Schweitzer-Mauduit International Inc. (NYSE:SWM) Q3 2018 Earnings Call November 8, 2018 8:30 AM ET
Mark Chekanow - Director of Investor Relations
Jeffrey Kramer - Chief Executive Officer
Andrew Wamser - Executive Vice President and Chief Financial Officer
Daniel Jacome - Sidoti & Company
Kurt Yinger - D.A. Davidson
Welcome to the SWM Third 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 the 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.
Thank you, Catherine. Good morning, I'm Mark Chekanow, Director of Investor Relations at SWM. Thank you for joining us to discuss our third quarter 2018 earnings results. Before we begin, I'd like to remind you that the comments on today's conference call may 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 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 will now turn the call over to Jeff.
Thank you, Mark. And good morning, everyone. Yesterday, we reported third quarter results with sales up 1% to $260 million and adjusted EPS up $0.77. During the quarter we worked hard to offset a highly inflationary raw material environment which conceals several pieces of good news. For example, we delivered another solid quarter of organic growth in AMS. Although input cost headwinds in the final stage expenses from our facility consolidation project pressured margins.
We'll detail these two topics throughout the call. But three important takeaways from the quarter are: the Austin closure is now complete with fixed cost set to decline in the fourth quarter. Second. we've recently implemented another round of price increases to offset raw materials cost pressure, and we'll continue to do so as required. And third, we completed a highly strategic bond financing during the third quarter, which provides additional balance sheet flexibility.
While the bond debt does carry higher interest rate expense and will have a modest impact on earnings, it was timed well in a rising rate environment. Though input cost inflation has been a challenging headwind this year, we have generated enough offsets to neutralize a good portion of these additional costs, and expect to still be essentially on plan as we close out the year. Excluding the impact of the bonds and refinancing activities, we expect to finish the year at the lower end of our initial guidance. Of note the third quarter adjusted EPS comparison to prior year was skewed by a third quarter 2018 expense of $0.02 per share related to our recent refinancing activities, and a third quarter of 2017 gain of $0.11 per share from an asset sale.
Now shifting to our operating segments. AMS delivered 4% organic sales growth consistent with our investment theme. Filtration cells continue to have strong momentum leading the portfolio during the quarter with awarded business up double digits, and solid growth in other sub segments. We also saw our infrastructure and construction business come back after a slow start to the year. Recall that earlier this year tough weather conditions had posed installation challenges for the downstream users of our products. We were encouraged to see this area get back on track with our core erosion and sediment control products driving growth.
Transportation and Medical had modest sales growth and both are up solidly year-to-date. Our transportation films business remains a globally growing product line driven by increased consumer penetration and category awareness. Consistent with trends earlier this year and across many industries, operating margins were impacted by higher input costs, but we expect AMS margin pressure to subside in the coming quarters. Regarding resin prices, market prices for polypropylene continued to increase and were up approximately 30% during the third quarter compared to last year.
While polypropylene doesn't represent our entire resin cost basket, it is a significant purchase for us. In addition to rising market prices, we had a challenging comparison to last year as high third quarter margins 2017 were boosted by some opportunistic and attractive resin purchases by our procurement team. In response to continued escalation in resin, we recently implemented another price increase on a large portion of the AMS revenue base. Unfortunately in a rising cost environment, price increases typically have a timing lag for implementation, but we believe we will be generally caught up from a price recovery standpoint heading into 2019.
Another impact on margins where the final stage cost associated with the Austin closure. We are pleased to report that we have completely exited the facility at the time of this call. As we have been discussing throughout the year, this action is an important component of driving our $10 million Conwed synergy plan by reducing fixed costs. As is typical in these exercises, as we have come to the final stages we have been essentially occurring duplicate costs in Austin. We also kept several lines running a little longer than anticipated as we had higher than expected volumes on certain products that we were transitioning to other facilities.
All told, the project is essentially complete with slightly more cost than originally expected in Q3 impacting AMS results. We believe this demonstrates our ability to execute against our commitments. Though the resin increase and Austin closure combined for a tough quarter for margins, we expect the fourth quarter will benefit from price increases and lower fixed costs. While we are addressing short-term cost pressures, we have remain committed to executing our longer-term strategic growth projects. We recently generated our first sales of a new filtration paper product realizing a unique synergy between EP's manufacturing capabilities and AMS' commercial organization expanding offerings in our important filtration product category.
