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Schweitzer-Mauduit International (NYSE:SWM)
Q3 2019 Earnings Call
Nov 05, 2019, 8:30 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Welcome to SWM's third-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 later this afternoon. [Operator instructions] It is now my pleasure to turn the floor over to Mr. Chekanow. Sir, you may begin.

Mark Chekanow -- Director of Investor Relations

Thank you, Josh. Good morning. I'm Mark Chekanow, director of investor relations at SWM. Thank you for joining us to discuss SWM's third-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 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 relate 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. Good morning, everyone. Yesterday, we reported third quarter adjusted EPS of $1.01, an increase of nearly 30% versus last year. It was a strong quarter on several fronts, highlighted by another quarter of solid profit growth in both of our operating units.

The combination of AMS's healthy organic sales growth, fixed cost reductions and lower raw material costs drove significant segment margin expansion. EP posted profit growth as well, with positive price/mix performance, strong operations and lower input costs, more than offsetting the impact of lower volumes. We also delivered strong free cash flow for the quarter, putting us at $95 million year to date just below our 2019 goal of exceeding $100 million. I'll now review our business segments in more detail.

For AMS, segment profits were up 39% in the quarter and up 24% year to date. Sales growth in the quarter of 4 or 5%, excluding currency impacts, was again led by transportation and filtration, where steady demand in our key market applications continue to drive results. We also saw another good quarter for medical, with growth in both consumer finger bandages and specialty hospital products. Consistent with our results throughout 2019, infrastructure and construction lagged the portfolio as we've seen some softness in demand in some of our submarkets.

Within our fastest-growing industries, transportation was particularly strong this quarter, with sales of our core aftermarket paint protection films growing double digits. We continue to invest and innovate in this high-value product category to leverage current momentum. In recent calls, we've discussed our capacity expansion in Europe, as well as a new manufacturing line that is being installed in our Asian facility during the fourth quarter of this year, giving us global capabilities and the ability to capitalize on increasing international demand. These investments should increase our competitive advantage in this highly strategic product area.

Relatedly, glass lamination products also delivered high-growth as our products continue to add value in areas such as ballistic resistant glass for military applications and other growing transportation markets like high-speed rail, which require reinforced windows. We believe our efforts to internationalize the films business by adding production capacity and increasing our commercial presence has paid dividends in these submarkets. In filtration, RO water again led our business with double-digit gains. The consistent growth in this space has anchored our filtration sales gains over the last two years, and our outlook remains positive.

Recall that last quarter, we disclosed our recently launched filtration paper for the RO industry, an excellent synergy between our EP and AMS segments. This product is manufactured on our paper assets and sold through the AMS commercial team. The addition of this capability allows us to now offer our own customers three key components of RO filtration devices, further deepening our relationships in both the commercial and innovation level. We believe our material matches, and in many cases, exceeds the quality levels achieved by our competitors, and coupled with other offerings, creates an unmatched bundling capability and opportunity to increase wallet share across our existing customer base.

We have begun servicing customers and believe we have ample opportunity to increase our sales of this product in the coming years. Andy will cover margin performance shortly, but suffice it to say, we are pleased with the margin expansion realized during the quarter. The expansion is due to a combination of growth, efficiencies, cost reductions and favorable resin costs. In addition, we continue to execute on a host of initiatives to enhance performance of the business, many of which will be supported by the IT systems investments we are making.

Even with these improvements, we remain focused on additional efficiency opportunities through an aggressive rollout of Lean Six Sigma and enhanced business intelligence tools. These initiatives are key for our ability to leverage our organic sales growth and drive to a 20% segment operating margins over the next several years. Moving to engineered papers. Segment profits were up 7% in the quarter as the somewhat soft sales quarter was more than offset by solid manufacturing performance, good cost controls and lower pulp costs.

The fundamental themes for 2019 results remain generally consistent during the quarter with positive price/mix providing an offset to the anticipated lower volumes as we continue our strategy of managing for profitability by focusing on high-value products. With regards to the volume decline, key factors continue to be the planned exit of some low-margin nontobacco volumes and overall lower recon volumes, including heat-not-burn sales. While it's fair to say that heat-not-burn sales have lagged expectations this year, we are working with our customers on new product launches, which, if successful, are expected to result in a rebound in sales. I would emphasize, though, that given these new -- these are new product introductions, sales could be lumpy with an initial pipeline fill sometime during 2020.

