Schweitzer-Mauduit International: Dividend Thesis Remains Intact (NYSE:SWM)


Schweitzer-Mauduit International, Inc. (SWM), the dividend-paying company that I brought to the attention of my dear readers in June, has recently published its Q2 results, and I am pleased to conclude that the dividend investment thesis I formulated is, by all means, relevant. On August 5, SWM declared the quarterly dividend of $0.44 per share, unchanged vs. the previous quarter, but lack of dividend growth is of secondary importance here. The essential fact here is that SWM had not suspended the rewards because the company’s liquidity is ample despite the turbulent period in the global economy.

Nevertheless, the second quarter was not entirely smooth. Though SWM beat on EPS, its revenue fell short of expectations. Even for Schweitzer-Mauduit, which is focused on the stable cigarette papers market, the pandemic spawned headwinds that jeopardized sales dynamics.

But, surprisingly, Advanced Materials & Structures, the division that, in theory, is most exposed to the softness in the global economy, did not suffer from a deep reduction in sales, and, contrarily, delivered a 4.8% increase in Q2 revenues and 3.4% increase in H1 revenues. Here it is worth understanding that the GAAP net sales were bolstered by the consolidation of Tekra, a converter of high-performance films and substrates, which has been acquired this year in line with SWM’s diversification strategy. With this one-off effect stripped off, organic sales of the AMS division were 15% weaker than in 2Q19. Commenting on the principal culprits of the double-digit top-line decline, CEO Mr. Kramer clarified that the transportation end-market was an Achilles heel:

“On an organic basis, sales declined 15%, driven mainly by weak demand in transportation which masked good performance in other end markets. Excluding transportation, AMS segment organic sales declined only 4%.”

Here it is worth reminding that SWM’s transportation end-market has a complex structure: it encompasses a few industries like aerospace and automotive. For instance, the firm produces paint and surface protection films for harsh environments, railcar and flatbed cover, and glass lamination interlayer films. So as stay-at-home orders were enforced, sales of body shops were almost nullified and there was no rationale for them to increase inventory, thus sales of SWM’s products used for paint protection cratered. Filtration, construction and infrastructure, and industrial end-markets were also under strain. Contrarily, the medical end-market delivered remarkably strong results, precisely like in Q1, and that is fully explainable given the pandemic catapulted the demand for face masks, instrument packaging, etc.

Source: Unsplash

However, the most important fact was lackluster performance of Engineered Papers, SWM’s bulwark and the essential provider of cash flows (see page 2 of the 2019 Form 10-K). Being relatively immune to the economic downswings due to the non-cyclical nature of the demand for cigarettes (and, hence, cigarette papers), the flagship division also tackled the headwinds. The principal issue was the temporary closure of the Ancram facility in New York State. It would be pertinent to quickly remind that though SWM has a few facilities in and outside the U.S., the Ancram plant is its only location where wrapper and binder products are produced (see page 28 of the 2019 Form 10-K); as the CEO commented during the call:

“…some sales and associated products in our wrapper and binder business service from Ancram were lost or delayed after our inventories on hand were depleted.”

But while the stoppage of the facility hampered production of necessary volumes, the demand was still strong. Here are the CEO’s remarks:

“Our EP segment and overall financial results would have been more positive if New York state business restrictions did not force us to halt these operations, as wrapper and binder materials that are used in small cigar production have been in high demand.”

Importantly, Mr. Kramer also emphasized that “the industry remains generally unaffected by COVID-19,” so I hope that after the facility was brought back online, EP’s sales will gradually recuperate and climb higher moderately in the short term.

As a quick reminder, the essential customers of Schweitzer-Mauduit’s EP segment are Philip Morris-USA, Philip Morris International, Japan Tobacco, and British American Tobacco; combined, they were responsible for 29% of 2019 sales (see page 7 of the annual report). Unfortunately, SWM did not shed light on how sales to its principal stakeholders affected the Q2 top line.

Thanks to quick cost optimization, a 15% contraction in EP’s sales did not shatter the bottom line, and its operating profit fell only ~2.6% to $31.7 million (see page 29), thus securing cash flows necessary to cover shareholder rewards. In sum, though the group’s top line was battered and fell 5.8%, the GAAP net earnings even increased ~4.9% vs. 2Q19, which looks a bit puzzling considering the challenges SWM had to address. Upon deeper inspection, this happened because interest expense almost halved, falling from $15.1 million in 2Q19 to $8.1 million (please, take notice that half-year interest paid changed only slightly, see page 7). And, why were these expenses down so precipitously? Because Schweitzer-Mauduit repaid almost $90 million in debt in Q2 using FCF, thus also reducing its interest commitments.

Was the dividend adequately covered?

Poor organic sales performance has also taken a toll on the H1 net operating cash flow, which fell 10.4% to $49.3 million. But the company’s capital intensity is relatively low, so, SWM remained FCF positive. FCF to Equity amounted to $34.4 million, covering the dividends paid ~1.26x.

Brief remarks on Quant Rating

On August 15, Schweitzer-Mauduit had a Neutral Quant Rating, as its poor Momentum, together with mediocre Growth and Revisions outweighed decent Value and Profitability. Speaking on Value, SWM is reasonably priced compared to the sector and its own five-year average multiples.

Final thoughts

In my previous piece, I suggested that a ~6% dividend yield might be a buying signal for those investors who have been considering adding the player to their portfolios for some time. A correction, however, did not happen, and the yield is still hovering slightly above 5%, which is still quite an attractive level considering the depressed yield environment and SWM’s reasonable valuation.

The essential conclusion that can be drawn after reading the second-quarter report is that Schweitzer-Mauduit is clearly not on a shaky footing. The company is capable of addressing emerging impediments quickly. At the same time, its flagship cigarette paper business is safe and sound, as demand remains stable, and the toughest period is likely behind. At least, Wall Street is expecting sales growth in Q3 and Q4.

But the long-term risks I mentioned in the previous article are still relevant. The essential issue is that the cigarette paper market will not expand at bumper pace, instead, as smoking rates in the developed countries (e.g., see the U.S. data) have been steadily creeping lower, the market will slowly shrink or teeter on the same level for quite some time. SWM understands that there is a material risk of sales stagnation in the 2020s, so it initiated an acquisition program and ameliorated its portfolio with highly engineered nets and films businesses. So, if the EP segment faces stasis in the 2020s, Advanced Materials & Structures will likely shine propped up by the recuperation and expansion of the global economy. Meanwhile, I am slightly skeptical that SWM will consider meaningful DPS increases in the medium term, as it needs cash to cover potential acquisitions, so it would be reasonable to maintain a strong cash position and finance deals using cash on hand, not funds provided by fresh debt issuances (I hope its debt will continue creeping lower in the 2020s). Anyway, the ~5.2% yield is already quite attractive.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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