Schweitzer-Mauduit International 10-K 2005
Documents found in this filing:
Washington, D.C. 20549
(Commission file number)
SCHWEITZER-MAUDUIT INTERNATIONAL, INC.
(Exact name of registrant as specified in its charter)
(Registrants telephone number, including area code)
Securities Registered Pursuant to Section 12(b) of the Act:
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes x No o
The aggregate market value of the outstanding common stock, par value $0.10 per share (the Common Stock), held by non-affiliates of the registrant as of June 30, 2004 (the last business day of the registrants most recently completed second fiscal quarter) was $450.8 million, based on the last sale price for the Common Stock of $30.63 per share as reported on the New York Stock Exchange on said date. For purposes of the foregoing sentence only, all directors and executive officers are assumed to be affiliates.
There were 15,125,623 shares of Common Stock issued and outstanding as of February 28, 2005.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrants definitive Proxy Statement relating to its 2005 Annual Meeting of Stockholders (the Proxy Statement) and filed pursuant to Regulation 14A are incorporated by reference into Part III of this Form 10-K.
As used in this 2004 Annual report on Form 10-K, unless the context indicates otherwise, references to we, us, our, SWM, Schweitzer-Mauduit or similar terms include Schweitzer-Mauduit International, Inc. and its consolidated subsidiaries.
Our Securities and Exchange Commission, or SEC, filings, which include this Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all related amendments, are available free of charge, on our Web site at www.schweitzer-mauduit.com, Investor Relations, SEC filings. These reports are available soon after they are filed electronically with the SEC. The Web site also allows access to historical financial information, press releases and quarterly earnings conference calls, our Code of Conduct, corporate governance guidelines, Board of Directors committee charters, as well as disclosure of any amendment to or waivers of our Code of Conduct granted to any of the principal executive officer, principal financial officer or principal accounting officer. Quarterly earnings press releases are posted immediately to our Web site, making them available to stockholders and other interested parties. The Web site provides additional background information about us including further information on our history, products and locations.
Our quarterly earnings conference calls are typically held on the same dates as our quarterly earnings releases and are likewise available through our Web site via a webcast. The tentative dates for our quarterly earnings conference calls related to 2005 financial results are April 28, 2005, July 28, 2005, October 27, 2005 and January 26, 2006. These dates are subject to change. Instructions on how to listen to the webcasts and updated information on times and actual dates are available through our Web site.
Our wholly-owned direct subsidiaries are Schweitzer-Mauduit Canada, Inc., or SM-Canada, Schweitzer-Mauduit Spain, S.L., or SM-Spain, a holding company organized under the Spanish holding company regime and the primary foreign investment holding company for SWM, and Schweitzer-Mauduit International China, Limited, a currently inactive holding company incorporated in Hong Kong. We indirectly through SM-Spain have subsidiaries in France, Brazil and Indonesia. SM-Spain owns directly 100 percent of Schweitzer-Mauduit Holding S.A.R.L., a French holding company, or SMH, and together SM-Spain and SMH own 100 percent of 2 holding companies, Schweitzer-Mauduit Industries S.A.R.L., a French corporation, or SMI, which holds our investment in the French reconstituted tobacco operations, and Schweitzer-Mauduit France S.A.R.L., a French corporation, or SMF, which holds our French and Indonesian paper operations. SMI owns directly 72 percent of the issued and outstanding shares of LTR Industries S.A., a French corporation, or LTRI. SMF, directly or indirectly, owns 100 percent of 3 principal French operating subsidiaries, Papeteries de Mauduit S.A.S., or PdM, Papeteries de Malaucène S.A.S., or PdMal, and Papeteries de Saint-Girons S.A.S., or PdStG, and 100 percent of our Indonesian paper operations, P.T. PDM Indonesia. SMF also owns 100 percent of PDM Philippines Industries, Inc., or PPI, which was established in 2004 to acquire the operating assets in conjunction with a pending Philippines acquisition. SM-Spain also owns directly 99.99 percent of the issued and outstanding shares of Schweitzer-Mauduit do Brasil S.A., a Brazilian corporation, or SWM-B. We did not have any unconsolidated subsidiaries, joint ventures or special purpose entities as of December 31, 2004.
Our principal executive office is located at 100 North Point Center East, Suite 600, Alpharetta, Georgia 30022-8246 and our telephone number at that address is 1-800-514-0186. Our stock is traded on the New York Stock Exchange, or NYSE, under the symbol SWM.
We are a multinational diversified producer of premium specialty papers headquartered in the United States of America and are the worlds largest supplier of fine papers to the tobacco industry. We
manufacture and sell paper and reconstituted tobacco products to the tobacco industry as well as specialized paper products for use in other applications. Tobacco industry products comprised 93 percent of our consolidated net sales in each of the years 2004, 2003 and 2002. The primary products in the group include cigarette, plug wrap and tipping papers used to wrap various parts of a cigarette, or Cigarette Papers, and reconstituted tobacco leaf, or RTL, which is used as a blend with virgin tobacco in cigarettes, reconstituted tobacco wrappers and binders for cigars and paper products used in cigarette packaging. These products are sold directly to the major tobacco companies or their designated converters in North and South America, western and eastern Europe, Asia and elsewhere.
We are the premier manufacturer of high porosity papers, which are used in manufacturing ventilated cigarettes, and the leading independent producer of reconstituted tobacco leaf used in producing blended cigarettes. We conduct business in over 90 countries and currently operate 10 production locations worldwide, with mills in the United States, France, Brazil and Indonesia.
Our manufacturing facilities have a long history of producing paper dating back to 1545. Our domestic mills led the development of the North American tobacco-related papers manufacturing industry, which was originated by Peter J. Schweitzer, Inc. that began as an importer of cigarette papers from France in 1908.
The manufacturing facilities include:
· Lee Mills complex, consisting of the Columbia, Eagle, Greylock and Niagara mills, located in Lee, Massachusetts
· Ancram Mill located in Ancram, New York
· Spotswood Mill located in Spotswood, New Jersey
· Fiber Operations located in Winkler, Manitoba
· Papeteries de Mauduit Mill located in Quimperlé, France
· Papereries de Malaucène Mill located in Malaucène, France
· Papeteries de Saint-Girons Mill located in Saint-Girons, France (acquired 1998)
· LTR Industries Mill located in Spay, France
· Schweitzer-Mauduit do Brasil Mill located in Santanésia Pirai, Brazil (acquired 1998)
· PT PDM Indonesia Mill located in Medan, Indonesia (acquired 2004)
We are in the process of acquiring tobacco-related paper manufacturing assets in the Philippines. The assets to be acquired include land, buildings, production equipment and related utilities and support assets. The production equipment being acquired includes 2 paper machines, with annual production capacity of approximately 8,500 metric tons, and related converting equipment. The acquisition is expected to be completed in the second quarter of 2005, subject to governmental permitting.
Financial Information About Segments. We operate and manage 3 reportable segments: United States, or U.S., France and Brazil. These segments are based on the geographical location of our manufacturing operations. These business segments manufacture and sell cigarette, plug wrap and tipping papers used to wrap various parts of a cigarette, reconstituted tobacco products and paper products used in cigarette packaging, as well as certain non-tobacco industry products. While the products are similar in each segment, they vary based on customer requirements and the manufacturing capabilities of each of the operations. The Indonesian financial results are included in the French business segment because the results of the Indonesian operation are not material for segment reporting purposes and since the products of the Indonesian business are primarily sold under a French trademark and are coordinated with sales of our French operations in southeast Asia. Sales by a segment into markets primarily served by a different segment occur where specific product needs cannot be cost-effectively met by the manufacturing operations domiciled in that segment.
Additional information regarding Segment Performance is included in Part II, Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operation, of this Annual Report on Form 10-K. In addition, selected financial data for our segments is available in Note 8, Segment Information, of the Notes to Consolidated Financial Statements. Reference is also made to Part II, Item 7A, Quantitative and Qualitative Disclosures About Market Risk, of this Annual Report on Form 10-K for a discussion regarding the risks associated with foreign operations.
