Description

Company Overview

In 1995, Kimberly-Clark spun off Schweitzer-Mauduit International (SWM), a specialty paper manufacturer generating nearly all its revenues from the tobacco industry.  Supplying specialty paper to the tobacco industry meant that SWM’s revenues were 100% correlated to the industry and the global headwinds it was facing.  The tobacco industry is in a continual state of decline (at best, remaining flat in the good years) while continuing to generate recession-resistant, strong, and predictable cash flows.  SWM harvested those cash flows to payout a dividend (currently around 4.6%) and expand its negligible non-tobacco manufacturing footprint that included resin-based nets, films, and nonwovens.  Eight years and six acquisitions later, SWM is on track to generate two-thirds of its revenue from its Advanced Materials and Structure (AMS) segment that designs and manufactures specialty products and applications for niche segments of the filtration, healthcare, transportation, construction, and industrial industries.  The remaining revenue comes from its Engineered Papers (EP) segment which produces specialty paper primarily for the tobacco industry.

Advanced Materials and Structure (AMS)

Each of the five Industries that AMS serves are global, substantial, and heavily fragmented.  However, SWM products are designed for a very niche segment of those markets that require exacting design and manufacturing tolerance that a commodity product is not capable of achieving.  In 2021, AMS is projected to generate roughly $1 billion in revenue with 65% of its sales coming from industries (filtration, transportation, and healthcare) growing in the high single digits.  Servicing these global niche segments has created both a barrier to entry and a competitive advantage for SWM.  Larger competitors would find it difficult to justify the investment (both time and capital) to generate the additional revenue (assuming they got the lion’s share in all the different markets) as it would have little impact on their overall revenues.  The smaller players lack the expertise and/or internal infrastructure to custom design and manufacture in-house and deliver globally on a timely basis.  It takes, on average, 18 months of testing for SWM to get its original approval for its products.  Once approved, it is expected that SWM will be a main supplier to the customer for the foreseeable future unless SWM does something to jeopardize the relationship (decline in quality or late product delivery).  Based on its expertise and the trustworthy reputation SWM has developed, it is quite common for a customer to reach out directly to SWM to design a product for an upcoming application without opening it up to a bidding process.  Because of this strategic relationship, SWM maintains a strong market share and margins with the customers it serves.

Engineered Papers (EP)

Engineered Papers produce specialty papers for the tobacco and non-tobacco industries with tobacco-related papers making up the bulk of the segment revenues.  EP’s key paper product is low ignition propensity (LIP) cigarette paper.  This technology is specifically designed to self-extinguish when not active, reducing accidental fires from people falling asleep or neglectful when smoking.  Mandated in the US and EU, SWM is a leader in LIP cigarette paper through direct sales and licensing of its intellectual property.  Another key tobacco product for SWM is its reconstituted tobacco leaf (RTL).  Most cigarettes sold today contain RTL paper which is made from the pulp of tobacco stems and leaf scraps and is used inside cigarettes to add flavor while reducing the amount of smoke inhaled.  RTL is also involved in a relatively new cigarette platform called Heat no Burn (HnB) that is supposed to be “healthier” than ignited tobacco cigarettes.  The contents of these cigarettes are heated to just under a combustion temperature with the belief that less smoke reduces the risks associated with smoking.  Recent innovations like RTL have helped SWM’s tobacco business improve plant utilization, lower expenses, and improve cash flows even while the global tobacco industry has been in decline.

SWM’s non-tobacco papers are found in products such as alkaline batteries, flooring laminates, foodservice packaging, and papers for printing and writing.  These commoditized products are manufactured in just enough volume to gain economies of scale and keep EP’s plant utilization at a specific level.  Since SWM’s non-tobacco products have no competitive edge and low profitability, the company does not invest meaningful time or money trying to improve that segment of its business yet.  With its expansion into AMS and a growing customer base, SWM is looking for ways to integrate all its products either in its internal manufacturing or through cross-selling opportunities.

