Schweitzer-Mauduit International's (SWM) CEO Jeff Kramer on Q1 2018 Results - Earnings Call Transcript

Schweitzer-Mauduit International Inc. (SWM) Q1 2018 Earnings Conference Call May 3, 2018 8:30 AM ET

Executives

Mark Chekanow - Director of Investor Relations

Jeff Kramer - Chief Executive Officer

Andy Wamser - Chief Financial Officer

Analysts

Dan Jacome - Sidoti & Company

Kurt Yinger - D.A. Davidson

Operator

Welcome to SWM's First Quarter 2018 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. At this time all participants have been placed in a listen-only mode and floor will be open for your questions following the presentation. [Operator Instructions] It is now my pleasure to turn the floor over to Mr. Chekanow. Sir, you may begin.

Mark Chekanow

Thank you, Vitra. Good morning, I'm Mark Chekanow, Director of Investor Relations at SWM. And thank you for joining us to discuss SWM's first quarter 2018 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-cash 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 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 Web site www.swmintl.com.

I will now turn the call over to Jeff.

Jeff Kramer

Thank you, Mark, and good morning everyone.

Yesterday, we reported first quarter results with sales up 12% to more than $260 million and adjusted EPS up 24% to $0.82 a share. It was a good start to the year with consolidated sales, operating profit, EBITDA, free cash flow and EPS all up versus last year. As we've discussed our 2018 operating plan was based on relative stability in our paper business and improved organic sales growth in AMS and we delivered on both fronts.

For the quarter, the key takeaways are strong manufacturing performance and favorable currency driving top and bottom-line growth in EP and accelerated organic sales growth in AMS offset by short- term margin pressures, which we expect to improve throughout the year.

Cash flow was up significantly versus last year, I'll bet in our seasonally lowest quarter and as we indicated on our last call, we project free cash flow to exceed $100 million in 2018.

AMS delivered 7% organic sales growth with solid gains across most of our portfolio. Transportation, filtration, industrial and medical all showed strong increases while infrastructure and construction lagged.

Going into more detail, our Transportation business delivered strong results on the heels of a soft fourth quarter. Recall that after a high growth in mid-2017, our customers paired back inventories significantly impacting Q4 results. We indicated that this was expected to be a short-term issue and in fact these sales bounced back and resumed their growth trend to start the year. While the quarterly comparisons may be lumpy, our healthy order backlog for these specialty films supports a positive outlook.

In our Filtration business, we are pleased to see a rebound in water filtration sales as the general market role over the past 18 to 24 months had consistently hindered AMS growth. As anticipated, we see the beginning of 2018 upturn as the filter replenishment cycle returns and customers plan for new capacity coming online in the Middle East.

We also saw continued growth in process filtration driven mainly by gains in semiconductor manufacturing where our products filtered liquid solvents used in chip production.

In our Infrastructure and Construction business, we were affected by extended and severe winter conditions across most of the northern parts of the country during the first quarter. While we don't like to use weather as an excuse, this market is highly sensitive to poor conditions as it impacts construction crews ability to complete projects. Simply put many of the end users of our erosion control blankets and sediment control socks have been unable to perform installations at their sites.

We believe a portion of these delay sales will be recovered throughout the remainder of the year. Unfortunately, we did not experience the entire flow through of higher organic sales so the bottom-line. As anticipated, our Austin side incurred elevated costs as we get closer to a final exit later this year. We flush through high cost inventory, incurred accelerated depreciation on several assets and endured the typical inefficiencies related to closing a plant resulting in P&L impacts.

The higher cost associated with this site accounted for the majority of the adjusted segment margin decline. However, we expect to offset these costs later this year when we realize the synergy from closing this facility, which annualize to majority of our $10 million run rate target.

The second issue is higher resin costs, particularly polypropylene which is up versus last year and is forecasted to remain elevated in 2018. In response, we recently implemented price increases to our customers. The increases are intended to mitigate higher resin prices and we have seen many resin users announce similar actions. The price increase will benefit the coming quarters and we anticipate it will offset a large portion of the cost pressure.