Financial information about foreign and domestic operations, contained under the caption Managements Discussion and Analysis of Financial Condition and Results of Operation appearing in Part II, Item 7 herein and in Notes 3, 4 and 8 (Debt, Income Taxes and Segment Information, respectively,) to Consolidated Financial Statements contained in Financial Statements and Supplementary Data appearing in Part II, Item 8 herein, are incorporated in this Item 1 by reference.
We manufacture and sell paper and reconstituted tobacco products to the tobacco industry as well as specialized paper products for use in other applications.
Tobacco industry products include cigarette, plug wrap and tipping papers used to wrap various parts of a cigarette; reconstituted tobacco leaf used as a tobacco blend with virgin tobacco in cigarettes; reconstituted tobacco wrappers and binders for cigars; and paper products used in cigarette packaging. These products are sold directly to tobacco companies or their designated converters in North and South America, western and eastern Europe, Asia and elsewhere.
Each of the 3 principal types of paper used in cigarettescigarette, plug wrap and tipping papersserves a distinct purpose in the function of a cigarette.
Cigarette paper wraps the column of tobacco in a cigarette. Certain properties of cigarette paper, such as basis weight, porosity, opacity, tensile strength, texture and burn rate must be controlled to tight tolerances. Many of these characteristics are critical to meet the requirements of high-speed production processes utilized by cigarette manufacturers as well as their desired attributes of finished cigarettes such as lower ignition propensity or reduced deliveries of tobacco-related smoke constituents.
Plug wrap paper forms the outer layer of a cigarette filter and is used to hold the filter materials in a cylindrical form. Conventional plug wrap is manufactured on flat wire paper machines using wood pulp. Porous plug wrap, a highly air permeable paper, is manufactured on inclined wire paper machines using a furnish consisting of long fibers, such as abaca, and wood pulp. Porosity, a measure of air flow permeability, ranges from a typical level of less than 100 Coresta on conventional plug wrap to 35,000 Coresta on high porosity papers. High porosity plug wrap is sold under the registered trademark
POROWRAP® and is used on filter-ventilated cigarettes. High porosity papers can also be used for such specialty products as battery separator paper.
Tipping paper, produced in white or buff color, joins the filter element to the tobacco-filled column of the cigarette. The ability to produce tipping paper, which is both printable and glueable at high speeds, is critical to producing a cigarette with a distinctive finished appearance.
Reconstituted tobacco is used by manufacturers of cigarettes, cigars and other tobacco products. We currently produce reconstituted tobacco in 2 forms: leaf, or RTL, in France, which is manufactured by LTRI, and wrapper and binder in the United States. RTL is used by manufacturers of cigarettes primarily to blend with virgin tobacco as a design aid to achieve certain attributes of finished cigarettes, such as taste characteristics and reduced deliveries of tobacco-related smoke constituents, and to cost-effectively utilize tobacco leaf by-products. Wrapper and binder are reconstituted tobacco products used by manufacturers of machine-made cigars. Binder is used to hold the tobacco leaves in a cylindrical shape during the production process. Wrapper is used to cover the outside of the cigar, providing a uniform, finished appearance.
Commercial and industrial products include lightweight printing and writing papers, coated papers for packaging and labeling applications, business forms, furniture laminates, battery separator paper, drinking straw wrap, filter papers and other specialized papers primarily for the North American, western European and Brazilian markets. Like porous plug wrap, certain of these non-tobacco industry products use a fiber blend consisting of long fibers. These products are generally sold directly to converters and other end-users in North America and western Europe and through brokers in Brazil. The non-tobacco industry products are a diverse mix of products, certain of which represent commodity paper grades produced to maximize machine utilization.
Our U.S. segment primarily supplies the major, and many of the smaller, cigarette manufacturers in North America, and also has significant sales in South America and Japan. The customer base for the U.S. operations consists of more than 175 customers in approximately 33 countries. Our French segment relies predominantly on worldwide exports, primarily to western Europe, Asia (in part through our Indonesian manufacturing facility), eastern Europe and the former Commonwealth of Independent States, and, in lesser but substantial amounts, to Africa, the Middle East and Australia. The customer base for the French operations consists of a diverse group of over 200 customers in more than 80 countries. Our Brazilian segment primarily supplies customers in Brazil, but with increasing sales to other South American countries. The current customer base of the Brazilian operations consists of the cigarette manufacturers in Brazil, as well as approximately 20 customers in approximately 5 countries outside Brazil. Customers of all 3 business segments include international tobacco companies, regional tobacco manufacturers and government monopolies.
Philip Morris Incorporated, or Philip Morris, including its subsidiaries, and B.A.T. Industries PLC, or BAT, including its Brazilian subsidiary Souza Cruz S.A., or Souza Cruz, and its other subsidiaries, are our 2 largest customers. Philip Morris and BAT, together with their respective affiliates and designated converters, accounted for 30 percent and 18 percent, respectively, of our 2004 consolidated net sales. Although the total loss of one or both of these large customers could have a material adverse effect on our results of operations, this is not considered likely given the significant share that our capacity represents of the total world-wide supply available to meet the demand for cigarette-related fine papers. A material variation in demand from one of these customers or due to external factors such as government legislation and changes in consumer behavior however could result in a decline in demand for our products.
Philip Morris Supply Agreement. Since January 1, 1993, we have been the single source of supply of Cigarette Papers to Philip Morris U.S. operations. In December 2004, we reached an agreement with
Philip Morris to extend the Second Amended and Restated Agreement for Fine Paper Supply, or Second Amended Supply Agreement. This agreement extends our position as the supplier of Cigarette Papers to Philip Morris U.S. operations through December 31, 2007, except that Philip Morris has the continuing right to acquire up to 10 percent of its prior-year purchases of Cigarette Papers from other suppliers, although to-date it has chosen not to do so. By its terms, the current extension to the Second Amended Supply Agreement automatically renews for 2 additional successive terms of 2 years each unless either party gives notice of non-renewal 24 months before the end of the then-current contract term. If a decision is made to terminate, the agreement provides for a 2-year phase-out period during the last 24 months of the then-current contract term. Further, pursuant to an addendum to the Second Amended Supply Agreement, we have an exclusive supply arrangement with Philip Morris U.S.A. for a jointly developed banded cigarette paper that is used in lower ignition propensity cigarettes. We produce banded cigarette paper in sufficient quantities to support Philip Morris commercial sales of lower ignition propensity cigarettes, which are currently in the State of New York and limited commercial sales nationally. We have entered into a licensing and royalty agreement covering this new paper with Philip Morris.
Souza Cruz Supply Agreements. On February 2, 1998, as part of our agreement to purchase a Brazilian specialty paper manufacturer named Companhia Industrial de Papel Pirahy, or Pirahy, the predecessor of our Brazilian operations, SWM-B entered into 2 exclusive supply agreements with its former owner and its largest customer, Souza Cruz, to supply all of Souza Cruzs needs for papers which SWM-B is capable of producing. The supply agreements for tobacco-related papers and coated paper used in the packaging of cigarette products, as amended in February 2000, had initial terms of 6 years through February 1, 2004 and phase-out periods of 18 months and 12 months, respectively. In July 2002, Souza Cruz advised us that these exclusive supply agreements would not be renewed. In December 2003, SWM-B and Souza Cruz agreed to an extension of SWM-Bs exclusive supply of Souza Cruzs tobacco-related paper requirements through February 1, 2005 concurrent with the first 12 months of the phase-out period. Subsequent to February 1, 2005, Souza Cruzs tobacco-related paper requirements are expected to be included in BATs global sourcing and a separate supply agreement will not be negotiated between SWM-B and Souza Cruz, although we believe it is the expectation of both parties to maintain a mutually beneficial commercial relationship.
