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Schweitzer-Mauduit International (NYSE:SWM)
Q2 2019 Earnings Call
Aug 08, 2019, 8:30 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Welcome to SWM's second-quarter 2019 earnings conference call. Hosting the call today from SWM is Dr. Jeff Kramer, chief executive officer. He is joined by Andrew Wamser, chief financial officer; and Mark Chekanow, director of investor relations.

Today's call is being recorded and will be available for replay after this afternoon [Operator instructions] It's now my pleasure to turn the floor over to Mr. Chekanow. Sir, you may begin.

Mark Chekanow -- Director of Investor Relations

Thank you, Darinda, and good morning, everyone. I'm Mark Chekanow, director of investor telations at SWM. Thank you for joining us to discuss our second-quarter 2019 earnings results. Before we begin, I'd like to remind you that the comments included in today's conference call include forward-looking statements.

Actual results may differ materially from the results suggested by these comments for a number of reasons, which are discussed in more detail in our Securities and Exchange Commission filings, including our quarterly reports on Form 10-Q and our annual report on Form 10-K. Some financial measures discussed on this -- during this call are non-GAAP financial measures. Reconciliations of these measures to the closest GAAP measures are included in the appendix of this presentation and the earnings release. Unless stated otherwise, financial and operational metric comparisons are to the prior-year period and relates to continuing operations.

This presentation and the earnings release are available on the Investor Relations section of our website, www.swmintl.com. I'll now turn the call over to Jeff.

Jeff Kramer -- Chief Executive Officer

Thank you, Mark, and good morning, everyone. Yesterday, we reported second-quarter sales of $270 million, which were equal to last year and adjusted EPS of $1.06, up 6%. It was a positive quarter highlighted by both segments delivering profit growth. AMS continued to demonstrate organic sales gains and good margin expansion, consistent with our expectations of a strong 2019.

A combination of fixed-cost reductions, efficiency gains and some easing of raw materials contributed to the improvement. EP delivered solid performance as well. Positive price mix, which is key for this segment, more than offsetting lower volumes and unfavorable currency and contributing to sequential improvement after a challenging first-quarter start to the year and showing profit growth over last year's second quarter. I would also like to call attention to several press releases we issued in recent weeks, where we officially announced two strategic growth projects, an Asia capacity addition in our fast-growing transportation business and a new product introduction in our filtration business where we leverage both our EP assets and AMS sales channels.

Overall, we are pleased where we stand at midyear, and free cash flow is tracking as expected toward $100 million. One note, second-quarter GAAP earnings did reflect a significant onetime expense from our pre-2,000 tax assessment related to our operations in Brazil that Andy will detail later in the call, and which is excluded from our $1.06 of adjusted EPS. I'll now review our businesses, beginning with AMS. Segment profits were up 13% in the quarter and 17% year to date.

And I would like to note that this was pure organic growth. Sales growth of 2% or 3%, excluding currency impacts, was led by transportation and filtration, and fundamentals remain strong for these fast-growing product lines. During the quarter, AMS hit a milestone with segment profit margin exceeding 20% for the first time. Within transportation, we continue to see healthy global demand for our surface protection films.

Recall, we commissioned our first international film line in Europe last year, and that line is now fully operational. This has led us to announce a follow-on capacity investment at our recently expanded and upgraded facility in China. Paint protection films have been one of the fastest-growing applications across the AMS portfolio, and we remain fully committed to maintaining industry leadership on this important technology. This latest investment puts us in a strong position in the local Asian market.

And once completed, we will be the only manufacturer of these films with production sites across three continents. In filtration, RO water, again, led our business with double-digit growth. As we said last quarter, customer indications are positive regarding this near-term outlook, while our continued long-term bullishness in this space is supported by the underlying need for improved access to drinking water on a global basis. Our customers see ongoing capacity additions on the horizon, and the continued strength of the replenishment cycle is evident in our growth.

In recent calls, we have mentioned the launch of a new specialty filtration product, but until recently have provided limited details for competitive reasons. However, we officially announced our product offering in late July after participating in several filtration trade shows during the summer in Asia. Our new paper serves as a critical component in the manufacturing process of reverse osmosis water filtration cartridges and represents a new product from us in this important subsegment. With the high level of quality we have achieved, initial feedback from our customers is that our paper offers improved processing performance, given our consistency in manufacturing a defect-free and uniform material.

This launch is an example of the synergies between our AMS and EP operations as this highly engineered product is produced by our paper operations in France and sold through our global AMS commercial organization, which already markets several other products into the RO marketplace. The addition of this membrane vacuum paper increases our competitive position as we offer an unmatched bundling capability, enhances our value proposition as a preferred supplier and further strengthens our customer relationships. We look forward to a multiyear ramp-up as we expect to grow within this expanding filtration subsegment industry. Rounding out the AMS segment, after a strong first quarter, medical sales were off slightly during the second quarter but remain up year to date.