Another notable highlight is that our new film line in the UK is producing high quality products, and received its first full customer qualification, marking another important commercial milestone for this investment. Moving to Engineered Papers, second quarter sales decline 1%, good price, mixed performance provided nearly a full offset to a 6% volume decline driven by our tobacco business. Currency which has been a strong tailwind for us to date is no longer providing a year-over-year benefit giving the pullback in the Euro compared to last year's level.
The year-to-date segment volume decline is 3% generally reflecting the standard trends of the tobacco market. There were no particular product lines that drove the volume decline, but positive price mix was supported by our specialty wrapper and binder recon products price increases in our non-tobacco paper business, a strong quarter for our battery separator papers and LIP volumes outperforming the rest of the cigarette paper products. Similar to AMS, EP also felt pressure from rising costs specifically wood pulp which was up more than 35% during the quarter compared to last year.
We have raised prices where contracts permit with a further portion of our contract price escalators with large cigarette manufacturers to take effect in early 2019. Regarding heat-not-burn, as well as the broader reduced risk product category, I'd like to review the fact that that affect us and those that do not particularly as there has been increased headlines in the US recently on vaping products which are an entirely different category from which we participate.
Consistent with some of the data and commentary reported by the major tobacco companies, our third quarter heat-not- burn volumes were down. As we have shared previously, rollout of new products such as this are lumpy as our customers navigate this new commercial landscape across a variety of international markets, and our volumes remain up substantially year-to-date. We continue to engage in very active development discussions across our customer base, and remain optimistic about our ability to capitalize on its long-term potential.
But repeat, that it may not be a linear path from quarter-to-quarter. As a reminder, we supplied tobacco base materials for heated steps. This technology has not yet been approved in the US where recent headlines regarding the FDA's concern over vaping products has been escalating. Simply put, the vaping products in the US are primary flavored nicotine liquids and the FDA is concerned about their popularity among adolescents. This is not a market we participated.
I will now turn the call over to Andy?
Thank you, Jeff. I'll now review our financial results starting with segment performance. In the third quarter AMS net sales increased 4% to $121 million. Adjusted operating profit was $17.5 million or 14.5% of sales, down 440 basis points versus last year. Tthe market contraction was a function of several factors. The largest of which was higher resin cost. As Jeff referenced earlier, higher costs were driven by elevated market prices, compared to last year's quarter when we benefited from some very attractive opportunistic resin purchases. For perspective, the year-over-year impact of resin cost was responsible for approximately 300 basis points of margin contraction.
The other key pressure on margin was inefficiencies associated with the Austin site closure, which accounted for approximately 200 basis points of margin contraction. In aggregate, these cost elements totaled about 500 basis points --more than offsetting the benefits of our organic growth. Going forward, we expect the benefits of both the newly implemented price increases, and the closing of our Austin facility to provide an uplift to our AMS margins.
The Engineered Paper segment's net sales were down 1% with favorable priced mix of 5% providing the offset to a 6% decline in volume. The adjusted operating margin for this segment was 19.7%, down 400 basis points versus last year. The year-over-year year margin decline was driven by significantly higher raw material costs which accounted for the full impact and operating margin. Wood pulp comprises the majority of the cost inflation as that was up more than 35% year-over-year. We continue to look for efficiency improvement opportunities, and price increases. But the majority of the contractual price escalators will not take effect until early 2019.
Adjusted corporate unallocated expenses decreased by 11% during the quarter due to fluctuations of general administrative expenses, but we're down 1% year-to-date. This is more indicative of a spending trend and a demonstration of our solid cost control. On a consolidated basis net sales increased 1% as there was no acquisition benefit and currency had a minimal impact. Adjusted operating profit was $36.7 million and adjusted EBITDA was $46.5 million, both down versus last year for the reasons just discussed.