Essentially all sales of tobacco-related products by the U.S., French and Brazilian segments are sold by our marketing, sales and customer service organizations directly to cigarette manufacturers or their designated converters, and to cigar manufacturers, except in China where sales are generally made to trading companies for resale to cigarette producers. Most of our U.S. and French segments non-tobacco related products, which represent approximately 5 percent of each of their respective net sales, are sold on a direct basis. The Brazilian segments non-tobacco related products comprise 39 percent of its net sales, substantially all of which are channeled through agents.
The typical modes of transportation we utilize in the delivery of product to our customers include truck, rail and ocean-going vessels. As is typical in our industry, ownership of the product generally transfers to our customer upon shipment from the mills, except for certain export sales where ownership typically transfers at the foreign port or customer facility.
We are the leading producer of Cigarette Papers in the world. LTRI is the leading independent producer of RTL for use in cigarettes. We do not sell our products directly to consumers or advertise our products in consumer media. The specialized nature of these tobacco-related papers requires research and development capability to develop them and special papermaking equipment and skills to meet exacting
customer specifications. These factors have limited the number of competitors in each of the tobacco-related paper categories discussed separately below.
Cigarette PaperAs the sole domestic producer of Cigarette Papers in North America, we believe that we have the majority supply position, estimated at 70 to 75 percent of the North American cigarette paper market. European suppliers, such as Wattens GmbH, or Wattens, an Austrian subsidiary of Trierenberg Holding, or Trierenberg, and Miquel y Costas & Miquel S.A., a Spanish corporation, or Miquel y Costas, supply the balance of the North American market. We believe that the bases of cigarette paper competition are security of supply, price, consistent quality, level of technical service and performance requirements of the customers cigarette-making equipment.
We have developed 2 technologies to address the emerging market for cigarette paper for lower ignition propensity cigarettes in the United States and Canadabanded cigarette paper and print banded cigarette paper. We are the leading producer of commercially proven cigarette paper for lower ignition propensity cigarettes. Only limited competitive cigarette papers for lower ignition propensity cigarettes have been offered for sale by our competitors.
The principal competitors of our French cigarette paper businesses are Wattens, Miquel y Costas and Julius Glatz GmbH, or Glatz, an independent German company. PdM and PdStG, indirect wholly owned subsidiaries in France, sell approximately 70 percent of their products in western Europe and Asia. We believe that the bases of competition for PdMs and PdStGs products are the same as for our U.S. segment. The principal competitors of our Indonesian cigarette paper business are PT Surya Zig Zag and PT BMJ, which are owned by Indonesian cigarette production companies and account for 60 to 65 percent of the cigarette paper market in Indonesia.
The principal competitors of our Brazilian cigarette paper business are Wattens, Miquel y Costas and Cartieira Del Maglio S.p.A, an independent Italian company. SWM-B has an estimated 80 percent share of the cigarette paper market in Brazil and an estimated 60 to 65 percent share of the cigarette paper market in South America. We believe that the bases of cigarette paper competition for SWM-B are the same as for our U.S. segment.
In recent years, the number of cigarette paper manufacturers has declined worldwide. In addition to the bankruptcy of RFS Ecusta Inc. in the United States during 2002, smaller cigarette paper manufacturers in the United Kingdom, Argentina, Mexico and Colombia have either ceased or significantly reduced their production of cigarette paper, reflecting the competitive nature of this product and efforts by the worlds major cigarette manufacturers to consolidate their suppliers. This reduction of worldwide cigarette paper production capacity has been offset, however, by cigarette paper production capacity added by SWM, Wattens, Glatz and in China. New capacity added in western Europe by Wattens and Glatz in 2003 and 2004, respectively, has contributed to recent pricing and demand pressures for cigarette papers in western Europe.
Plug Wrap PaperWe believe that our U.S. segment has an estimated 85 to 90 percent share of the North American market for plug wrap papers. The remainder of the North American market is shared by 2 competitors: Miquel y Costas and Wattens. Our French businesses hold an estimated 60 percent of the western European high porosity plug wrap market. Wattens is our principal competitor in that market. Through the Brazilian business supply of conventional plug wrap papers and the U.S. business supply of porous plug wrap papers, we have an estimated 70 percent share of the South American market for plug wrap papers. Miquel y Costas and Wattens are our principal competitors in that market.
We believe that the primary basis of competition for high porosity plug wrap is technical capability with price being a less important consideration. On the other hand, conventional plug wrap entails less technical capability with the result that price and quality are the primary bases of competition.
Tipping PaperWe believe that our U.S. segment has an estimated 60 to 65 percent share of the North American market for base tipping paper, which is subsequently printed by converters. Our principal competitor in this market is Tervakoski Oy, a Finnish subsidiary of Trierenberg. We believe that the bases for competition are consistent quality, price and, most importantly, the ability to meet the runnability and printability requirements of converting equipment and high-speed cigarette-making machines.
PdMal, another of our indirect wholly-owned French subsidiaries, operates a base paper and finished tipping paper mill in Malaucène, France, and ranks among the largest converted tipping paper producers in western Europe, with an estimated 15 percent market share. PdMal produces printed and unprinted, and laser and electrostatically perforated tipping papers. PdStG and SWM-B also produce base tipping paper that is converted and sold by PdMal. PdMals principal European competitors are Tann-Papier GmbH, an Austrian subsidiary of Trierenberg, Benkert GmbH (Germany) and Miquel y Costas. We believe that the bases of competition for perforated tipping paper in Europe are perforation technology, consistent quality and price.
Our Brazilian segment has an estimated 65 to 70 percent share of the South American market for base tipping paper, which is subsequently printed by converters. Our principal competitor in Latin America is Miquel y Costas. We believe that the bases of tipping paper competition for SWM-B are the same as for our U.S. segment.
Reconstituted TobaccoLTRI is the leading independent producer of RTL in the world. We believe that the basis of competition in this market is primarily quality. However, sales volumes are influenced by worldwide virgin tobacco prices as lower prices of virgin tobacco may result in lower reconstituted tobacco sales volumes.
LTRIs principal competitors are (i) R.J. Reynolds Tobacco Company, which produces RTL for both internal and external use, (ii) Yelets, an affiliate of Japan Tobacco Inc. which operates in Russia, (iii) B.V. Deli-HTL Tabak Maatschappiji B.V., an independent producer which operates in Holland, and (iv) cigarette companies such as Philip Morris and BAT, which produce RTL primarily for internal use.
We estimate that approximately 50 percent of reconstituted cigar wrapper and binder used in the U.S. market is produced internally by domestic cigar manufacturers. Our U.S. segments Ancram mill and Nuway Tobacco, a cast process manufacturer, produce the balance.
Other ProductsAs noted above, we produce papers for lightweight printing and writing, coated papers for packaging and labeling applications, business forms, furniture laminates, battery separator papers, wrapping paper for drinking straws, filter papers and other specialized papers. We believe that price is the primary basis of competition for drinking straw wrap, printing and writing and filter papers, while consistent quality and customer service are believed to be the primary competitive factors for battery separator and business forms papers. We do not possess a significant market share in any of the above segments, except for battery separator papers, where we hold approximately 30 percent of the worldwide market. We continue, to the extent feasible, to convert our production of less profitable papers to more profitable niche applications.
Wood pulp is the primary fiber used in our operations. Our operations consumed 105,100 and 97,000 metric tons of wood pulp in 2004 and 2003, respectively, all of which was purchased. Our operations also use other cellulose fibers, the most significant of which are in the form of flax fiber and tobacco leaf by-products, as the primary raw materials for Cigarette Papers and reconstituted tobacco products, respectively. While tobacco leaf by-products are generally the property of the cigarette manufacturer for whom the reconstitution is contracted, we and our subsidiary LTRI purchase some tobacco leaf by-products for use in the production of RTL and wrapper and binder products. In addition to cellulose
fibers, our operations use calcium carbonate as another significant raw material in the production of many of our paper products. Calcium carbonate, or chalk, is used in the production of Cigarette Papers, as well as in certain of our other paper products, to provide desired qualities and characteristics, such as opacity, as well as end-product performance attributes.