Infrastructure and construction also declined modestly in the quarter. Moving to engineered papers, while there was some divergence between volume decreases offset by price mix positives, we were generally pleased with the overall results with sales up 2%, excluding currency pressures and with operating margin increasing. LIP and other tobacco papers were stable in the quarter, despite industry declines in part due to customer inventory movements. A 9% volume decline consistent with our first-quarter results reflected another tough comparison for heat-not-burn Recon products as our customers were launching products last year and filling their supply chain.

We expect that these comparisons should ease significantly in the back half of the year. We also saw lower volumes in nontobacco papers, particularly in printing and writing, an area we have strategically deemphasized given its lower margin profile. Traditional RTL was also soft but was partially offset by our wrapper and binder Recon products where new product introductions into the Asian small cigar market are performing very well. So to recap, while volumes were lower, our price mix more than offset those losses given the portfolio shift toward our higher-value products with total sales up 2% without the negative currency impact.

I would also note that while we did benefit from higher contract prices that we set earlier this year to recapture higher wood pulp costs that most of the price mix benefit was on the mix side. Cost pressures across our raw materials' basket was less acute than in the first quarter. We performed well from an efficiency standpoint, despite the lower volumes and continue to look at our capacity and other cost-reduction programs to keep the attractive 20-plus-percent margins our EP segment generates. I'll now turn the call over to Andy to discuss our financial results in more detail.

Andy Wamser -- Chief Financial Officer

Thank you, Jeff. Starting with AMS, second-quarter sales increased 2% to $127 million, and adjusted operating profit increased 13% to $25.5 million. While currency impacts on AMS sales are relatively small compared to our EP segment, sales would have been up 3% without the negative impact of foreign currency. Margin expansion of 190 basis points put adjusted operating margin just over 20%.

And note, this increase was compared to our strongest quarter of 2018 when adjusted operating margin was approximately 18%. Sales growth combined with our actions to reduce fixed costs and the benefit of softening polypropylene resin costs drove the gains. Regarding polypropylene, market prices continued to contract during the second quarter and flow through our P&L. The engineered paper segment net sales were down 2% to $143 million, however, were up 2%, excluding the 4% negative impact from foreign currency.

And adjusted operating profit was up slightly to $33.8 million. While the euro exchange rate remained unfavorable compared to 2018, the negative comparisons should ease in the second half of the year if current levels hold. We're pleased to report that positive price mix of 11% more than offset the volume decline of 9% in the quarter. Similar to the first quarter, we continue to shed lower margin nontobacco paper volumes, and we again faced a tough comparison for heat-not-burn.

On a positive side, our tobacco paper portfolio, including LIP, held up well. The net mix effect of these trends was decidedly favorable. And combined with contractual price increases that went into effect earlier this year was the key to our operating profit growth. Adjusted operating margin for this segment was 23.6%, up 70 basis points versus last year.

Wood pulp costs were up modestly versus prior year. And while there has been some recent pullback in wood pulp prices, there is a delay on the benefit flowing through our P&L. Separately, though, we continue to see some pressure from other input costs such as energy, chemicals and labor. Corporate unallocated expenses increased moderately versus last year.

The deferred compensation pressure we experienced in the first quarter from the rapid increase in our stock price reversed in the second quarter, but was offset by other corporate expenses for IT investments and some consulting fees for various corporate projects. On a consolidated basis, net sales were essentially flat, but without the impact of currency would have increased 2%. Adjusted operating profit was $50.6 million, up 6%, and adjusted EBITDA was $60.2 million, up 4%. Shifting to consolidated earnings.

Second-quarter 2019 GAAP EPS was $0.66 versus $0.83 in the prior year and included a $0.24 impact from tax assessments in Brazil related to pre-2,000 activities. We provided significant details in our 10-Q, but to summarize, the assessments relate to local taxes on raw materials and social security-type benefits for employees. We've been working with local tax authorities and resolving these matters for approximately 20 years, with one case going in our favor and one against. We note that a large portion of this expense represents interest and penalties.

Though, we plan to pursue appeals, potentially utilize offsetting tax credits and/or apply for programs that may minimize the final impact. However, at this point, GAAP required the booking of the full potential expense. We have excluded expenses associated with the tax assessments from our adjusted EPS. The remainder of our non-GAAP adjustments mainly relate to our typical noncash purchase accounting expenses in AMS.

Adjusted EPS was $1.06 versus $1 a year ago, up 6%. Recall that second-quarter 2018 earnings were our strongest of the year, and it represented a challenging comparison. Thus, we were pleased to deliver solid earnings growth in the quarter. Results were driven by the operating profit increase in both segments, which was partially offset by higher interest expense from our third-quarter 2018 debt financing.