Our commitment to our customers on this innovative product line remains unchanged. One other factor affecting our third-quarter results was U.S. smoking attrition perking up due to increasing trial and adoption of vaping products throughout 2019. Given the recent news surrounding these products, we expect that pressure to ease somewhat.

In addition to attrition, we also saw some impact to LIP volumes as some customers rebalanced their inventories. We know, however, that despite this inventory drawdown and slightly higher attrition, our year-to-date LIP volumes are only down slightly as a result of market share gains. We believe this relative outperformance is a testament to our strong customer relationships, service and quality. Regarding our continued positive price/mix of 6% in the quarter, a positive driver was the momentum in our wrapper and binder business for small cigar products.

This high-value product line continues to be a bright spot with the EP business and the key contributor to profitability. To conclude our discussion of engineered papers performance, I think it is important to take a moment to thank Michel Fievez, our EP segment leader following his recently announced retirement. During his 12-year tenure at SWM, Michel has been instrumental in the success of our paper operations. He has overseen the rollout of LIP in various geographies, has led multiple restructuring and operational excellence initiatives that have supported strong segment profitability over the years.

He has partnered with our large customers to foster long-term collaborative relationships that have resulted in SWM's sustained market leadership and has charted a forward strategy around our growth initiatives that have set up the business for continued success. We thank Michel for his numerous contributions. At the same time, we welcome a proven industry veteran, Omar Hoek who will join SWM in January from Ahlstrom, a diversified global specialty papers leader. We have full confidence that Omar, working with the strong EP leadership already in place, will build upon our success to date and provide valuable leadership going forward, particularly in the areas of commercial development and innovation, which continue to be a fundamental component of EP strategy.

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, third quarter sales increased 4% to $126 million, and adjusted operating profit increased 39% to $24.4 million. Sales would have been up 5% without the negative impact of foreign currency. Margin expansion of 480 basis points put adjusted operating margin at 19.3%, a very strong performance and compares very favorably to our third quarter results from last year when our margins were pressured by higher costs.

Strong organic sales growth, coupled with an improved fixed cost structure and the benefit of softening polypropylene resin costs drove the gains. Regarding polypropylene, market prices have stabilized and are expected to remain favorable to prior-year levels in the near term. The engineered papers segment net sales were down 7% to $130 million, however, were down 4%, excluding the negative impact from foreign currency. More importantly, however, adjusted operating profit was up 7% to $29.5 million.

Positive price/mix of 6% provided a partial offset to the volume decline of 10% in the quarter. We continue to shed lower margin nontobacco paper volumes. And as Jeff referenced, we weathered the impact of higher smoking attrition in the U.S. and some inventory drawdowns by certain customers.

Strong manufacturing performance and cost controls within our manufacturing plants, along with the positive impacts of the price mix movements and lower wood pulp costs all contributed to margin expansion of 290 basis points to 22.6%. As we noted last quarter, there is a lag from when the year-over-year declines in wood pulp costs are realized in our P&L. We are now seeing some of that favorability, and given current pricing, we expect the year-over-year benefit to continue in the near term. Outside of wood pulp, however, we are seeing pockets of inflationary cost pressures with labor and energy costs.

Corporate unallocated expenses increased versus last year, rising to 12 million in the quarter. The biggest component of the increase stem from higher deferred compensation expenses versus last year's third quarter. Other corporate expenses for IT investments and some consulting fees for various projects also contributed to the increase compared to last year. As a reminder, with deferred compensation expenses and their year-over-year comparisons, they are driven by the relative movement of our stock between the current quarter and the year ago quarter.

For some perspective, when excluding deferred compensation expense, our unallocated cost bucket in 2019 annualizes to about 43 million. And this includes the IT system investments we mentioned at the beginning of the year. On a consolidated basis, net sales were down 2%, but essentially flat without the impact of currency. Adjusted operating profit was $41.9 million, up 14%, and adjusted EBITDA was $51.4 million, up 11%.