Overall, our trailing 12-month adjusted EBITDA is a $196 million essentially flat with the trailing 12-month prior period despite the pressures from rising raw material costs and a short-term expenses associated with our Austin synergy plan. Shifting to consolidated earnings, third quarter 2018 GAAP EPS was a $1.33, up from $0.84 in the prior year. The increase was driven by two items. The first was a $0.43 benefit from an adjustment related to the tax expenses book in the fourth quarter of 2017, as a result of the new tax legislation in the US.
The second was a $0.25 gain from the revaluation of a contingent consideration liability effectively an earn- out related to the Conwed acquisition. Both of these items were excluded from third quarter adjusted EPS which were $0.77 versus a $1.00 a year ago. Of note, third quarter 2018 adjusted EPS included $0.02 write-off of unamortized debt issuance costs associated with refinancing of our credit facility. And as a reminder, last year's third quarter adjusted EPS had an $0.11 gain from an asset sale, making $0.89 a more apples-to-apples year ago comparison.
The decline in adjusted operating profit was partially offset by lower tax rate. Our normalized third quarter tax rate was 21.2% down from 27% a year ago and year-to-date normalized rate now stands at 23.8%. Currency impact on EPS was negative $0.01 for the quarter.
Looking at our full-year performance relative to guidance, as we said on prior calls, there are several puts and takes. Sales growth has been fairly positive though organic growth, pricing actions and various efforts to improve profitability have been more than offset by raw material costs well exceeding our expectations at the beginning of the year. Tax rates continue to run favorable to our initial projection in the early 2018 euro strengths has now subsided.
As Jeff referenced earlier, putting aside the impact of the bond financing, we believe we're still on track to finish at the lower end of our original guidance. However, our recent financing activities are expected to have a negative $0.05 impact to our 2018 adjusted EPS that was not contemplated when we issued guidance earlier this year.
Moving the cash flow and liquidity, year-to-date 2018 free cash flow was $72 million, up from $63 million a year ago. CapEx was approximately $7 million in the quarter and $21million year-to-date, which analyzes below our guidance for approximately $40 million. We anticipate heavier spending in the fourth quarter, but is likely will finished below our original plan. From a leverage perspective for the terms of our credit facility, we were at 2.6x net debt to adjusted EBITDA at the end of the third quarter, down from 3x at year-end 2017.
Lastly, we announced a 2% increase in our dividend continuing to build our track record of dividend growth. The debt refinancing completed in the third quarter which included our inaugural issuance of unsecured notes was a key milestone for SWM with several long-term strategic benefits. First, the addition of unsecured debt to our capital structure enhances our financial flexibility. Second, in a rising interest rate environment, we were able to lock in eight year fixed rate debt. Third, we have accessed new capital like spinning our investor base to the fixed income market adding creditors beyond our supportive bank facility syndicate.
Lastly, we reset the maturities on our revolver and term loan to five and seven years respectively, which would have otherwise been maturing in 2020 and 2022. We highlight that SWM received an attractive BA3BB minus corporate credit rating from the rating agencies through a rigorous business and financial diligence process, demonstrating their confidence in our cash flow generation, and the growth potential of our business. Of course, these bonds do carry a higher interest rate. For modeling purpose, we suggest using a baseline effective interest rate of approximately 5% reflecting current rates.
From there you can mile the potential of rising interest rates associated with LIBOR given the revolver and term loan or floating rate debt, and would assume some debt reduction on the revolver throughout 2019 absent any M&A activity. Regarding the negative $0.05 impact on 2018 result due to these financing activities, two sets of expenses were incurred during the third quarter and the fourth quarter impact of higher exit expense is expected to be $0.03.
We note that the financing completed in September was leveraged neutral. As we use the proceeds from the bonds to repay borrowings on our credit facility and term loan. At the end of the third quarter, our new debt structure was comprised of $350 million of senior unsecured notes. The $200 million term loan and $95 million outstanding on our $500 million revolving credit facility, which also includes a $400 million accordion.
And I will turn the call back over to Jeff.