As reflected in our GAAP adjustments, we have split out interest expense on our debt from the interest expense associated with the tax assessment in Brazil. Our normalized second-quarter tax rate was 21.6%. Moving to cash flow and liquidity. Year to date, 2019 free cash flow was $37 million.

Per our typical seasonal pattern, we expect cash flow to be stronger in the second half of the year and finish at approximately $100 million or above. capex was approximately $9 million in the quarter and $18 million year to date, which annualizes within our $35 million to $40 million guidance. As a reminder, our higher capital spend in 2019 versus 2018 reflects certain growth investments in AMS, particularly the capacity expansion for transportation films and IT investments to support enhanced business intelligence capabilities across the business. From a leverage perspective, for the terms of our credit facility, we were at 2.5x net debt to adjusted EBITDA at the end of the second quarter, unchanged from year-end 2018, and we would expect leverage to tick lower as we get -- as we close out the year.

Now back to Jeff.

Jeff Kramer -- Chief Executive Officer

Thanks, Andy. Our quarter and year-to-date performance are tracking as planned with both segments delivering operating profit growth and margin expansion during the quarter. We remain excited about the growth prospects in AMS and are executing on several strategic growth initiatives in transportation and filtration. We want to underscore that these initiatives as well as other recently completed projects were all part of our AMS vision as we made acquisitions over the past five-plus years.

We targeted companies we believe could benefit from our intention to deploy growth capital, particularly for international capacity expansion and innovative new product development. And also our operational excellence capabilities to integrate and deliver on cost-reduction synergies. While we continue to look at M&A to add scale and diversify the company, we are pleased with where the business stands and its strong year-to-date profit growth without the benefit of acquisitions. On the EP side, we are strategically managing the profitability of our business in the face of tobacco industry headwinds with stable to positive trends in several high-value product lines.

And we continue to focus our efforts in these areas as well as opportunities to improve efficiencies and cost structure. Lastly, while raw materials inflation was a drag on our results in 2018, both our resin and wood pulp costs appear trending in the right direction. And absent a rise from current levels should be favorable in the second half of the year. We appreciate your continued interest and support.

And that concludes our remarks. Darinda, please open the line for questions.

Questions & Answers:


Operator

[Operator instructions] Our first question comes from Steve Chercover from D.A. Davidson. Your line is open.

Steve Chercover -- D.A. Davidson -- Analyst

Thanks, and good morning everyone.

Jeff Kramer -- Chief Executive Officer

Good morning.

Steve Chercover -- D.A. Davidson -- Analyst

So my first question is on new paper filtration products. Are they in a trial phase? Or are they in full-blown commercial production?

Jeff Kramer -- Chief Executive Officer

They are fully commercialized at this stage. We've been scaling this product up over the past several months and are fully qualified at several customers.

Steve Chercover -- D.A. Davidson -- Analyst

That's good. OK. And then through the first half, the price mix is offset. Again, sticking with paper, a 9% volume decline.

In the second half, do you expect the volume declines to be more in line with the attrition? And can you maintain such a rich mix?

Jeff Kramer -- Chief Executive Officer

So we expect our mix to continue to be positive overall. If you recall, the volume declines are a summary of a couple of different things. One, if we had deliberately deemphasized our printing and writing papers in our nontobacco Paper segment, so we're down materially in that. Second is in heat-not-burn, if you recall in our reconstituted tobacco products last year, the first half of the year, one of our customers was filling the product pipeline.

And so we didn't think those lines were going to be sustainable. And we believe in the second half of the year, those comparisons should ease up. And we have seen a little bit of weakness in our more traditional Recon business but are seeing some positives in our wrapper and binder. So we expect to still see some volume pressures in the second half, but we also expect to see good product mix and margins.

Steve Chercover -- D.A. Davidson -- Analyst

OK. And keying in on the word, sustainability, the margins in AMS, are they sustainable at 20%?

Jeff Kramer -- Chief Executive Officer

Yeah. We think we've hit a little bit of a peak. Second quarter always traditionally is a good solid quarter for us. So we expect them to ease off.

But I think what you should be seeing is the general trend is exactly where we're predicting it to go. We're seeing our efficiency gains, we're seeing some high-margin products launched and getting good shares in that. So I think the second half margins will be lower than this peak margin in the quarter but will be up year-on-year materially.

Steve Chercover -- D.A. Davidson -- Analyst

Thank you. Can you give us a sense of the capital required to commission a TPU film line? And will there be any freight or perhaps tariff savings by producing in China?

Jeff Kramer -- Chief Executive Officer

Yes. So a couple of things. One, these lines are not materially expensive to install. We have the facility.