Also we are encouraged by the sales momentum despite the margin impact of these short-term issues and our confidence our actions will result in better profitability for the year. Finally, our key strategic projects are progressing well as the new facility in China is up and running and we are hitting internal milestones for our new European film line start up later this year.

Switching to Engineered Papers, first quarter results were solid, segment volume was up 2% largely due to growth in non-tobacco papers as total tobacco volume was stable. Currency particularly the euro drove the majority of the 10% sales increase in the quarter. Regarding segment margins, we reported healthy growth versus last year. However, that first quarter 2017 results were suppressed due to production issues related to several line restarts.

Favorable comparisons aside, we performed well in the quarter from a manufacturing perspective with productivity gains offsetting higher pulp costs. In response to this inflationary pressure, we have also selectively raised prices and will continue to monitor the pulp market and evaluate further actions.

Regarding our strategic priorities, heat-not-burn sales were up significantly over last year. At that time, we had just begun to generate commercial sales as our initial major customer ramped up production and built inventories. We expect continued growth in 2010 and have begun shifting initial commercial quantities to a second major customer who is preparing to launch their product. We acknowledge that there has been some volatility on the street regarding category growth reflected in earnings reports of key industry players.

We have been consistent stating that heat-not-burn is an attractive long-term play but is still in the early phases of rollout and will experience some fits and starts as it gains acceptance. We remain optimistic on the long-term outlook for this innovative product line and see this more as an offset to secular declines in demand for our other tobacco related products rather than a game changer in the near-term.

I'd also like to highlight a positive legal result in our LIP business resulting in a one-time settlement of $1.2 million from our competitor. While relatively small, it signals the strength and defensibility of our patent portfolio. We know this is not our primary infringement case, where we received a favorable ruling in late 2017. As stated previously with regard to that case, we are assessing potential positive outcomes but there is no update to provide now.

I will now turn the call over to Andy.

Andy Wamser

Thank you, Jeff.

I will now review our financial results starting with segment performance. In the first quarter, AMS net sales increased 15% to $115 million with pro forma organic sales growth of 7%. Conwed was acquired mid-January 2017. 2018 first quarter had three additional weeks of Conwed contribution.

Adjusted operating profit with $16.2 million or 14.1% of sales down 310 basis points. The market contraction was primarily driven by the inefficiencies of our Austin plant as Jeff detailed earlier which is scheduled for closure later this year.

As part of this process, we are incurring accelerated depreciation expenses and realizing the lower margins beneficially manufactured product that are flown through the P&L. These anticipated expenses account for more than 2/3rds of the 310 basis point margin decline. The second primary driver with higher resin costs which impacted margins by more than 100 basis points.

In addition recent investments in our new Chinese facility and the acquired Conwed operations resulted in higher depreciation equating to another 50 basis points. Looking forward, however, we believe the price increases to customers beginning in the second quarter will provide an offset to higher resin costs and the annualized synergies from the Austin site closure in the second half of the year will exceed these short-term pressures. The engineered paper segment net sales were up 10% on a 2% increase in volume.

Foreign currency movement provided an 8% benefit to the top-line assuming card exchange rates hold the favorable comparison would be more muted in the second half of the year. The adjusted operating margin was 23.1% up 180 basis points due primarily to stronger manufacturing performance in the soft year ago quarter, which offset higher pulp costs.

Off note, while currency did provide a boost to operating profits that had no impact on the operating margin expansion.

Adjusted corporate unallocated expenses increased by 6%, but as a percent of total SWM sales declined approximately 30 basis points to 3.6%. On a consolidated basis, net sales increased 12% but were up 9% pro forma for Conwed and up 4% pro forma for Conwed and excluding currency.

Adjusted operating profit was $40.6 million up 11 % and adjusted EBITDA was $50.7 million up 13 %. The increase in accelerated depreciation and depreciation on new assets contributed to EBITDA growth exceeding operating profit growth.