Thank you, Andy. As we enter the homestretch of 2018, we remain diligently focused on delivering on our operating plan. We acknowledge the headwinds that we based on input costs are unfortunately above our assumptions at the outset of the year, and of course earnings volatility along the way. However, we believe we have acted appropriately as we have navigated this environment and remain committed to a long-term strategic direction. We are in frequent discussions with our customers and the low pricing discussions are never easy, our increases have generally been accepted by the market and our collaborative customer centric approach is especially valuable in the context of these discussions.
We look forward to realizing the benefits of our latest increases and the completion of the Austin facility consolidation in AMS, and some pricing resets in EP early next year. All told, we believe we are weathering the cost storm fairly well, finding offsets anywhere from SG&A controls to taxes that supplement our pricing actions. We consider our expectation to finish at the lower end of our original guidance excluding the bond impact, a significant achievement in the face of roughly $20 million of year-over-year input cost increases thus far in 2018.
We appreciate your continued interest and support. That concludes our remarks. George, please open the line for questions.
Our first question comes from the line up then Dan Jacome with Sidoti and Co. Your line is now open
Good morning. A couple questions, first on the AMS segment. I think the press release called out some softness in the industrial markets, but then conversely the water-filtration market seems to have taken off. Can you give us a little bit more granularity on those two verticals please?
Sure. So let's start with our filtrations market, which is one of the key marketplaces that we participate in. We've actually seen good growth in both our water-based segments that particularly go into reverse osmosis as you may recall in earlier conversations, there are two components of growth in that segment. New facility construction but also a replenishment cycle that had previously --last year been a bit delayed.
We're seeing that replenishment cycle continue to accelerate, and we're seeing very good growth there. But we're also seeing good growth in our process segment side too which is filtration of other fluids. So, overall, it's been a very positive segment for us, and we hope that that continues into the future. The industrial segment for us on the other hand is more of a catch-all of a number of sub segments. And so there isn't anything particular in that. It's just a number of our segments in that --a number of our sub segments in that overall segment have just been down, but there's nothing material to discuss on that.
Okay, no, that's helpful. Just following on the water filtration so the replacement cycle turn around so to speak, do you --have all these project delays rolled off or there's still some left and does incremental outside in the next couple quarters, just trying to understand that better.
Yes. So just to be clear those aren't project related. Those costs are replenishment cycles, so once you've been installed in RO system, the cartridges basically have a five year-ish life cycle at the end of that time usually the falling or the efficiency has fallen off sufficiently that you need to restock the facility. And that's just the typical lifestyle life cycle. It just had been delayed last year due to low energy costs because you actually have a trade-off between overall efficiency and replacing some of these cartridges with the rising cost of energy over the last year.
It's been --just been time for them to finish those replenishment cycles.
Got you, okay. Well then on industrial, is there one or two segments there that you're seeing the most strength just for us to know?
Yes. In general in it's pretty-- again it's really much of a catch-all. It's such a number of sub segments. I don't think there's anything particular to call out.
Okay. Then lastly wanted to talk about, so your CapEx expectations I think are coming in a little bit and sorry if I missed that. What's driving that again?
Yes. So our original guidance at the beginning of the year was $40 million as we sit here to the first three quarters we are sitting at $21 million. I would expect this to be to end the year close to $30 million as we look at the year. The real two key drivers for the lower end of the other CapEx is really just --with the existing projects that we did have we had lower expenses than we anticipated. We were conservative what those original estimates. And then there were some CapEx related update. But again we are as said, are cautiously optimist again about that segment overall.
So it's not indicative of what we think the long-term potential there is. It's just that some selective projects have been delayed.
So there was some heat -not-burn projects incorporated in the original guidance. So --
CapEx would include, obviously CapEx for the EP and AMS and then some of the larger projects within EP were not burn related.
Our next question comes from the line of Kurt Yinger with D.A. Davidson. Your line is now open.
Yes, good morning, Jeff, Andy and Mark. I just wanted to start it out could you bucket the volume and price within the 4% AMS growth this quarter?
Not just in the growth in general again the filtration was the double digits, infrastructure and construction was about 5%; transportation was low single digits and in line with medical et cetera.
And I mean how much of the 4% overall number was price versus volume?
I mean it was pretty balanced but we haven't broken that out.
