Schweitzer-Mauduit or SWM (SWM) is well known as a major supplier of cigarette papers and reconstituted tobacco leaf or RTL to the tobacco industry. But when I last wrote about the company in 2015, it was also in the early stages of a strategic transformation focused on deploying some of the cash flows from its fiber-based businesses into building a resin-based business. The strategy is intended to decrease SWM’s dependence on the tobacco industry which, given the decline in smoking prevalence in SWM’s most important markets, appears to offer an uncertain outlook.
I was a little skeptical about the transformation at the time, given that they were entering a completely new field of operations, with different input materials, different customers and different product applications. Given that the company’s stock price was at $40 at the time of publication, while it remains below $35 currently, I think my skepticism was warranted to some extent. At the same time, I must admit that their efforts in the Advanced Materials and Structures business, as they call their resin-based operations, have steadily advanced to become a more sizeable and higher-returns business over the past four years. The AMS segment accounted for about 45% of Schweitzer-Mauduit’s total revenues in 2018, and a somewhat more modest contribution to adjusted operating profit before corporate expenses. This has been accomplished from essentially a standing start in 2013.
But at what cost has this transformation been accomplished? Substantially, the entire AMS business has been built up through acquisitions, with the most notable ones being Delstar in 2013, Argotec in 2015 and Conwed in 2017. There were a number of smaller acquisitions as well, such as Smith & Nephew’s wound dressings business and Pronamic’s air filtration business (both in 2014). If we calculate the total amount paid for these acquisitions, the company has deployed $836 million of capital into building its AMS business (before capital expenditures), partly financed from free cash flows and partly from additional debt. That is quite a large number of course, especially when taking into account the company’s total market capitalization of slightly over $1 billion. The amount of revenue they acquired comes to roughly $406 million in total, reached by adding up the revenue numbers disclosed at the time of acquisition, which implies they paid on average about 2.1x sales for these acquisitions.
Total revenue generated by the AMS segment in 2018 came to $468 million, while the operating margin for this segment has been expanding over the last couple of years to reach roughly 15% in 2018. These numbers suggest SWM paid full prices for the assets bought to form the AMS business, while organic growth after the respective acquisitions took place has been decent but not particularly impressive.
In my 2015 article, I warned about the danger that the company would overpay for acquisitions outside its core area of competence. Although it looks like they have avoided destroying much value, they haven’t really managed to create much value either. Their engineered papers business, reported as the EP segment, has predictably suffered from decreasing tobacco industry volumes, and has seen its margins come under pressure as well. The AMS business meanwhile, although it has been expanded substantially, has so far failed to entirely compensate for the profit erosion in the EP segment.
The problem for investors is therefore not that SWM has paid full prices for the newly acquired assets, but rather that the returns from the legacy EP business have come under pressure. Whether the strategic direction chosen in 2013 has been the right decision is still up for debate, but alternative capital deployment strategies (like buybacks and dividends) would not have guaranteed spectacularly better outcomes in my opinion. Simply put, the company was in a difficult position in 2013 because its prospects were so heavily tied to the tobacco industry.
So where does the company go from here? They have managed to diversify their business by focusing on acquisitions supplying customers outside of the tobacco industry, albeit at great expense, and have wisely chosen their acquisitions in fields which appear to have favorable long-term demand characteristics. In order to evaluate their prospects going forward, I will take a look at their legacy EP business first and then focus on the AMS segment.
The engineered papers segment accounted for 55% of total company revenues in 2018, with the tobacco industry accounting for as much as 88% of revenues generated by this segment in 2018. The remainder of sales is primarily generated by much lower-margin products such as food-service papers and printing papers that are used to fill up excess manufacturing capacity.
SWM’s paper business relies heavily on the North American and EU markets, where cigarette consumption has been on a long-term downward trajectory. As a result, the company has generally experienced volume pressures in this segment. Another effect of decreasing industry cigarette shipments has been excess capacity in the tobacco papers industry, which has led to pricing pressures that are likely to persist into the future.
SWM has particularly strong share of market in North America, which has in recent years seen an acceleration in the decline of cigarette industry shipments as a result of cessation and competition from vaping devices like Juul. It is currently expected by several large industry players that US cigarette shipments will continue to decline at historically above-average rates, which will certainly impact volumes at SWM’s EP segment. The largest US cigarette manufacturer, Altria (MO), has recently indicated it expects cigarette volumes to decline between 4-6% per annum through 2023.
The European Union is the other large market for SWM’s engineered papers segment, with somewhat better volume performance than North America, but notably more competition in tobacco papers. SWM had market share of somewhat over 40% in this market during 2018, with a number of European competitors like delfortgroup, Julius Glatz and Miquel y Costas making up the rest of the market. Due to the concentrated nature of the industry in its two main markets, SWM has little means to reduce excess capacity through industry consolidation. Expanding into product lines outside of tobacco products is also difficult, as most of these product markets are quite competitive and oftentimes offer substantially lower margins than those currently achieved. In fact, SWM has de-emphasized non-tobacco papers in recent years because of the poor margins that were being realized on those products.