Flax straw is purchased and subsequently processed into flax tow at processing facilities in Canada and France. The flax tow is then converted into flax pulp at pulping facilities in the United States and France. Flax tow and flax pulp are also purchased externally, but these purchases only represent approximately 35 percent of the flax pulp currently consumed by our operations in the United States, France and Brazil. Certain specialty papers are manufactured by our operations in France, requiring small amounts of other cellulose fibers, all of which are purchased.
All of our needs for calcium carbonate are purchased. Our Quimperlé mill in France and Pirahy mill in Brazil have third-party vendor-operated calcium carbonate plants on-site which supply significant quantities toward the needs of those mills. In addition, our mills also purchase calcium carbonate produced by vendors at plants which are not on-site at our mills.
We believe that our purchased raw materials are readily available from several sources and that the loss of a single supplier would not have a material adverse effect on our ability to procure needed raw materials from other suppliers.
The papermaking processes use significant amounts of energy, primarily electricity and natural gas, to run the paper machines and other equipment used in the manufacture of pulp and paper. In France and in the United States, availability of energy is generally not expected to be an issue, although prices can fluctuate significantly based on variations in demand. In France, we have entered into agreements with an energy cogeneration supplier whereby the supplier will construct and operate cogeneration facilities at our Spay and Quimperlé Mills and supply steam, which will be used in the operation of our mills. When completed in 2005, these cogeneration facilities are expected to provide energy cost savings and improved security of supply beginning in 2006. In Brazil, where that countrys production of electricity is heavily reliant upon hydroelectric plants, availability of electricity has been affected in the past by weather and rain variations. Our Brazilian business currently has a sufficient supply of energy to continue its current level of operation.
We have historically experienced a steady flow of orders. Our mills typically receive and ship orders within a 30-day period, except in the case of RTL where orders are generally placed well in advance of delivery. We plan our manufacturing schedules and raw material purchases based on our evaluation of customer forecasts and current market conditions.
The U.S. segment does not calculate or maintain records of order backlogs. Philip Morris, our largest customer, provides forecasts of future demand, but actual orders for Cigarette Papers are typically placed 2 weeks in advance of shipment.
Our French segment does maintain records of order backlogs. For Cigarette Papers, the order backlog was $39 million and $54 million on December 31, 2004 and 2003, respectively. This represented approximately 47 and 69 days of Cigarette Paper sales for the French segment in 2004 and 2003, respectively. LTRIs RTL business operates under a number of annual supply agreements. The order backlog for RTL was $62 million and $106 million on December 31, 2004 and 2003, respectively.
The Brazilian segment does not calculate or maintain records of order backlogs. Approximately 40 percent of its sales are to Souza Cruz, its largest customer. Souza Cruz provides forecasts of its future demand, typically 8 weeks in advance, in order for the Brazilian operations to manage production and ensure a sufficient supply to meet Souza Cruzs anticipated requirements.
Sales of our products are not subject to seasonal fluctuations, except in the United States where customer shutdowns of 1 to 2 weeks in duration typically occur in July and December, and in Brazil where customer orders are typically lower in December due to a January and February holiday season.
We have research and laboratory facilities in Spay, France, Santanésia, Brazil and Alpharetta, Georgia and employ approximately 60 research personnel. We are dedicated to developing Cigarette Papers, reconstituted tobacco and non-tobacco paper product innovations and improvements to meet the needs of individual customers. The development of new components for tobacco products and the development of new non-tobacco paper products are the primary focuses of these research and development functions, including several development projects for our major customers. We expensed $9.3 million in 2004, $8.3 million in 2003 and $7.6 million in 2002 on research and development.
We believe that our research and product development capabilities are unsurpassed in the industry and have played an important role in establishing our reputation for high quality, superior products. Our commitment to research and development has enabled us, for example, to (i) produce high-performance papers designed to run on the high-speed manufacturing machines of our customers, (ii) produce papers to exacting specifications with very high uniformity, (iii) produce cigarette paper with extremely low basis weights, (iv) develop cigarette paper for lower ignition propensity cigarettes, (v) produce highly porous cigarette and plug wrap papers, and (vi) produce papers with other specifically engineered properties required for end-product performance attributes. We believe we are in the forefront of the specialty paper manufacturing process, having invested heavily in modern technology, including on-line banding and off-line printing capabilities for lower ignition propensity cigarette papers, laser technology and modern paper-slitting equipment. We believe that our commitment to research and development, coupled with our investment in new technology and equipment, has positioned us to take advantage of growth opportunities abroad where the demand for American-style premium cigarettes continues to increase.
As of December 31, 2004, we owned 125 patents and had pending 77 patent applications covering a variety of Cigarette Papers, RTL and cigar wrapper and binder products and processes in the United States, western Europe and several other countries. We believe that such patents, together with our papermaking expertise and technical sales support, have been instrumental in establishing us as the leading worldwide supplier of Cigarette Papers, RTL and reconstituted wrapper and binder made by the papermaking process.
Management believes that our POROWRAP® trademark for highly porous plug wrap paper, the PDM logo and the JOB PAPIER A CIGARETTES, PAPETERIES DE MAUDUIT and SCHWEITZER trade names also have been important contributors to the marketing of our products.
As of December 31, 2004, we had 3,744 regular full-time active employees of whom 619 hourly employees and 271 salaried employees were located in the United States and Canada, 1,173 hourly employees and 718 salaried employees were located in France, 149 hourly employees and 56 salaried employees were located in Indonesia, 707 hourly employees and 48 salaried employees were located in Brazil and 3 salaried employees were located in the Philippines.
North American OperationsHourly employees at the Lee, Massachusetts, Spotswood, New Jersey and Ancram, New York mills are represented by locals of the Paper, Allied-Industrial, Chemical and Energy Workers International Union (PACE). During 2002, a 3-year collective bargaining agreement was reached for the Lee Mills expiring on July 31, 2005. In 2004, a new collective bargaining agreement was signed at our Spotswood mill, effective through August 28, 2007. In 2004, we also reached a 4-year
collective bargaining agreement for the Ancram mill effective through September 30, 2008. We believe employee and union relations continue to be positive.
The fiber operations of our Canadian subsidiary are non-union. We believe that employee relations are positive.
French OperationsHourly employees at our mills in Quimperlé, Malaucène, Saint-Girons and Spay, France are union represented. New collective bargaining agreements were signed in 2004 in Malaucène and Spay, expiring December 31, 2004 and February 28, 2005, respectively, and 2 of the 3 unions representing employees in Quimperlé signed a new bargaining agreement expiring December 31, 2005. A new collective bargaining agreement was signed in 2004 for the mill in Saint-Girons and is scheduled to expire May 31, 2006. We are currently in discussions with the unions representing employees at our Malaucène and Spay mills concerning renewal of those labor contracts. Over the years, there have been intermittent work stoppages at the French operations lasting from a few hours to several days. We believe that, overall, employee relations are positive and comparable to similar French manufacturing operations.
Hourly employees of our Medan, Indonesia mill are union represented. The current collective bargaining agreement has been extended to April 1, 2005. We believe that employee relations are positive and our acquisition of the mill was well received by the workforce.
Brazilian OperationsHourly employees at the Pirahy mill are represented by a union. The current annual collective bargaining agreement expires on May 31, 2005. We believe that, overall, employee relations are positive and comparable to similar Brazilian manufacturing operations.
Capital expenditures for environmental controls to meet legal requirements and otherwise relating to the protection of the environment at our facilities in the United States, France, Brazil, Indonesia and Canada are estimated to be approximately $1 million in both 2005 and 2006, of which no material amount is the result of environmental fines or settlements. These expenditures are not expected to have a material adverse effect on our financial condition, results of operations or competitive position; however, these estimates could be modified as a result of changes in our plans, changes in legal requirements or other factors.