Shifting to consolidated earnings. Third quarter 2019 GAAP EPS was $0.90 versus $1.33 in the prior year. The comparison was largely driven by $0.68 per share of one-time benefits last year that related to U.S. tax reform and the writedown of a contingent liability.

The remainder of our non-GAAP adjustments mainly relate to our typical noncash purchase accounting expenses in AMS, modest restructuring activities in EP to reduce costs and some tax benefits that are excluded from adjusted EPS. Adjusted EPS for the third quarter was up 29% to $1.01 versus $0.78 a year ago. This strong growth was mainly a result of operating profit increasing in both segments and a slightly favorable tax rate, which was partially offset by higher unallocated expenses, as well as higher interest expense from our third-quarter 2018 debt financing. Excluding the impact of our non-GAAP adjustments, our third quarter tax rate was 17.9%, bringing the year-to-date rate embedded in our adjusted EPS to 20.2%, both down slightly from the prior year.

With respect to our earnings guidance, we remain comfortable with our guided range of $3 -- $3.40 to $3.60 per share. Throughout the year, we've seen fairly consistent areas of puts and takes. With favorability on raw material costs and offsets from a weaker-than-expected euro, higher smoking attrition in the U.S. and higher deferred compensation expenses.

Moving to cash flow and leverage. Year to date 2019 free cash flow was very strong at $95 million. Given we typically have strong cash flows during the fourth quarter, some of which may have been pulled forward, we believe we'll comfortably exceed our goal of more than 100 million of free cash flow for the full year. Capex was approximately 6 million in the quarter and 24 million year to date, which annualizes a little below our 35 to $40 million guidance range, but we expect some of those planned investments to carry over into 2020.

From a leverage perspective, for the terms of our credit facility, we were at 2.3 times net debt to adjusted EBITDA at the end of the third quarter. This is down from 2.5 times from midyear and is expected to steadily tick down as we generate cash. Now back to Jeff.

Jeff Kramer -- Chief Executive Officer

So putting it all together, we were pleased to deliver another solid quarter, highlighted by operating profit growth in both AMS and EP. We are executing on our vision for profit stability and high cash flow in EP and strong top and bottom line growth in AMS, which we consider a powerful combination capable of supporting steady enterprise growth. Our quarter and year-to-date performance are tracking as planned, and we continue pressing forward on several strategic growth initiatives across our business, ranging from capacity expansions and new product commercialization to cost reduction efforts and IT upgrades. Financially, we continue to improve the balance sheet, pushing our leverage lower to ensure our comfortable liquidity position when the right M&A opportunities present themselves.

In the meantime, we are focused on delivering on our financial commitments to our shareholders and positioning the company for sustainable profit growth. We appreciate your continued interest and support. And that concludes our remarks. Josh, please open the line for questions.

Questions & Answers:


Operator

[Operator instructions] Our first question comes from Steve Chercover with D.A. Davidson. You may proceed with your question.

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

Thanks, good morning everyone. So just with the leverage now down to 2.3 times, can you help us with a couple of things? I mean, first of all, presumably, you're in a position to go shopping, is there a pipeline of potential acquisitions and how are the valuations?

Jeff Kramer -- Chief Executive Officer

So Steve, we're always -- I mean, we've been pretty clear. We have a very disciplined approach to our M&A process, and we're always looking for potential add-ons that complement the technologies or markets that we're putting in. So our pipeline continues to be fairly robust around that. Valuations are certainly not cheap in that respect.

But for the right opportunity that matches the markets and opportunities that we see in the future, we like to have that dry powder available for us.

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

OK. I figured as much. And then can you remind us -- sorry if I don't have photographic memory, what kind of repo you might have authorized because it was only a month ago that your stock went to $33 for no reason. And I'm sure that it would make sense to aggressively act on such dislocations.