Instead, SWM has chosen to focus on innovation in its tobacco papers segment, with its pioneering efforts regarding LIP papers, or lower ignition propensity, as the best example of its success in this regard. LIP papers are engineered specifically to ensure that cigarettes that are not actively smoked extinguish themselves. Given the fact that cigarettes are an important cause of unintended fires, this product offers real benefits over conventional cigarette papers. The company has benefited from its lead in LIP because of regulations requiring the use of such papers in North America and the European Union (both since 2011) among other markets.
SWM owns a number of patents regarding LIP technology, which it has deployed in a legal strategy in an attempt to fend off competition. It has also licensed its patents for use to other companies, most notably its main competitor in Europe, delfortgroup. The patent portfolio is therefore an important component of SWM’s economic moat in cigarette papers, and probably the main reason why the company achieves notably high operating margins (21% in 2018) in this segment. In my opinion, it would be impossible to achieve such a high margin in an industrial paper business without patent protection.
SWM’s management has indicated that securing technological innovation through patent protection is indeed an important component of maintaining a competitive edge in its engineered papers division. The intellectual property in effect protects its business from becoming commoditized, although I expect this business to experience intensified competition when the patents on its LIP technology expire. SWM’s most important patents regarding LIP technology are currently estimated to expire in the early 2020s (between 2021-2023 mostly).
A more recent innovation are tobacco papers and RTL for heated tobacco units, such as HEETS and Heatsticks marketed by Philip Morris (PM) for use with its IQOS device. PM is the market leader in heated tobacco and has seen significant consumer adoption in markets like Japan and South Korea. Given that SWM is not currently a supplier for this product, I do not expect SWM to profit in the short term from the fact that IQOS was approved for sale in the US by the FDA last April.
The arrival of IQOS in the US is expected to start with a trial in Atlanta this month, and could serve as an accelerator for the heated tobacco category globally, most importantly through higher visibility for these products. For instance, Atlanta is home to one of the busiest airports in the world and smoking, even if it is banned in a lot of public places, is still a very visible activity. The US is widely seen as an exporter of popular culture, and its presence in this market can give IQOS a more prominent profile globally, not in the least through consumers’ posts on social media.
The recently announced intention of Philip Morris and Altria to merge will not immediately change this assessment, although it would be logical to assume that in case IQOS succeeds in the US, the combined company will eventually manufacture heated tobacco units in Altria’s facility in Richmond. Given SWM’s position as a major supplier of the tobacco industry in North America, local manufacturing of heated tobacco units can therefore offer SWM a sales opportunity.
In sum, heated tobacco is definitely an important market development for SWM, and the company will continue to benefit from its supplier relationship with British American Tobacco (BTI), the distant no.2 in this category. While BAT trails Philip Morris by quite a large margin in the heated tobacco category, the company has been making inroads into several markets including Japan. To the extent that these products, and especially BAT’s glo, continue to find significant consumer adoption, SWM will therefore be well-positioned to benefit. At the moment it is the only independent company commercializing RTL products for use in heated tobacco sticks. It should be noted though that several large tobacco companies operate RTL operations for internal use, which may limit their need for external suppliers.
An interesting product line outside of the tobacco industry is the separator paper business used in the production of alkaline batteries. Given the dynamic developments in battery technology, primarily lithium-ion batteries and SWM’s expertise in separator material technology, it is probably not that surprising that SWM has recently joined the Soteria Battery Innovation Group, which aims to improve Li-ion batteries through an open technology platform. Separator materials in batteries are used to prevent short-circuiting by separating the anode and cathode, while still allowing the charge carrier through in order to form an electric circuit. Needless to say this characteristic requires a highly engineered product, even more so because the material also needs to be (electro)chemically stable and be able to withstand the stresses of the battery manufacturing process.
Finally, given the proclivity of certain types of batteries to overheat, the separator can act as a safety mechanism that closes off its micropores through melting in case a certain unsafe temperature threshold within the cell is reached. Such a mechanism can shut down a potentially hazardous process of overheating in battery cells, which makes it an attractive safety feature for high performance batteries such as those used in electric cars and in electric power storage facilities. As these batteries usually consist of large amounts of cells, a single cell overheating can cause the entire battery to fail, and potentially the rest of the structure as well. Therefore, significant improvements in separator technology are highly likely to be received well in the marketplace.
The product requirements of such a safety feature will probably mean development of separators for Li-ion batteries will be focused on resin-based materials instead of paper products. For SWM to use its know-how of separator technology from the paper side of its business to potentially develop a resin-based product is an interesting example of potential synergies between the two segments, but it does not impact the company’s valuation in the short term.
Advanced Materials and Structures
As noted, the AMS segment consists of a number of businesses that were acquired over the past five years or so. In 2017, the company announced its decision to rebrand its Conwed, Delstar and Argotec operations to SWM, although the product names employed by these subsidiaries will be retained. The AMS segment is more complicated than the Engineered Papers segment, primarily because its manufacturing output supplies a greater number of different industries with a greater number of different products.