We normally maintain approximately 30 to 60 days of inventories to support our operations. Our sales terms average between 30 and 60 days for payment by our customers, dependent upon the products and markets served. For a portion of our business, particularly our French businesses export sales, extended terms are provided. With respect to our accounts payable, we typically carry approximately a 30 to 60 day level, in accordance with our purchasing terms, which vary by business segment. The accounts payable balance varies in relationship to changes in our manufacturing operations, particularly due to changes in prices of wood pulp and the level and timing of capital expenditures related to projects in progress.
In addition to our U.S. operations, we have manufacturing facilities in France, Brazil, Indonesia and Canada. Collectively we market and sell products in over 90 countries, many of which are third world markets. While not an exhaustive list of the various risks that may impact our foreign operations, and while the level of risk varies amongst countries, our operations in foreign countries are subject to possible material international business risks, including unsettled political and economic conditions; expropriation; import and export tariffs, controls and restrictions; monetary exchange controls; inflationary economies; changes in currency value; changes in business and income tax regulations and risks related to restrictions on repatriation of earnings or proceeds from liquidated assets of foreign subsidiaries.
The names and ages of the executive officers as of March 3, 2005, together with certain biographical information, are as follows:
There are no family relationships between any of the directors, or any of our executive officers. None of our officers were selected pursuant to any arrangement or understanding between the officer and any person other than the Company. Our executive officers serve at the discretion of the Board of Directors and are elected annually by the Board. Detailed information about our executive officers is provided below.
Wayne H. Deitrich has served as our Chief Executive Officer since August 1995 and was elected Chairman of the Board of Directors immediately after our spin-off from Kimberly-Clark Corporation, or Kimberly-Clark, on November 30, 1995, and has served continuously in that capacity since that date. From June 1995 through August 1995, Mr. Deitrich served as PresidentSpecialty Products Sector of Kimberly-Clark. From 1993 through May 1995, Mr. Deitrich was the PresidentPaper and Specialty Products Sector of Kimberly-Clark, and from 1992 to 1993, he was PresidentPaper Sector of Kimberly-Clark. From 1988 through 1992, Mr. Deitrich served as the President of Neenah Paper, a business unit of Kimberly-Clark.
Jean-Pierre Le Hétêt has served as our Chief Operating Officer since April 1998 in addition to having served as PresidentFrench Operations from August 1995 through October 2002. Mr. Le Hétêt was elected to the Board of Directors immediately after the spin-off on November 30, 1995, and has served continuously since that date. From 1991 through August 1995, Mr. Le Hétêt was the President of Specialty Products, France, a business unit of Kimberly-Clark. Prior to that time, Mr. Le Hétêt served as General Manager of Specialty Products, France.
Thierry E. Bellanger has served as our PresidentFrench Operations since November 2002. From July 1999 through October 2002, Mr. Bellanger was Director of Operations for the Paper Sector in France. From March 1997 through June 1999, he served as Director of Operations for our Tobacco Sector in France. Prior to March 1997, Mr. Bellanger served in various positions at PdM and LTRI.
Peter J. Thompson has served as our PresidentU.S. Operations since November 1998. From April 1998 through November 1998, Mr. Thompson was DirectorSales and Marketing for the U.S. Operations. Mr. Thompson joined us in January 1997 as a Marketing Manager in the U.S. Operations. Prior to joining us, he was employed by Tape, Inc. from May 1995 through January 1997, where he held several senior management positions in marketing, sales and finance. Mr. Thompson was employed by Kimberly-Clark from June 1984 through May 1995 in a variety of financial positions.
Otto R. Herbst has served as our PresidentBrazilian Operations since April 1999. Prior to April 1999, he served as General Manager for New Business and Services from 1997 through March 1999 for Interprint, a manufacturer of security documents, telephone cards and business forms. From 1990 through 1997, Mr. Herbst served as Director of Agaprint, a manufacturer of packaging materials, business forms, commercial printing papers, personalized documents and envelopes.
Paul C. Roberts has served as our Chief Financial Officer and Treasurer since August 1995. From June 1995 through August 1995, he served as Chief Financial OfficerSpecialty Products Sector of Kimberly-Clark. From January 1995 through May 1995, he was DirectorCorporate Strategic Analysis of Kimberly-Clark, and from 1988 through 1994, Mr. Roberts was DirectorOperations Analysis and Control, Pulp and Paper Sector of Kimberly-Clark.
John W. Rumely, Jr. has served as our General Counsel and Secretary since January 2000. From March 1998 through December 1999, he served as Associate General Counsel. From May 1989 through February 1998, Mr. Rumely was Assistant General Counsel of Alumax Inc., an international integrated producer of aluminum products that was subsequently acquired by Alcoa Inc.
Wayne L. Grunewald has served as our Controller since August 1995. From July 1995 through August 1995, he served as ControllerSpecialty Products Sector of Kimberly-Clark. From December 1989 through June 1995, he was ControllerU.S. Pulp and Newsprint, a business unit of Kimberly-Clark.
Item 2. Properties
As of December 31, 2004, we operated 9 paper mills (which include 4 fiber pulping operations) on 4 continents. We operate these mills in 3 business segments based on the geographic locations of the manufacturing operations: the United States, France (which includes the Indonesian operations acquired in February 2004), and Brazil.
We have approximately 193,000 metric tons of annual paper production capacity and approximately 80,000 metric tons of annual reconstituted tobacco products production capacity, dependent upon the production mix. We also operate flax fiber processing operations in France and Canada. We own each of these facilities and the associated operating equipment except for a flax tow storage facility in Winkler, Manitoba, which is leased.
Machine operating schedules at all of our locations were at or near capacity during 2004, except that we have more capacity than is currently being used for long fiber products in France, for RTL in France as the result of the RTL capacity added in 2003 and for all product lines in the United States. New cigarette paper capacity is being added in our Brazilian operations, which may not be fully utilized in 2005. In addition, the French paper operations are likely to operate at less than full capacity in 2005 as a result of less demand for tobacco-related papers in western Europe due to excise tax increases on cigarettes and the impact of increased paper production capacity added by competitors in western Europe in 2003 and 2004. During 2004, we sold 163,000 metric tons of paper products and 64,000 metric tons of reconstituted tobacco products, representing 84 percent and 80 percent, respectively, of the above-indicated approximate annual capacities.
We maintain administrative and sales offices in Alpharetta, Georgia, in Quimperlé and Spay, France, in Hong Kong, China, in Santanésia and Rio de Janeiro, Brazil, in Madrid, Spain, in Medan, Indonesia and in Moscow, Russia. Our world headquarters are also located in Alpharetta. All of these offices are owned except for those located in Alpharetta, Hong Kong, Rio de Janeiro, Madrid and Moscow.
We are in the process of acquiring tobacco-related paper manufacturing assets in the Philippines. The assets to be acquired include land, buildings, production equipment and related utilities and support assets. The production equipment being acquired includes 2 paper machines, with annual production capacity of approximately 8,500 metric tons, and related converting equipment. The acquisition is expected to be completed in the second quarter of 2005, subject to governmental permitting.
We consider all of our facilities to be well-maintained, suitable for conducting our operations and business, and adequately insured.
In addition to the operating equipment listed below, our Brazilian subsidiary has a paper machine which was taken out of service in 2001 and was fully written off. There are no plans to operate this equipment in the future.
At our U.S. segments Lee Mills facility, we operate a machine that is owned by Kimberly-Clark. Ownership of the machine was retained by Kimberly-Clark in the 1995 spin-off of the Company and is operated solely for the purpose of producing a proprietary product used as an in-process material by Kimberly-Clark. Under the contract for its continued operation, the current term of which is scheduled to expire in December 2009, we essentially invoice Kimberly-Clark the actual costs of operating the machine, including allocations of indirect and fixed overhead costs. While certain of such costs could be eliminated if the contract is not renewed or is otherwise terminated, we may be unable to eliminate a portion of the approximately $2 million of indirect and fixed overhead costs that are currently absorbed by that operation.