Shifting to consolidated earnings, first quarter 2018 GAAP EPS was $0.68 up from $0.45 in the prior year. Adjusted EPS was $0.82 up from $0.66 and representing 24% growth. While EPS growth was supported by growth in operating profits, we also benefited from a lower tax rate. Our first quarter tax rate was 25.6% down from 34.3% last year when we had higher discrete tax items. The primary driver of the lower tax rate was changes to the U.S. tax code.

We cautioned that while this current rate is very favorable compared to 2017 there could be variability in our quarterly rate as we continue to assess and interpret the new tax laws. Currency translation was a positive $0.03 impact to first quarter EPS.

I'd like to take a moment to discuss an accounting change and its impact on our financials. Due to new accounting guideline, a portion of pension related expenses we previously recognized as operations have now moved below the operating line into other income and expenses. The change does not affect net income or earnings per share measures. We estimate the total reclass for 2018 to be about $3 million with the vast majority relating to our paper segment.

The results in our release reflects this change for the current and prior period and the updated investor presentation on our Web site reflect those changes on a quarterly basis for 2016 and 2017.

In addition we've modified our calculation of adjusted EBITDA to exclude our JVs and other income and expenses, which fall below operating income. The result essentially equates to operating profit plus D&A. Conforming to the methodology, we believe investors typically calculate when assessing our business.

Moving to cash flow and liquidity, first quarter 2018 free cash flow was $16 million. This was a substantial improvement from prior year driven by higher income and lower CapEx. CapEx with about $6 million in the quarter, which annualizes well below our $40 million guidance, but we anticipate spending will pick up toward the anticipated range as the year progresses.

From a leverage perspective for the terms of our credit facility, we were at 2.9x net debt to adjusted EBITDA at the end of the first quarter down slightly from year-end 2017. As we previously noted absent acquisitions we expect that our leverage ratio will move lower as we generate free cash flow and deliver expected EBITDA growth in 2018.

Now back to Jeff.

Jeff Kramer

Thanks Andy. To wrap up first quarter was positive overall. Sales grew in both segments with particular strength in some key AMS markets. Margins were good in paper, we claimed the small success in LIP litigation and currency and tax were both favorable versus last year.

Clearly we'd like to see more of the AMS sales growth drop to the bottom-line, but we expect significant profitability improvement in the coming quarters given the actions we've taken on price and projected synergy delivery from the site closure. As we've consistently said, we are focusing on executing our 2018 synergy plan and supporting several growth initiatives across the cost growth businesses.

We also remain active in assessing additional M&A opportunities, while non-tobacco sales at 50% was an important milestone. It is not our destination and we will continue pursuing additional strategic actions to support long-term growth.

We appreciate your continued interest and support. And that concludes our remarks. Please open the line of questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And our first question comes from the line of Dan Jacome, Sidoti & Company. Your line is open.

Dan Jacome

Good morning. Can you hear me?

Jeff Kramer

Oh, yes.

Dan Jacome

Great. Good morning. So a couple of questions. First, on the AMS segment encouraged to see that the water filtration business picked up. I'm just curious how long if I want to call this a bore cycle, how long do you expect this to last. Is this something that you foresee could be a few quarters or we're now at an inflection point based on industry history and so forth that this could last several years.

Jeff Kramer

Yes. So, as you recall our reverse osmosis water business is following the megatrends of the need for increased freshwater. So we're generally positive and bullish on the segment overall and growth is driven by two primary methods. One is replenishment of equipment that is typically installed and typically a five year cycle. And then, the installation and development of new large scale reverse osmosis plants.

We have been discussing over the last several quarters that the replenishment cycle had been expanded longer than we had thought it would be. And that was really the tradeoff between efficiency and energy costs and with the suppressed energy cost over the last recent years a lot of these installed plants have been able to extend their replenishment cycle. What we're starting to see, and we've been hoping to see over the last couple of quarters is that replenishment cycle seems to be picking up. It's like maintenance in any industrial plants you can probably delay it for a little, but you can't delay it forever, and so we're starting to see the early signs of that replenishment cycle and we're encouraged by that.