Okay and then could you just talk about any initial feedback you've had on the price increases on the AMS products? And whether you've seen any sort of volume impact from that --from the previous price hikes you've announced?
Yes. So in general I think the price discussions go as you expect. No one likes to see a price increase, but I think there is a general understanding throughout the marketplace that raw materials are increasing, and so we actually have very constructive conversations with our end users. We have not seen a material impact on volumes because of those increases.
Okay, that's helpful. And then 2018 has certainly been a year of greater stability in Engineered Papers. Could you just maybe update us based on your visibility at present and how you're seeing 2019 with some of the bigger pieces of LIP and RTL?
Yes. We typically don't like to give that much guidance going forward at this particular time in the year, but we don't see any major changes in the general overall trends of the marketplace. It's-- I think it's been fairly consistent from the things that we've said in the past. So I would just keep the consistent view.
Okay and then qualitatively do you think the heat-not-burn opportunity going into next year is bigger or smaller as it sort of relates to being able to offset some general volume weakness in traditional cigarette related products?
Yes It's always an interesting discussion. I think we've been pretty consistent and we find that marketplace to be attractive. We think it's a fascinating concept. I think we're well positioned, in fact, we've always said we think it would be a little bit lumpy, but we think the outlook is going to be generally positive to us to offset those. And I don't think we've changed that. It's more of a question around timing and how things work. I think part of the interesting news for us is because the end-use manufacturers will need to continue to tailor their products to continue to have success in the marketplace.
I think that continues to position us very well because we are that development part because we are that development partner of choice in many cases.
Okay, that's helpful, thank you. And then how much of your EP related volumes have price escalators that are in some way directly tied to market pulp?
Yes. Quite a bit of the cigarette paper businesses have building guidance and so it really is a lag around that
And then just lastly, net leverage is down to sub 3x maybe you could just give us an update on how you're thinking about M&A as we turn the page into 2019? And just any general high-level comments about valuation or opportunities that you're seeing?
Yes. So just in general, I don't think our investment or strategic strategy has changed. Our key focus for the business is delivering organic growth for the overall corporation particularly in the AMS segment. And focusing on margins and cash flows et cetera. So I don't think that's changed. I think even with the bond financing, we consistently like where we are in the marketplace. So the good news is I don't believe we need to do any acquisitions.
I think though that as we've said, we will continue to look at the marketplace and continue to screen the marketplace see if there was something that would be attractive and accretive to us that fits into our strategic sandbox as we play today. The market segments that we have and so we continue to do that. Overall, I would say in the marketplace evaluations are still on the higher side rather than more reasonable side. I think there's still interesting cash chasing attractive deals. But with that said, we continue to see opportunities within many of our segments, and will continue to screen for those.
And our next question, the follow-up question from Dan Jacome from Sidoti and Co. Your lines now open.
Hi. Just one more. I think I heard you guys say there was some new film products in AMS that you were targeting or something about new capacity. Can you -- did I miss hear that on specialty film I guess?
No. I think, Dan, we had talked a little bit before. We had one of the interesting synergies that we had as we believed we had the opportunity to utilize some of our EP paper making capabilities, and leverage that into our filtration marketplaces and take advantage of the commercial relationships we have there. We had put in a material capital investment to make that product. We've now scaled our product up and have introduced it into the marketplace, and are getting very favorable feedback on it. But for competitive reasons, we're not sharing more details at this particular time other than to say that that project is making significant progress.
Right. That was my next question is what end market specifically because you've had a couple pockets of especially the last year that saw a lot of strength. So I'll leave it at that.
Yes. But this would be new volume that's pretty new.
You mean new end market?
No. It's in the same filtration, a new product though, yes.
And they show no further questions at this time. I would like to turn the call back over to Dr. Jeff Kramer for closing remarks.
Well, again everyone, thank you very much for your participation. And interest in SWM. It was a challenging quarter, but I think a lot of the actions that we've discussed have offset some of those pressures. We continue to thank all of our stakeholders for their interest and support. And we'll continue to endeavor to do the best we can to justify and earn your support in the future. So thank you very much.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. And you may all disconnect. Everyone have a great day.