The following are locations of our principal production facilities, all of which are owned, and operating equipment as of December 31, 2004:
U. S. Segment
Item 3. Legal Proceedings
We are involved in various legal proceedings relating to contracts, commercial disputes, taxes, environmental issues, employment and workers compensation claims, product liability and other matters. We periodically review the status of these proceedings with both inside and outside counsel. We believe that the ultimate disposition of these matters will not have a material adverse effect on the results of operations in a given quarter or year. Below is a summary of our major outstanding litigation.
Imposto sobre Circulação de Mercadorias e Serviços, or ICMS, a form of value-added tax in Brazil, was assessed to SWM-B in December of 2000. SWM-B received 2 assessments from the tax authorities of the State of Rio de Janeiro for unpaid ICMS taxes from January 1995 through November 2000, which together with interest and penalties totaled approximately $13.6 million based on the foreign currency exchange rate at December 31, 2000, collectively the Assessment.
The Assessment concerned the accrual and use by SWM-B of ICMS tax credits generated from the production and sale of certain non-tobacco related grades of paper sold domestically that are immune from the tax to offset ICMS taxes otherwise owed on the sale of products that are not immune. One of the 2 assessments, estimated at December 31, 2000 at approximately $9.1 million, related in part to tax periods that predated our acquisition of Pirahy and is covered in part by an indemnification from the sellers of Pirahy, or Assessment 1. The second assessment pertains exclusively to periods that SWM-B owned the Pirahy mill, or Assessment 2. While SWM-B is primarily responsible for the full payment of the Assessment in the event of an ultimate unfavorable outcome, SWM-B is not aware of any difficulties that would be encountered in obtaining reimbursement of that portion of any payment resulting from Assessment 1 from the previous owner under the indemnification.
SWM-B contests the Assessment based on Article 150, VI of the Brazilian Federal Constitution of 1988, which grants immunity from ICMS taxes to papers used in the production of books, newspapers and periodicals, or immune papers, and the raw material inputs used to produce immune papers. SWM-B further contends that the statutory provision relied on by the State of Rio de Janeiro to argue that ICMS tax credits generated in the course of the production of immune papers must be reversed rather than applied to other ICMS taxes owed violates the Brazilian Federal Constitution and the legal principle of non-cumulativity for ICMS tax set forth in Article 155, Section 2, II, of the Brazilian Federal Constitution of 1988. Additionally, SWM-B contends that the statutory provisions relied on by the government do not address immunity from the incidence of the ICMS tax, but are addressed to exception from the tax. This distinction is central to SWM-Bs further contention that the only exceptions permitted to the constitutionally mandated principle of non-cumulativity are for exemptions from tax and no exceptions from this principle are permitted in cases of immunity from tax.
The State of Rio de Janeiro tax authorities, based on appeals of the Assessment, reduced the original amount of Assessment 1 by approximately $1.6 million and denied our appeal of Assessment 2. Following these decisions at the administrative level, judicial actions captioned Schweitzer-Mauduit do Brasil S.A. vs State of Rio de Janeiro were filed in the Judiciary Branch of the 11th Public Treasury Court of the State of Rio de Janeiro to annul the tax and to enjoin enforcement pending final adjudication of the Assessment. The courts issued injunctions, which were upheld on appeal, against enforcement of the Assessment
without the requirement for any bond or posting of other collateral by SWM-B, pending final determination of SWM-Bs action to annul the tax debits.
In August and November 2003, the judges hearing the challenges in the State of Rio de Janeiro ruled in SWM-Bs favor in its suits to vacate Assessment 2 and Assessment 1, respectively, affirming the bases of SWM-Bs legal challenges of the Assessment. The State of Rio de Janeiro automatically appealed these favorable decisions. On May 4, 2004, the 1st Civil Chamber of the Court of Appeals of the State of Rio de Janeiro entered an order, published on June 7, 2004, granting the State of Rio de Janeiros appeal of the lower courts decision annulling Assessment 2 against SWM-B. The appellate court reached its decision based on a majority vote of the 3-judge panel, with 1 judge issuing a written dissenting opinion. In June 2004, SWM-B filed a motion and supporting brief with the appellate court for a rehearing en banc. On August 24 2004, the 9th Civil Chamber of the Court of Appeals of the State of Rio de Janeiro entered an order, published on October 29, 2004, denying the State of Rio de Janeiros appeal of the lower courts decision annulling Assessment 1 against SWM-B. The State of Rio de Janeiro automatically appealed this favorable decision.
SWM-B continues to vigorously contest the Assessment and believes that the Assessment will ultimately be resolved in its favor. However, the final resolution of this matter may entail judicial proceedings up to and including presentation of the matter to the Supreme Court of Brazil and is not likely to be finally resolved for several years. Based on the foreign currency exchange rate at December 31, 2004, the Assessment, as reduced in August 2001, totaled approximately $14.0 million as of December 31, 2004, of which approximately $6.4 million is covered by the above-discussed indemnification. No liability has been recorded in our consolidated financial statements for the Assessment based on our evaluation that SWM-B is more likely than not to prevail in its challenge of the Assessment under the facts and law as presently understood.
In February 2004, SWM-B filed suit against the State of Rio de Janeiro to recover ICMS credits previously reversed in 2000 following receipt of the Assessment. After the Assessment was filed against us, SWM-B changed its procedures and did not utilize ICMS tax credits through the end of production and sale of immune papers during 2001. As a result of having received the August and November 2003 favorable lower court rulings to the above Assessment 2 and Assessment 1, respectively, SWM-B petitioned the court for permission to offset overpaid ICMS taxes against current tax liabilities. SWM-B believes it has a reasonable chance of success in this case. The amount of the claim totals approximately $1.5 million, based on the foreign currency exchange rate at December 31, 2004. During March 2004, the court rejected SWM-Bs claim, which decision SWM-B has appealed. As of December 31, 2004, no asset has been recorded for this potential recovery.
In connection with our spin-off from Kimberly-Clark and pursuant to the resulting Transfer, Contribution and Assumption Agreement and the related Distribution Agreement between Kimberly-Clark and us dated October 23, 1995, we undertook to indemnify and hold Kimberly-Clark harmless from claims and liabilities related to the businesses transferred to us that were not identified as excluded liabilities in the above-mentioned agreements. To date, no claims which we deem material to our financial condition or results of operations have been tendered to us under this indemnification that have not been previously disclosed. As of the date of these financial statements, there are no claims pending under this indemnification that we deem to be material.
Our operations are subject to federal, state and local laws, regulations and ordinances relating to various environmental matters. The nature of our operations expose us to the risk of claims with respect to
environmental matters, and there can be no assurance that material costs or liabilities will not be incurred in connection with such claims. While we have incurred in the past several years, and will continue to incur, capital and operating expenditures in order to comply with environmental laws and regulations, we believe that our future cost of compliance with environmental laws, regulations and ordinances, and our exposure to liability for environmental claims and our obligation to participate in the remediation and monitoring of certain hazardous waste disposal sites, will not have a material adverse effect on our financial condition or results of operations. However, future events, such as changes in existing laws and regulations, or unknown contamination of sites owned, operated or used for waste disposal by us (including contamination caused by prior owners and operators of such sites or other waste generators) may give rise to additional costs which could have a material adverse effect on our financial condition or results of operations.
We incur spending necessary to meet legal requirements and otherwise relating to the protection of the environment at our facilities in the United States, France, Brazil, Indonesia and Canada. For these purposes, we incurred total capital expenditures of $2.1 million in 2004, and anticipate that we will incur approximately $1 million in both 2005 and 2006, of which no material amount is the result of environmental fines or settlements. The foregoing capital expenditures are not expected to reduce our ability to invest in other appropriate and necessary capital projects and are not expected to have a material adverse effect on our financial condition or results of operations.
Not applicable. There were no matters submitted to a vote of our security holders during the fourth quarter of 2004.