We're also starting to see the announcement of new reverse osmosis plants. I know people are signing deals in the Middle East and I think there are things happening in Asia as well. That's a longer cycle. It takes a couple of years to build those from signing, but we're encouraged by that. So long-term we think this is a positive trend. We think the replenishment cycle seems to be picking up. It's just the first quarter of that. So, I want to be a little bit cautious, but our team is encouraged by what they're seeing.

Dan Jacome

All right. Good. That helps. On the medical, I think you noted some strength there. Can you detail that a little further what sort of products and maybe buckets in medical are you seeing the most upside?

Jeff Kramer

Yes. A lot of that growth came in our Finger Bandit's division we're the market leader in supplying materials to that. There were a couple of new products that were introduced and we saw some -- just some general strength along the category. The rest of them of the marketplace was up as well. It's a smaller category for us but one that is profitable and we're encouraged by what we see there as well.

Dan Jacome

Okay. Last one, then I'll get back in the queue. The resin costs still inflationary. Is there any industry chatter about what they may look like next year? I know you don't have a crystal ball, but you mentioned in your commentary -- I know you mentioned in your commentary '18 headwind continues. But is there any line of sight on '19?

Jeff Kramer

Yes. So as you can imagine, we're spending a lot of time trying to understand what things are happening because the forecast for polypropylene has changed a couple of times over the last quarter or two. We had originally expected polypropylene prices to beat this first quarter and start their downward trend. We're still seeing -- we are expecting some but we're not expecting it to fall greatly.

I believe there will be some capacity coming on in the future towards the end of '19 that might impact the supply demand balance, but we try to be a little bit cautious in trying to forecast that marketplace. And so we're really concentrating on '18 which means -- we think polypropylene prices will remain elevated, but we've also taken pricing actions to account for that.

Dan Jacome

Oh, interesting. Is that resin capacity expected to -- is that going to be in the North America market or somewhere else?

Jeff Kramer

You are probably speaking to the wrong person to give you the detail on polypropylene and I would rather you go to the closer experts.

Dan Jacome

Okay. Got you. Okay. Great thanks. I'll get back in the queue.

Jeff Kramer

Thanks.

Operator

Thank you. And our next question comes from the line of Kurt Yinger from D.A. Davidson. Your line is open.

Kurt Yinger

Yes. Good morning, Jeff, Andrew and Mark.

Jeff Kramer

Good morning.

Andy Wamser

Good morning.

Kurt Yinger

Just starting off, I'm wanting to sort of return to the water filtration, so it sounds to me like you're seeing the benefits of the replacement cycle now and then you're also maybe a bit more confident about new installations benefiting the out years. Is that sort of the correct way to think about it?

Jeff Kramer

Yes. I think that's how you would characterize my comments. Again, I just want to be cautious, we thought we'd see the pick up earlier. So we'd like to see a couple more quarters go through the replenishment cycle to make sure it really is an up tick. But again, as you can imagine the very important segment for us and our team is spending a lot of time with our customers and they are giving us information that says they see the replenishment cycle picking up. And they're seeing new increase in orders or potential orders or new desalinization plants and so we find that to be encouraging.

Kurt Yinger

Okay, great. And then, can you talk about which products on the paper side are sort of subject to the price increases with the pulp inflation we've seen?

Jeff Kramer

Yes. It would be any of our paper related products or cigarette papers even our non-cigarette paper materials it's pretty across the board. We originally expected elevated pulp prices during the year and we had forecasted for that what we're seeing those is pulp pricing is going up higher even then we had originally expected. I think we're not the only ones experiencing that it's across the industry and it might be related to some actions that occurred in China.