Andy Wamser -- Chief Financial Officer

Yes, it's a good question. But at this time, we don't have anything authorized for the share repurchase. We've been pretty consistent in terms of saying, in terms of how we think about capital where after the conwed transaction, we wanted to make sure that we delevered the balance sheet, which I think we now have done and successfully integrated the conwed business, which you're now seeing some of the fruits of that labor now with some of the AMS growth this year. So it's something we certainly talk about.

But right now, it's not the highest priority of capital and just -- I'll leave it at that.

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

But I mean, to your point, you have done a good job delevering? And I guess, I call it, good housekeeping. I mean, it wasn't $33 for no reason a pretty compelling opportunity, I would assume that you have a good idea of your own intrinsic value and I'd be astonished if that didn't fall in as a pretty good use of capital.

Jeff Kramer -- Chief Executive Officer

No, it's a good point and -- but it's -- I would just go back to -- in terms of how we think about the capital return. It's heavily focused on the dividend right now, where, on an annualized basis, would be just over $50 million. And the balance of the free cash flow we've been using is to delever. But certain -- we will always look at the potential of share repurchase.

But right now, it's just deprioritized.

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

OK. And then just changing gears a wee bit. Forgive me, I took a long time to get on the call, but I haven't heard anything to suggest that sales got pulled forward into Q3. So if that's accurate and if wood pulp remains fairly benign, is it fair to say that you should be at the high end of your guidance that you issued at the beginning of the year? And are you willing to tighten that at all?

Andy Wamser -- Chief Financial Officer

Yes. I mean, as we look for the -- into the fourth quarter, I think it's fair to -- we feel very comfortable with the guidance that we gave of the $3.40 and the $3.60. Sure, there's a chance in terms of we could be at the higher end or in the midpoint, but there's still a lot of uncertainty in terms of just the markets. We do have a lot of volatility with November, December.

And you don't know how some of your customers are going to be filling their inventory and their pipeline. So I would say, in general, December is a pretty volatile month, and that can have the big swing for us.

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

OK. And do you want to remind us of any seasonality that we should be aware of? Because I've been looking at your model, and it's kind of 50-50, whether Q4 is better or worse?

Andy Wamser -- Chief Financial Officer

Yes. What I would say is we would expect fourth quarter for this year to be at least or above where we were last year, but I think the other thing to keep in mind is that there was a deferred comp benefit last year, which will be somewhat of an impact this year. So keep that unallocated expense in mind.

Jeff Kramer -- Chief Executive Officer

Steve, your question about, do we understand the seasonality of the fourth quarter. And that, I think, going back to Andy's comment around. Sometimes the fourth quarter is hard for us to predict. So we have some very big company customers, and sometimes they might move inventory into the fourth quarter.

Sometimes they will delay it until January of the next year. And that can swing it pretty much. And I think what you've said is the seasonality seems to be sometimes 50% good, 50% bad, and I think that's an illustration of it. And that's why you hear a little bit of uncertainty about making strong predictions on fourth quarters is December can just be a little bit uncertain.

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

OK. But if I heard Andy's comment that it's similar to Q4 of '18, then I feel pretty good.

Andy Wamser -- Chief Financial Officer

Yes, that's fair.

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

OK. Thank you.

Operator

[Operator instructions] Our next question comes from Chris McGinnis with Sidoti & Company. You may proceed with your question.

Chris McGinnis -- Sidoti and Company -- Analyst

Good morning, thanks for taking my questions. Just to keep up, I guess, just around the guidance and kind of the reiteration this morning. Q4 should be a little bit tougher on that. The deferred comp.

Can you just maybe talk what you're thinking about at this point of modeling to continue to keep the guidance out there?

Andy Wamser -- Chief Financial Officer

Sure. So this level set for the fourth quarter in terms of maybe talking on an OP basis, and then we can talk about some of the puts and takes that go below the line. So on an OP basis, we would expect the fourth quarter to be at or slightly above from where we were last year. What I would keep in mind some of the benefits that we had is the fourth quarter had an artificially lower tax rate as we trued up for the first three quarters.

We also had the benefit of about $0.14 from our JVs. So we got some of that in the third quarter. So then when you think of it in aggregate, I'd say OP could be up a little bit slightly from last year. But on an EPS basis because of some of the below the line items, with pats and the JVs, there will be a little bit more of a headwind.