Item 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Since November 30, 1995, our common stock, $0.10 par value, or Common Stock, has been listed on the New York Stock Exchange, trading under the symbol SWM. On February 28, 2005, our stock closed at $34.05 per share.
The table below presents the high and low sales prices of our Common Stock on the New York Stock ExchangeComposite Transactions reporting system during the periods indicated.
As of March 3, 2005, there were 4,355 stockholders of record.
We have declared and paid cash dividends of $0.15 per share of our Common Stock every fiscal quarter since the second quarter of 1996. We currently expect to continue this level of quarterly dividend. We have credit agreement covenants that require us to maintain certain financial ratios, as disclosed in Note 3 of the Notes to Consolidated Financial Statements, none of which under normal business conditions materially limit our ability to pay such dividends, and we do not currently anticipate any change in business conditions of a nature that would cause future restrictions on dividend payments as a result of our need to maintain these financial ratios.
The following table provides information, as of December 31, 2004, with respect to the shares of our common stock that may be issued under our existing equity compensation plans:
(1) The Equity Participation Plan is described in Note 6 of the Notes to Consolidated Financial Statements appearing in Part II, Item 8 herein.
(2) The Outside Directors Stock Plan consists of shares registered for the purpose of issuance to our outside Directors for payment of their retainer fees quarterly in advance. Directors retainer fees are $6,750 quarterly, which are payable in our common stock. The number of shares issued each quarter is determined based on the then fair market value of the shares, which is determined in accordance with the plan as the average of the high and low price of our common stock on the last business day preceding the date of issuance. Certain Directors have elected to defer receipt of quarterly retainer fees under the terms of our Deferred Compensation Plan for Non-Employee Directors, resulting in an accumulation of stock unit credits. The Director has the option, upon retirement or earlier termination from the Board of Directors, to have these stock unit credits distributed in the form of our common stock or in the form of cash. While held in the deferred compensation plan account, these stock unit credits carry no voting rights and cannot be traded as common stock, although declared dividends create additional stock unit credits. As of December 31, 2004, deferred retainer fees have resulted in 18,701 accumulated stock unit credits, excluding credited dividends (19,988 accumulated stock unit credits including credited dividends).
(3) The Restricted Stock Plan is described in Note 6 of the Notes to Consolidated Financial Statements appearing in Part II, Item 8 herein. Shares awarded under the terms of this plan are both subject to forfeiture and cannot be sold or otherwise transferred until fully vested or such restrictions are otherwise lifted. Such shares are deemed by us to be issued and outstanding and are subject to all other financial interests, including our declared dividends. As of December 31, 2004, 54,000 shares issued under this plan remained restricted.
We have had no unregistered sales of equity securities during the fiscal year ended December 31, 2004.
During fiscal 2003 and 2004, we repurchased 495,047 shares of our Common Stock having a value of $13.1 million pursuant to authorizations to purchase up to $20.0 million approved by the Board of Directors. The number and average price of Common Stock shares purchased in each month of the fourth quarter of fiscal 2004 are set forth in the table below:
* As announced in our press release dated January 30, 2003, the Board of Directors authorized the repurchase of shares of our Common Stock during the period January 1, 2003 through December 31, 2004 in an amount not to exceed $20.0 million. This repurchase of equity securities program expired on December 31, 2004.
On December 2, 2004, our Board of Directors authorized us to repurchase up to an additional $20.0 million of our Common Stock during the period January 1, 2005 to December 31, 2006. Corporate 10b5-1 plans have been used by us so that share repurchases can be made at predetermined stock price levels, without restricting such repurchases to specific windows of time. Future common stock repurchases will be dependent upon various factors, including the stock price, strategic opportunities and cash availability.
Item 6. Selected Financial Data
The following selected financial data should be read in conjunction with Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operation, and the consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K. The following selected financial data was prepared using the consolidated financial statements that appear elsewhere in this Annual Report on Form 10-K.
All dollar amounts are in millions except per share amounts, statistical data and ratios.
(1) 2001 operating profit included a $5.1 million pre-tax restructuring charge related to our Brazilian business exiting the Brazilian market for printing and writing uncoated papers and the resulting
shutdown of one of its paper machines. This restructuring charge reduced net income by $3.4 million, or $0.23 per share.
(2) Capital spending for 2004, 2003 and 2002 included $7.2 million, $63.0 million and $8.9 million, respectively, for the new reconstituted tobacco leaf production line at our mill in Spay, France.
(3) Capital spending for 2002, 2001 and 2000 included $0.4 million, $50.1 million and $12.7 million, respectively, for the banded cigarette paper capital project at our Spotswood mill.
(4) Cash provided by operations included advance payments from customers for future product sales amounting to $50.6 million in 2001 and $8.0 million in 2000 related to the banded cigarette paper project.
Net operating working capitalaccounts receivable and inventory less accounts payable and accrued liabilities
Current ratiocurrent assets divided by current liabilities
Total debt to capital ratiocurrent debt and long-term debt divided by current debt, long-term debt, minority interest and total stockholders equity
Net income return on equitynet income divided by average stockholders equity
Operating profit return on assetsoperating profit divided by average total assets
The following is a discussion of our results of operations and current financial condition. This discussion should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report and the selected financial data included in Item 6. The discussion of our results of operations and financial condition includes various forward-looking statements about our markets, the demand for our products and our future prospects. These statements are based on certain assumptions that we consider reasonable. For information about risks and exposures relating to us and our business, you should read the section entitled Factors That May Affect Future Results, beginning on page 50.
The Managements Discussion and Analysis of Financial Condition and Results of Operation is designed to provide a reader of our financial statements with an understanding of our recent performance, our financial condition and our prospects. The following will be discussed and analyzed:
· Chief Executive Officers Summary
· Recent Developments
· Industry Trends
· Critical Accounting Policies and Estimates
· Recent Accounting Pronouncements
· Results of Operations
· Liquidity and Capital Resources
· Other Factors Affecting Liquidity and Capital Resources
· Factors That May Affect Future Results
· Forward-Looking Statements
We are a multinational diversified producer of premium specialty papers and the worlds largest supplier of fine papers to the tobacco industry. We are the premier manufacturer of high porosity papers, which are used in manufacturing ventilated cigarettes, and the leading independent producer of reconstituted tobacco leaf used in producing blended cigarettes. We conduct business in over 90 countries and currently operate 10 production locations worldwide, with mills in the United States, France, Brazil, Indonesia and Canada.
We manufacture and sell paper and reconstituted tobacco products to the tobacco industry as well as specialized paper products for use in other applications. Tobacco industry products, which comprised 93 percent of our net sales for the years ended December 31, 2004 and 2003, include cigarette, plug wrap and tipping papers used to wrap various parts of a cigarette; reconstituted tobacco leaf for use as filler in cigarettes; reconstituted tobacco wrappers and binders for cigars; and paper products used in cigarette packaging. These products are sold directly to tobacco companies or their designated converters in North and South America, western and eastern Europe, Asia and elsewhere.
Non-tobacco industry products include lightweight printing and writing papers, coated papers for packaging and labeling applications, business forms, furniture laminates, battery separator paper, drinking straw wrap, filter papers and other specialized papers, primarily for the North American, western European and Brazilian markets. These products are generally sold directly to converters and other end-users in North America and western Europe and through brokers in Brazil.
We maintain an Internet Web site address at www.schweitzer-mauduit.com. The Web site provides additional background information including further information on our history, products, and locations.
I am pleased to report that in 2004 Schweitzer-Mauduits diluted earnings per share increased by 4 percent to $2.36. During the year, our common stock price increased by 14 percent. Including the common stock dividend, stockholders realized a gain of 16 percent.