Thesis

With the recent acquisition of Scapa, SWM’s Advanced Material and Structures segment has achieved critical mass and is expected to generate 67% of the company’s revenues.  This de-emphasizes the company’s dependency and exposure to the declining tobacco industry while harnessing its consistent cash flows to organically grow AMS through increasing product applications, expanding custom design and manufacturing opportunities, improving market share, reducing expenses, and increasing profitability.

Future Growth & Profitability

The future growth of SWM will come from its organic growth from AMS businesses (primarily from healthcare, filtration, and transportation) and this is also where future profitability will come from.

Healthcare

Prior to the Scapa acquisition, SWM’s healthcare division generated about $80 million in revenue.  Not only is Scapa expected to boost revenues to $250 million, but it will integrate product lines, consolidate operations, technologies, and customers relationships that were independent.  The newly unified healthcare division will expand its global reach through design, manufacturing, and cross-selling opportunities.  Management has already guided that the integration will produce $5 million in cost savings, adding over $3 million to its bottom line in 2021 and nearly $16 million in 2022.  The company’s expanded healthcare division will be able to not only sell existing product offerings to a new customer base but it will have the opportunity to lever new technologies, best practices, and the ability to custom design and manufacture products creating a stronger partnership with its expanded customer base.  The combined healthcare division will build on its strong foothold in wound care & surgical adhesives, IV and post-operative wound dressings, and gain traction in monitoring devices, wearables, diagnostic test strips, tropical cream, and ointments.  During Covid and continuing through the first half of 2021, surgical procedures, routine checkups, EKG, and other monitoring procedures were halted.  The backlog of surgical and testing procedures that are finally getting scheduled is causing hospitals and healthcare facilities to restock their supplies leading to improved demand for SWM’s healthcare products.

Filtration

The filtration division of AMS saw steady demand, even during the Covid shutdown.  SWM produces several products that are used in both water and air filtration.  During Covid, homeowners, schools, hospitals, office and government buildings, airlines and airports, and warehouses began upgrading their HVAC systems to increase air exchanges, improve air quality, and filtration.  Before Covid, most HVAC filters were changed at most two times per year.  Little if any attention was paid to the filter’s rating (MERV) with most households defaulting to MERV 8 and business MERV 11.  Since Covid, the EPA has recommended households upgrade to MERV 13 or “the highest-rated filter that your HVAC system fan and filter slot can accommodate.”  Businesses and office buildings have increased their filters to MERV 16, while hospitals are now using MERV 17-20 throughout the hospital instead of just the operating rooms.  Additionally, because the businesses are increasing the number of air exchanges per hour (how often the air is replaced), the number of recommended yearly filter replacements is increasing as well.  The higher the MERV rating, the more contaminants the filters are designed to remove from the air, and the higher degree of engineering required.  SWM offers a variety of films and nonwovens filtration products specifically designed and engineered for the high-end MERV-rated filters which carry high-profit margins.  

The water filtration side of SWM’s business is witnessing strong organic growth with a high sustainable market share.  Water scarcity is a growing global problem impacting countries like Saudi Arabia, Israel, China, India, and South Africa.  Even residents of states like California and Arizona have been impacted as extreme temperatures and reduced rainfall are causing water reserves to dwindle.  Globally, there are over 16,000 desalination plants in operation with most of these plants using reverse osmosis filtration to convert seawater into fresh, drinkable water.  Reverse Osmosis forces water (under extreme pressure) through semi-permeable microscopic membranes that removes salt, chemical contaminants, bacteria, and viruses.  These membranes can last three to four years but as they age, more pressure (energy) is needed to push the water through the membranes to get the same daily yield of fresh water.  The decision of when to replace these filters is based both on the age of the membrane and current energy costs.  High energy prices will often shorten the filter replacement cycle.  A desalination plant will incorporate between 10,000 and 30,000 filtration cartridges each containing a permeable membrane.  With the global population growing the fastest in areas where water scarcity is the highest (China, India, Indonesia, and Pakistan), worldwide demand for desalination plants is expected to grow by over 10% a year for the foreseeable future.  California currently has 11 desalination plants in operation with another 10 more plants being proposed.