So just to be clear, in terms of probably OP -- EPS could be slightly down just because of below the line items.

Chris McGinnis -- Sidoti and Company -- Analyst

OK. And just, I guess, just with that deferred comp, should be a negative going into Q4, just given the decline in the stock price last year versus where it is now?

Andy Wamser -- Chief Financial Officer

Yes. I mean, last year -- yes, last year, the benefit of the deferred comp was just under about 2 million for the fourth quarter. If you think about our unallocated bucket. If we strip out the impact of deferred comp for this year, it would -- our run rate would be about 43 million.

So -- and that's just kind of gives you a sense maybe for modeling in the future. The way I'd characterize it is kind of go back to '17, the unallocated was closer to that like 40 million. Last year, it was little bit artificially low because of the volatility to the downside, particularly in the fourth quarter of the share price. And then we've had a few million in terms of the impact this year.

So when you level set it, net-net, kind of going forward, it's probably about 43 million. And the reason why you see the increase in '17 to this year was largely because of some of the IT investments that we've talked about, we're going through a ERP implementation, and upgrading certain systems. So -- but that's been the biggest driver in terms of why your unallocated bucket, excluding the impact of deferred comp, is up.

Chris McGinnis -- Sidoti and Company -- Analyst

Very helpful. I appreciate that. Maybe just moving on, just with the kind of the negative press around the e-cigarettes. Are you starting to see any positive benefits from maybe some better volumes in Q4? Or how long would that take to impact you? If there was a trend back to cigarettes.

Andy Wamser -- Chief Financial Officer

Yes. I think it's a very hard assessment to make about how quickly things like that flow one way or the other. It's not completely tied together around that. So it's hard to say if -- I would say the recent news is too soon to make a dramatic increase right now.

But if you ask me how quickly that could run through the system. It's hard to say.

Chris McGinnis -- Sidoti and Company -- Analyst

Fair enough. I know you just touched on the margin improvement in the AMS segment. Can you just -- I may have missed it, if you did go through this, but can you just talk about the improvement in where the buckets came from? I know there's some cost savings, but also, it sounds like some leverage as well. Thank you.

Andy Wamser -- Chief Financial Officer

Sure. So if we think about the improvement in the AMS operating margin, it's really a few buckets. A third of it – a third of the improvement would be coming from the improved sales growth, which was 5%, excluding the impact of foreign currency. A third of it had to do with, I'd say, really cost -- better cost controls in terms of SG&A and think about the benefits of the plant consolidation efforts that we've gone through.

And then I'd say, just about a third was really about input costs.

Chris McGinnis -- Sidoti and Company -- Analyst

OK. And then just last question, just around kind of end market demand within AMS. Can you maybe -- when you're thinking about the remainder of the year, any changes from any of these stronger end markets versus the maybe the weaker performing end markets as we finish out the year?

Andy Wamser -- Chief Financial Officer

Sure. The only thing I just would add, for the fourth quarter, I would keep in mind that the fourth quarter for AMS last year was up materially. On a revenue basis, I mean, they were up 9%. So there will be some tough comps to a degree with some of our, I'll call it, transportation products.

But in aggregate, I think the same categories really are holding true to what we said this year and last year. So it's been pretty consistent where it's been, a lot of the transportation and filtration products really sort of leading the way with that portfolio.

Chris McGinnis -- Sidoti and Company -- Analyst

Thanks and good luck in Q4.

Andy Wamser -- Chief Financial Officer

Great. Thanks.

Operator

And I'm not showing any further questions at this time. I would now like to turn the call back over to Dr. Kramer for any further remarks.

Jeff Kramer -- Chief Executive Officer

Well, again, thank you all for your support throughout the year. We had a solid third quarter. We're going to continue to focus on delivering on the consistent themes that we've talked about, and hopefully, that is coming through in these calls. And I thank you, and I look forward to the call in Q4.

Operator

[Operator signoff]

Duration: 31 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

Chris McGinnis -- Sidoti and Company -- Analyst

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