative outlook). On July 20, 2005, Moody’s Investor Services (Moody’s) announced that it had placed the Company’s debt ratings (currently Baa2 for long-term credit) on review for possible downgrade. Moody’s expects this review to be completed within 90 days, and expects that International Paper’s ratings will continue to be investment grade following the completion of the review. The Company currently has short-term credit ratings by S&P and Moody’s of A-3 and P-2, respectively. NOTE 10 – RETIREMENT PLANS International Paper maintains pension plans that provide retirement benefits to substantially all domestic employees hired prior to July 1, 2004. These employees generally are eligible to participate in the plans upon completion of one year of service and attainment of age 21. Employees hired after June 30, 2004, who are not eligible for this pension plan, will receive an additional company contribution to their savings plan. The plans provide defined benefits based on years of credited service and either final average earnings (salaried employees), hourly job rates or specified benefit rates (hourly and union employees). A detailed discussion of these plans is presented in Note 15 to the Financial Statements included in International Paper’s Annual Report on Form 10-K for the year ended December 31, 2004. Net periodic pension cost for our qualified and nonqualified U.S. defined benefit plans comprised the following: 14
  17. 17. Three Months Ended Six Months Ended June 30, June 30, In millions 2005 2004 2005 2004 Service cost $ 29 $ 58 $ 34 $ 65 Interest cost 117 234 120 237 Expected return on plan assets (148) (296) (139) (278) Actuarial loss 24 47 46 84 Amortization of prior service cost 6 12 7 14 Net periodic pension expense (a) $ 28 $ 55 $ 68 $ 122 (a) Excludes a $29 million charge in 2005 for curtailments and special termination benefits related to Fine Papers, Industrial Papers and the Jackson Foodservice plant divestitures and organizational restructuring recorded in Net (gains) losses on sales and impairments of businesses held for sale and Restructuring and other charges, and a $1 million charge in 2004 for curtailments and special termination benefits related to a company cost reduction initiative recorded in Restructuring and other charges. While International Paper may elect to make voluntary contributions to its U.S. qualified plan up to the maximum deductible amount per Internal Revenue Service tax regulations in the coming years, it is unlikely that any contributions to the plan will be required before 2007 unless International Paper changes its funding policy to make contributions above the minimum requirements. The nonqualified plan is funded to the extent of benefit payments which equaled $12.8 million through June 30, 2005. NOTE 11 – POSTRETIREMENT BENEFITS International Paper provides certain retiree health care and life insurance benefits covering a majority of U.S. salaried and certain hourly employees. These employees are generally eligible for benefits upon retirement and completion of a specified number of years of creditable service. Excluded from the company-provided medical benefits are salaried employees whose age plus years of employment with the Company total less than 60 as of January 1, 2004. International Paper does not fund these benefits prior to payment and has the right to modify or terminate certain of these plans in the future. A detailed discussion of these benefits is presented in Note 16 to the Financial Statements included in International Paper’s Annual Report on Form 10-K for the year ended December 31, 2004. On January 21, 2005, final regulations for the implementation of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 were released resulting in a remeasurement of the plan as of the release date. The remeasurement and final subsidy calculations reduced the accumulated postretirement benefit obligation by $59 million, and reduced the 2005 periodic benefit costs for both the first and second quarter by $3 million. The components of postretirement benefit expense were as follows: 15
  18. 18. Three Months Ended Six Months Ended June 30, June 30, In millions 2005 2004 2005 2004 Service cost $ 1 $ 3 $ - $ 1 Interest cost 14 28 9 19 Actuarial loss 9 20 4 10 Amortization of prior service cost (11) (20) (10) (20) Net postretirement benefit cost (a) $ 13 $ 31 $ 3 $ 10 (a) Excludes a $3 million credit in 2005 for curtailments and special termination benefits related to Fine Papers, Industrial Papers and the Jackson Foodservice plant divestures and organizational restructuring recorded in Net (gains) losses on sales and impairments of businesses held for sale and Restructuring and other charges, and a $1 million credit in 2004 for curtailments and special termination benefits related to a company cost reduction initiative recorded in Restructuring and other charges. NOTE 12 - STOCK OPTIONS International Paper has a Long-Term Incentive Compensation Plan (LTICP) that includes a Stock Option Program, a Restricted Performance Share Program and a Continuity Award Program, administered by a committee of independent members of the Board of Directors who are not eligible for awards. The Company accounts for stock options granted under the plan using the recognition