The majority of products manufactured by the operating companies in this segment are based on plastic nettings, fibers or film produced from resin. The infrastructure & construction, filtration and transportation markets were the biggest contributors to AMS segment revenues in 2018.
Screenshot from the SWM August 2019 investor presentation detailing the company’s AMS segment.
Although SWM expects the end markets for its AMS segment to grow at or above the average expected growth rate in GDP, some of these markets are likely to be more cyclical than the economy as a whole. This argument applies especially to the infrastructure & construction markets, but also to the transportation and industrial markets. The filtration and medical markets are probably less cyclical in nature, although the filtration market may have some parts that have low cyclicality (such as water treatment) and some with higher cyclicality (such as HVAC). It is important to realize that SWM’s shift away from the tobacco industry also brings a change in the economic characteristics of the business, as the tobacco industry has generally been low-cyclical in nature.
Some of the best performing product lines in the AMS segment in recent years have been advanced filtration products, such as those used in reverse osmosis water filtration, process and air filtration, and transportation products. Products for the transportation market consist of thermoplastic polyurethane film products used for automotive paint protection (car wrapping), ballistic resistant glass and vehicle graphics. The filtration and transportation lines accounted for approximately 50% of AMS segment sales in 2018 and management expects these product segments to average sales growth of 5-7% per annum.
The transportation segment especially appears to have significant momentum due to increasing consumer awareness of TPU film for paint protection in the automobile aftermarket. The company is seeing significant demand growth in Asian markets, presumably in the higher end of the automobile market, and I certainly expect demand growth for car wrapping products to continue its strong development. First of all because car wrapping offers a wide range of possibilities in terms of vehicle customization. And secondly because the visual appeal of wrapped cars makes them perfect for being featured on social media, which means consumer awareness of these products will likely increase rapidly. The company has recently added a TPU production line in the UK and will add another one in its Suzhou, China facility, which is expected to reach commercial quantities of output by Q1 of 2020, to cater to this growth in demand.
The infrastructure and construction markets also constitute a big piece of the AMS segment’s revenues. Examples of product applications in these markets are SWM’s netting products applied in erosion control blankets for highway construction and barriers for mining sites (infrastructure), as well as fiber used in carpet cushions and film used for reinforced glass in high-rises (construction). This segment has significant diversity in product markets and offers reasonably attractive growth prospects over the longer term, but can probably be assumed to be quite vulnerable to economic downturns.
Another point of concern is the fact that the main input materials in this business, being oil-derivatives, are closely linked to oil prices. While this may have provided the company with some margin benefits when oil prices collapsed in 2014, they have mostly faced inflationary pressures on their raw materials since then. Management has indicated that they expect much of that pressure to be behind them for the current year, as they will cycle the most recent peak in oil prices in Q3 of this year.
Finally, the company has recently launched its first product that resulted from cross-pollination between its two business segments. It is a membrane backing paper for use with its reverse osmosis water filtration products. It has been developed by the EP segment but will be commercialized through the Advanced Materials and Structures segment. The reverse osmosis water filtration products are an interesting line of business, given the fact that the reverse osmosis process can be used to desalinate seawater in order to produce drinking water. Given long-standing global trends such as urbanization and population growth, water consumption and the need for reliable and ecologically responsible sourcing can be expected to increase at a steady pace.
I have been positively surprised by SWM’s ability to steadily build up an entirely new resin-based business, while continuing its ongoing operations in tobacco papers. The company has booked progress both in terms of the size of its AMS segment and its economic returns. At the same time, I do not think SWM has become a particularly attractive investment opportunity yet. The company still faces much of the same issue as it did at the time of my last analysis, namely the continued decline of cigarette consumption in its most important markets. Given that cigarette consumption is expected to decline at a notably accelerated pace of 4-6% in the USA for the next 3-4 years, and will probably exhibit an only mildly lower rate of decline in Europe, the company still faces an unattractive outlook in its EP segment. The company’s efforts regarding new product development and protection of its intellectual property are laudable from an investor standpoint, but cannot take away the serious uncertainties facing this business.
Additionally, the company does not have the same pricing power that its tobacco customers can lever to (partly) offset falling volumes. In fact, I expect SWM’s EP business will face margin pressures in future years, as volumes continue to erode and the expiration of its most important patents draws closer. Patent expiration will likely intensify competition in LIP papers and will probably lead to pricing pressures as a result. It seems unlikely that newly developed products, such as those focused on heated tobacco products, will be able to fully compensate for the decline of its main business, given the modest share of market that category currently holds.
Finally, the AMS segment has a wide range of interesting products in a number of attractive markets, but is a far less dominant player in any of its end markets than SWM’s EP business is in the tobacco industry. The company faces a wide range of larger and more diversified competitors in the AMS segment, including 3M (MMM) and Covestro. While I believe they will be able to compete successfully, I do not foresee the company being able to command the same kind of position in its AMS product markets as it has in tobacco papers. Weighing the positive outlook of the AMS segment against the very uncertain outlook of the EP segment still leads me to believe SWM is best avoided as an investment.
Disclosure: I am/we are long BTI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.