So we expanded our Suzhou plant with these things in mind and so we have the capability to just add another line into it. It's in the few millions of dollars of capital when we start to put that in. In terms of tariffs, we don't see a huge impact at this time. But you know the tariff situation is really changing on a day-to-day basis.

So it's hard to know. I think the important thing -- and so we don't see a big impact right now in our current businesses. But it's important to note that I think we're well prepared for the future as this uncertainty, I think, will continue for many years. And so having the flexibility to manufacture on various continents gives us a lot of flexibility of where we produce products for certain markets.

Steve Chercover -- D.A. Davidson -- Analyst

OK. And since they're not particularly capital intensive, are there barriers to entry beyond first-mover advantage?

Jeff Kramer -- Chief Executive Officer

Yeah. There's a lot of barriers to entry in this market. If you think about what these films are going to, these are very high-performance films and they have to have a certain level of optical clarity, physical characteristics to be able to drape on complex shapes without putting the air bubbles in, they have to be defect-free, meaning no gel particles, no pinholes, etc. And so I think it's easy to manufacture a thermoplastic polyurethane film, it's not easy to manufacture a high-quality transportation surface-protection film.

Steve Chercover -- D.A. Davidson -- Analyst

OK. And last question. Are there any contractual price givebacks that you have to endure as input such as pulp per tree?

Jeff Kramer -- Chief Executive Officer

Not that we see this year. No.

Steve Chercover -- D.A. Davidson -- Analyst

OK. Thanks, Jeff.

Operator

Our next question comes from Dan Jacome from Sidoti and Company. Your line is open.

Dan Jacome -- Sidoti and Company -- Analyst

Hi, good morning. Just one question, and I appreciate the time. So can you talk a little bit more about what you're seeing in your construction end markets? It looks like in the second quarter, it didn't really rebound it to the level you expected, just looking at the commentary we had on the first Q '19 call. So I wanted to learn a little bit more about what you're seeing in every pocket of that.

You can share details, commercial building and residential construction. And then where are you seeing that, for example, sort of erosion in blanket cycle for the highway construction, kind of figure out where this weaknesses are? And then has your viewpoint changed about how you're looking at that end market after the second half and into the next year? I think when you made the Conwed acquisition, you were targeting still 3% to 4% growth. Just want to -- are you guys still realistic and we're just going through kind of a short-term blip? Or there's something else that we need to think about longer term? Thank you.

Jeff Kramer -- Chief Executive Officer

Yeah, we think it's more of a short-term blip. Some of the weakness has really been in our soil stabilization businesses. And it's actually a result of two things if we think about it. Really, this extreme weather has really materially impacted the overall business, and it's impacted it for two ways, which is interesting.

One, which is more obvious as you have flooding and rains, you can't do the big construction projects, you have surface. So they don't need the surface blankets as much, et cetera. The second piece, surprisingly, is the extreme weather has actually had impact on the hay production. And hay is actually used as one of the pillar in the blanket.

And so there's actually been some limited capacity from our end-use customers in being able to actually make the blankets because of a different raw material and not ours. So it's kind of a one-two punch on that. So that weakness has been there for the first half. We are expecting to see a little bit stronger, to be honest, in the second quarter.

But I think you see the extreme weather continues even today. And yesterday, you see these storms passing through. We expect it to be solid in the second half of the quarter. I'm a little bit more cautious now on how I predict it because of these weather patterns, but it's still a very important part of our product line.

We still are the leading supplier in this. We have very strong customer relationships. So I think it's more of a blip than anything else.

Andy Wamser -- Chief Financial Officer

And just to provide context, I mean it's only down low-single digits. So it's not that material.

Dan Jacome -- Sidoti and Company -- Analyst

Yes. No, that's incredibly detailed. We appreciate you sharing that. Thank you and good luck with the rest of the current quarter.

Andy Wamser -- Chief Financial Officer

Thank you.

Operator

[Operator instructions] I'm showing no further questions at this time. I would now like to turn the call back over to Dr. Jeff Kramer for closing remarks.

Jeff Kramer -- Chief Executive Officer

All right. Well, I appreciate, again, everybody's support. I thought it was a very solid quarter. I hope everybody is noticing that we're executing on the things that we've said that we will be executing on, and we'll continue to do the best we can to perform and meet everybody's expectations.

So thank you very much.

Operator

[Operator signoff]

Duration: 29 minutes

Call participants:

Mark Chekanow -- Director of Investor Relations

Jeff Kramer -- Chief Executive Officer

Andy Wamser -- Chief Financial Officer

Steve Chercover -- D.A. Davidson -- Analyst

Dan Jacome -- Sidoti and Company -- Analyst

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