and measurement principles of APB Opinion No. 25, quot;Accounting for Stock Issued to Employees,quot; and related interpretations and the disclosure provisions of SFAS No. 123, quot;Accounting for Stock-Based Compensation.quot; A detailed discussion of these plans is presented in Note 18 to the Financial Statements included in International Paper's Annual Report on Form 10-K for the year ended December 31, 2004. No stock option-based employee compensation cost is reflected in net earnings, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net earnings and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation. Three Months Ended Six Months Ended June 30, June 30, In millions, except per share amounts 2005 2004 2005 2004 Net earnings, as reported $ 193 $ 266 $ 77 $ 154 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (9) (21) (15) (28) Pro forma net income $ 184 $ 245 $ 62 $ 126 Earnings per common share Basic and diluted - as reported $ 0.40 $ 0.55 $ 0.16 $ 0.32 Basic and diluted - pro forma $ 0.38 $ 0.51 $ 0.13 $ 0.26 During 2003, the Company decided to eliminate its stock option program for all U.S. employees with the intent of minimizing the use of stock options globally in 2006. In the United States, the stock option program was replaced with performance-based restricted shares for approximately 1,250 employees to more closely tie long-term incentive compensation to Company performance on two key performance drivers: return on investment (ROI) and total shareholder return (TSR). As part of this shift in focus away from stock options to performance-based restricted stock, the Company accelerated the vesting of all 14 million unvested stock options to July 12, 2005. The Company also considered the benefit to employees and the income statement impact in making its decision to accelerate the vesting of these options. Based on the current market value of the Company’s common stock on July 12, 2005, the exercise prices of all such stock options were above the current market value and, accordingly, the Company will record no expense as a result of this action. 16
  19. 19. NOTE 13 – SUBSEQUENT EVENTS Transformation Project: On July 19, 2005, International Paper announced a plan to transform its business portfolio to concentrate on two key platform businesses: Uncoated Papers and Packaging. In connection with this plan, the Company announced it would evaluate strategic options for other businesses, including the possible sale or spin-off of: • The Company’s 50.5 percent stake in Carter Holt Harvey, • The Coated and Supercalendered Papers Business, • The Beverage Packaging Business, including the Pine Bluff, Arkansas mill, • The Kraft Papers Business, including the Roanoke Rapids, North Carolina mill, • Arizona Chemical, • The Wood Products Business, and • Segments or potentially all of its 6.8 million acres of U.S. forestlands. After-tax proceeds from any potential divestments will vary, but the Company estimates that the range could be approximately $8 billion to $10 billion. Approximately 40-50% of such proceeds would be used to reduce debt and another 25-30% used to return value to shareholders. It is currently anticipated that the evaluation of Carter Holt Harvey Limited will be completed by the end of 2005. The evaluations of the other businesses are expected to be completed by the first quarter of 2006. Until such time as management and the Board of Directors approve specific plans for the sale of one or more of these businesses, they will continue to be reported as ongoing operations in the Company’s consolidated financial statements. In addition, the Company announced that it is evaluating the possible relocation of its Stamford, Connecticut headquarters to Memphis, Tennessee, where its operational headquarters is currently located. Other: On July 15, 2005, Carter Holt Harvey Limited announced that it had entered into a number of agreements to sell approximately 94,600 hectares of its forestlands for approximately NZ$441 million. Net proceeds after transaction costs and taxes are expected to be approximately NZ$385 million. The sales, expected to be completed in early October, are conditional on the approval of the Overseas Investment Commission and other normal commercial conditions. International Paper currently estimates that the sale transactions will result in a pre-tax loss after minority interest for U.S. reporting purposes of approximately $70 - $75 million ($40 - $45 million after taxes and minority interest) when completed. In 2001, International Paper and Carter Holt Harvey Limited had each acquired a 25% interest in International Paper Pacific Millennium Limited (IPPM). On August 1, 2005, International Paper purchased the 50% outside interest of IPPM for $46.1 million. IPPM is a Hong Kong-based distribution and packaging company with operations in China and other Asian countries. Beginning in August 2005, the financial position and results of operations of IPPM will be consolidated in International Paper’s financial statements. On August 3, 2005, International Paper entered into an agreement with a group of insurance carriers to settle International Paper’s claims against those carriers in the Hardboard Lawsuit which is pending in a state court in California. Under the settlement agreement, the carriers agreed to pay International Paper $242 million, including $25 million within 90 days of execution of the agreement and the balance thereafter in 47 equal monthly installments. In connection with this settlement, the Company will recognize income of approximately $220 million in the 2005 third quarter, reflecting the present value of payments to be received. 17