So we're continuing to look at that. We have selectively raised prices and we're continuing to monitor that situation. The good news is, we have a very extensive operational excellence program, it was -- we had good manufacturing performance and that helped us also offset some of the cost pressures we were seeing.

Kurt Yinger

Okay. Yes. I mean you guys definitely aren't the only ones.

Jeff Kramer

No. I see that.

Kurt Yinger

And then, can you talk a bit about the initial feedback on some of that AMS price increases as I understand, it really operate in some small markets where you can troll certain significant shares. How do you think about sort of balancing that with the ability to raise prices and protect margins?

Jeff Kramer

Yes. Two things, one is, I think it's globally recognized that polypropylene pricing is elevated and I think we know that helps in the discussions. It doesn't look like we're trying to do something that's untoward. We also have very long relationships with a lot of our customers. And we are a value-added play, so we're not a commodity player, so the same thing for our customers. Well, no one likes a price increase. It isn't the most material cost impact to them and so in general we've seen acceptance of the price increases based on again good relationships and the importance of understanding where things stand.

Kurt Yinger

Okay. And should that sort of fees in over the next several quarters or is it more immediate to where we'd start to see things really pick back up on the margin side in the second quarter?

Jeff Kramer

Yes. We should start seeing it flow through in the second quarter. We announced the price increase in the first quarter. And it usually delays to get through the whole thing, but we're seeing that and you should see it in our second quarter results.

Kurt Yinger

Okay. And then, can you talk about sort of the quarter and the results relative to your own expectations and sort of guidance for the year. Are there some puts and takes with perhaps the strong sales growth but margin pressures at the same time?

Jeff Kramer

Yes. Actually I think the quarter unfolded fairly closely to what we expected with the caveat about resin costs on both sides of the house. And so, the actions that were taken on AMS and the margin compression that we're seeing there didn't surprise us. I mean we knew the actions that we're taking and the way we put our operating plan together, we know when the closure flows through and those synergies start to develop.

On the paper side, volumes were about where we expect them to be the operating performance was about where we expected to be. It really the pulp costs, the continued rise in the first quarter which were a surprise. So we're pretty much on plan for the first quarter as we see it.

Kurt Yinger

Okay. And then, two more quick ones. Can you maybe quantify some of the cost that hit the quarter associated with the Texas facility transition?

Andy Wamser

Sure. So when you think about the AMS margin compression, we went down 310 basis points, about 200 basis points of that is related to the Austin new. So some of that was as Jeff talked about in his statement, going through we had higher cost inventory running through the system and then running through the P&L.

So that's about 200 basis points of it. And then, as we talked about, we do expect that facility to close later this year. And so we're looking forward to those synergies going through our system.

Kurt Yinger

Okay helpful. And then, lastly can you talk a bit about how you're feeling about the balance sheet here sort under 3x times levered and any update from M&A pipeline?

Andy Wamser

Sure. Balance sheet first, I would say with regard to leverage, you did see us tick down from 3x on a net debt to adjusted basis, tick down to 2.9x secure this quarter. I think absent any M&A activity this year, the expectation of our free cash flow forecast for the year and obviously our dividends, we'd expect to be levered then throughout the year.

With regard to M&A activity, I would say we always continue to see looking at things but our priority for the last year in particular has really been on integration and making sure that the Conwed business is integrated and we're getting all the efficiencies that we can and that -- and Austin is obviously a key part of that as we think about this. But, we are continuing to always evaluate new opportunities, but it's always a balance between making sure it's the right technology in the right end market and the right value. So, I would say we are active.

Kurt Yinger

Great. That's helpful. I will jump back in the queue.

Operator

Thank you. And Speakers, I'm not showing any questions at this time. I would now like to turn the call back over to management for any remarks.

Jeff Kramer

So again, I just want to summarize we had a solid first quarter. We appreciate all the support we're getting out in the investor community and we're happy to answer additional questions so feel free to contact us if you have any questions from the comments or the report. Thank you.

Andy Wamser

Thank you.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a nice day.