Transportation

Unlike other AMS segments which were insulated and even expanded during Covid, SWM’s transportation segment was negatively impacted as most of its end-markets greatly reduced or stopped their production.  SWM’s transportation segment develops films that are sandwiched between multiple layers of glass or plastic sheets to provide both strength and optical clarity for the automobile, train, and aerospace industries.  These films are designed to allow the glass to absorb an impact and fracture instead of shattering from an accident, impact from projectile or debris, or any other object whose velocity would have shattered the glass.  The fastest-growing division within the transportation unit is surface protection applications which use thermoplastic polyurethane (TPU) film, as an aftermarket protective coating that auto body and dealerships are applying to automobiles to protect them from scratches, chips, and ultra-violet rays.  Retailing at $1200 - $1800 per application, SWM has seen global adoption, especially in Asia.  Producing TPU films that are defect-free, ultra-clear, and easy to install requires manufacturing expertise and is the reason why SWM holds a high market share.  The same TPU film is used to make bullet-resistant glass for the government and private security companies.

Valuation

For 2021, SWM’s management has guided earnings per share to be between $3.75 - $4.05.  This includes a $0.10 contribution from the recent Scapa acquisition.  By 2022, management expects earnings to improve to $4.25 - $4.55.  This guidance does not include any benefits from cross-selling or improved utilization.  At $3.90/share, the mid-market of 2021’s guidance, SWM is trading at a 10 multiple, which is fitting for a specialty tobacco paper manufacturer.  One would expect a multiple in the mid to high teens for a growing and innovative specialty materials company.  Blending a conservative multiple for AMS (15x) and a 10x multiple for EP, an investor would arrive at a 13.4x multiple for the company.  Applying that to 2022’s earnings expectation, SWM stock would be trading just shy of $59 and when including the dividend yield provides a return of just under 60%.  An argument could be made that as SWM continues to integrate, expand its product offerings, and improves its utilization, and lower its expenses, that the company should have a multiple that is commensurate with other specialty performance material designer and manufacturer.

Summary

Eight years ago, Schweitzer-Mauduit International was solely a specialty paper manufacturer for the tobacco industry.  Today, SWM has pivoted away from its reliance on tobacco by generating 67% of its revenue from its Advanced Material and Structures segment.  With its acquisition of Scapa, the company’s AMS unit has achieved critical mass while its healthcare unit has grown to 25% of AMS revenues.  More importantly, the Scapa acquisition bolsters SWM’s expertise in custom design and manufacturing while uniting a number of niche, stand-alone healthcare products into a scaled-up platform.  The integration promises to provide strong opportunities for SWM to cross-sell its products and capabilities to its existing and recently acquired customer base.  Additional profitability will be generated from both expense reduction and operational optimization as SWM continues to integrate its most recent acquisitions, eliminate duplicate costs, expand the scale and scope of its manufacturing, and reduce its debt structure.

After the Scapa acquisition, SWM’s net debt/EBITDA expanded to 4.3x vs. its prior multiple of 2.3x.  By the end of 2021, the company expects to reduce the multiple to 4x and then anticipates at least a half-turn reduction in each subsequent year until it gets back to its prior 2.3x multiple.  The expanded net debt/EBITDA is at the high end of the company’s comfort level which means that they will be focusing their resources on growing their EBITDA vs. pursuing another acquisition.

There are two main reasons why SWM is undervalued:  1) The market still looks upon the company as a specialty paper supplier to the tobacco industry vs. a hybrid specialty material manufacturer which should carry a multiple in mid to high teens.  2) The company has net debt near $1 billion vs. a market capitalization of $1.2 billion.  These are the same reasons why the company does not screen well and is hidden in plain sight from investors.  Over time, these headwinds will be resolved as SWM pays down its debt and continues to expand the AMS portion of its business.

Catalyst

• Increase in organic growth and profitability from AMS segment.

• The market recognizes SWM as a specialty materials manufacture vs. paper manufacturer.

• Net debt/EBITDA returning to 2.3x multiple vs. current 4.3x multiple.