  20. 20. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This item 2 contains forward-looking statements with respect to possible events, outcomes or results that are, and are expected to continue to be, subject to risks, uncertainties and contingencies, including those identified in this Item. See “Forward-Looking Statements” on pages 31 through 33. Executive Summary International Paper (the quot;Companyquot; or quot;International Paperquot;) had anticipated some modest improvement in 2005 second quarter operating results following the strongest first quarter in years. However, while average prices were up slightly from the first quarter, sales volumes in the Printing Papers and Industrial Packaging businesses were lower than expected, leading to more market-related downtime than expected. These factors, combined with higher wood fiber, energy, caustic soda, and other raw material costs, offset benefits from cost reduction initiatives and improved manufacturing operations, resulting in flat earnings from continuing operations compared with the 2005 first quarter. Entering the third quarter, demand and pricing for International Paper products look mixed. On July 19, the Company announced a transformation plan that will focus the Company on two global platform businesses: Uncoated Papers and Packaging. This plan includes debt repayment, returning value to shareholders, and selective investments that will earn their cost of capital and provide solid returns to shareholders. At the same time, the Company continues to be even more focused on efforts to improve productivity, reduce costs and serve customers. Results of Operations For the second quarter of 2005, International Paper reported net sales of $6.5 billion, compared with $6.2 billion in the second quarter of 2004 and $6.6 billion in the first quarter of 2005. Net earnings totaled $77 million, or $.16 per share, in the 2005 second quarter. This compared with net earnings of $193 million, or $.40 per share, in the second quarter of 2004 and net earnings of $77 million, or $.16 per share, in the first quarter of 2005. Amounts include the effects of special items in all periods. Earnings From Continuing Operations (after tax, in millions) $300 $250 ($88) $37 $112 $200 $150 ($57) $77 $5 $100 $6 $24 ($24) $62 $50 $0 ix st ic e s ms r r r s me rte the rte le ial /M ere Pr Sa I te nti ua ua t er ns s/O I nt dQ dQ ow nd ial t io Ma m ec La era e/ D It e n n w co co Sp Ra Op lum e Se Se ra t ts/ Vo rpo 04 05 s Co 20 20 Co 18
  21. 21. Earnings from continuing operations were $77 million in the second quarter of 2005 compared with $62 million in the 2004 second quarter and $77 million in the 2005 first quarter. Earnings in the 2005 second quarter benefited from higher average price realizations ($112 million), cost reduction initiatives and improved mill operations ($37 million), and slightly higher gains from land sales ($6 million) compared with the 2004 second quarter. These benefits were partially offset by higher energy, wood and caustic soda costs ($88 million), and the impact of lower sales volumes and increased market-related downtime ($57 million). In addition, corporate items and other costs were higher ($24 million) primarily due to higher pension and supply chain initiative costs, although these were offset by benefits from lower net interest expense ($5 million) and lower special charges ($24 million). Compared with the first quarter of 2005, earnings from continuing operations in the second quarter benefited from cost reduction initiatives and improved mill operations ($25 million) and higher average price realizations ($19 million). These benefits were offset by lower sales volumes and increased market-related downtime ($32 million), higher wood fiber, energy, caustic soda, and other raw material costs ($17 million), and lower gains from land sales ($12 million). Additionally, compared with the 2005 first quarter, the 2005 second quarter was impacted by a higher effective tax rate ($15 million), which was offset by lower special charges ($15 million) and lower corporate overhead costs ($17 million). To measure the performance of the Company's business segments from period to period without variations caused by special or unusual items, International Paper's management focuses on business segment operating profit. This is defined as earnings before taxes and minority interest, excluding interest expense, corporate charges and special items that include restructuring charges, early debt extinguishment costs, legal reserves, insurance recoveries, gains (losses) on sales and impairments of businesses held for sale, and the reversal of reserves no longer required. Prior year industry segment information has been restated to conform to minor changes in the 2005 operational structure. 19

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