Our capital expansion projects are progressing. The new reconstituted tobacco leaf (RTL) production line in Spay, France achieved end-of-startup-curve operation mid-2004 and contributed to a 29 percent increase in RTL unit sales for 2004. Capital spending to implement the cigarette paper manufacturing strategy is nearly completed with the mid-year start-up of a rebuilt cigarette paper machine at our Spotswood, New Jersey mill and the January 2005 start-up of a new cigarette paper machine at our mill in Santanesia, Brazil. All of these projects are expected to contribute positively to financial results in 2005. After higher levels of capital spending of $92.0 million in 2003 and $46.7 million in 2004, spending in 2005 will be in the range of $30 million.
Consistent with our long-term Asian manufacturing strategy, in February 2004 one of the Companys subsidiaries, Schweitzer-Mauduit France S.A.R.L, acquired the outstanding stock of P.T. Kimsari Paper Indonesia (Kimsari), a specialty paper manufacturer located in Medan, Sumatra, Indonesia. Schweitzer-Mauduit France paid $8.4 million for the outstanding shares of Kimsari, funded through existing bank lines of credit.
Kimsari was formed in 1984 and began production of cigarette paper in 1985. Schweitzer-Mauduits French subsidiary, Papeteries de Mauduit, or PDM, was involved in the design and construction of the Kimsari mill in the mid-1980s, has provided intermittent technical support and licensed Kimsari to utilize the PDM trademark in the marketing of Kimsaris products in Indonesia. Since the acquisition, the marketing and sales of products are being coordinated with the efforts of Schweitzer-Mauduits French operations in the southeast Asian market. In recognition of the affiliation with PDM and the continued use of the PDM trademark, the name of Kimsari was changed to P.T. PDM Indonesia. P.T. PDM Indonesia was accretive to consolidated earnings in its first year as part of our Company.
In November, we reached agreement to acquire the tobacco-related paper manufacturing assets of a business in the Philippines for $11.3 million, subject to working capital adjustments. This acquisition is expected to be completed in the second quarter of 2005, after all applicable operating and environmental permits are transferred. This acquisition, combined with our Indonesian operation, will give us the ability to significantly expand market share in the southeast Asian market.
China Joint Venture
Our discussions with the Chinese State Tobacco Monopoly Administration have progressed. We are optimistic that a joint venture to construct and operate a paper mill to produce tobacco-related papers will be approved by the appropriate Chinese government agencies in 2005.
During 2004, Schweitzer-Mauduit maintained its position as the worlds leading supplier of tobacco-related papers and expanded its position as the leading independent producer of reconstituted tobacco leaf used in manufacturing blended cigarettes.
Worldwide cigarette production continued its long-term trend of increasing about 1 percent per year, and worldwide production of ventilated and blended cigarettes continued to grow by estimated annual rates of 4 and 2 percent, respectively. The ventilated and blended segments continue to be faster growing segments of the worldwide cigarette market. The increase in demand for these types of cigarettes is a factor in providing growth for the Companys tobacco-related products. Ventilated and blended cigarettes require the type of higher quality tobacco-related papers and reconstituted tobacco leaf made by the Company.
Cigarette production in both North America and western Europe declined by approximately 1.5 percent in 2004. Production increased in Asia, eastern Europe and Latin America, areas where our business strategy has us well positioned to participate.
Sale of lower ignition propensity cigarettes began in New York State in June, and nationwide sale in Canada is possible in the fourth quarter of 2005. Some news articles refer to these cigarettes as reduced fire risk cigarettes. Our company is supplying cigarette manufacturers with patent-protected banded cigarette paper for this application. Growth in sales of lower ignition propensity cigarettes is a positive dynamic for the Company.
The addition of 2 new cigarette paper machines by competitors in western Europe in 2003 and 2004 has resulted in excess capacity in that region which may result in a near term decline in cigarette paper sales from our French business unit. Continued weakness of the U.S. dollar versus the euro could support future selling price increases.
The Companys sales totaled $657.5 million, a 16 percent improvement compared to 2003. The improvement was the result of increased sales volumes, changes in currency exchange rates, an improved mix of products sold and higher average selling prices.
Compared to 2003, total sales volumes increased 9 percent. Sales volumes for the French businesses increased by 11 percent and sales volumes for the Brazilian business increased 9 percent while U.S. sales volumes decreased 2 percent. The Indonesian business sales volumes were up 24 percent year-over-year, although 2003 and January 2004 sales are not included in our financial results.
Operating profit was $57.7 million, a 7 percent improvement. Operating profit was favorably affected by increased sales volumes and higher average selling prices, partially offset by increased wood pulp, labor, energy, employee benefit and nonmanufacturing expenses. Additionally, pre-operating and start-up costs totaling $3.7 million related to rebuilt and new machines were incurred in the United States, Brazil and France, as well as $1.2 million of Paris, France office closure expenses. Sarbanes-Oxley Section 404 compliance costs for the year were about $1.3 million. These various cost items, in addition to inflationary cost increases and the impact of currency exchange rate changes, caused operating profit return on net sales to decline from 9.5 percent in 2003 to 8.8 percent in 2004.
The effective income tax rate was 22 percent compared to 23 percent for 2003. Minority interest was higher by $2.1 million due to improved earnings at LTR Industries.
Net income was $36.4 million, a 6 percent increase compared to 2003. Diluted earnings per share were $2.36 compared to $2.28 in 2003.
During 2004, 273,356 shares of the Companys common stock were repurchased at a total cost of $8.0 million. Our Board of Directors authorized the further repurchase of shares during the period January 1, 2005 through December 31, 2006 in an amount not to exceed $20.0 million.
Phillip Morris Supply Agreement
On December 20, 2004, we announced that we had reached an agreement with Philip Morris USA Inc. to continue our strategic supply agreement for fine papers. The term of the agreement is from January 1, 2005 to December 31, 2007. The strategic supply agreement continues our ongoing supply of tobacco-related papers to Philip Morris USA Inc. The two companies have been operating under a strategic supply agreement since January 1, 1993.
On November 15, 2004, we announced that an agreement had been finalized whereby one of our subsidiaries will acquire the tobacco-related paper manufacturing assets of KCPI, a Philippines company. The assets to be acquired include land, buildings, production equipment and related utilities and support assets. The purchase price will be $11.3 million, subject to working capital adjustments. This acquisition is expected to be completed in the second quarter of 2005, after all applicable operating and environmental permits are transferred.
KCPI has engaged in the manufacturing of tobacco-related paper products for the Philippines cigarette industry since 1967 and currently has approximately a 60 percent market share of the Philippines cigarette paper market. Products include cigarette paper, conventional plug wrap and both base and printed tipping paper. All of the tobacco-related paper sales are currently within the Filipino market. The production equipment being acquired includes 2 paper machines, with annual production capacity of approximately 8,500 metric tons, and related converting equipment. Net sales for the tobacco-related papers business for the fiscal year ended December 31, 2004 were $11 million. The business currently employs approximately 100 people.
The acquisition of the tobacco-related paper manufacturing assets in the Philippines is consistent with our long-term strategy for operations in Asia. This purchase will improve our ability to address the needs of
our customers in both the Philippines and the southeast Asian market. We plan to upgrade the production capabilities of the manufacturing equipment and the quality of the products being produced to better support the demand for tobacco-related papers in the region.
Lower Ignition Propensity Cigarettes
Regulations are being developed in Canada that would require lower cigarette ignition propensity properties. The proposed regulations mandate an ignition propensity standard for all cigarettes manufactured or imported into Canada on or after October 1, 2005. The final standard and the actual implementation date are still subject to change, although we expect Canada to implement the proposed requirements effective in the fourth quarter of 2005.
On January 26, 2005, we entered into Amendment No. 3 to the Credit Agreement dated as of January 31, 2002, or the Amendment (see Note 3 of the Notes to Consolidated Financial Statements). This Amendment is among Schweitzer-Mauduit International, Inc., Schweitzer-Mauduit France S.A.R.L, a French corporation, and a group of banks led by Société Générale as agent for the banks. Under the Amendment, we renewed our 364-day revolving credit facility under the Credit Agreement, extending these facilities from January 27, 2005 to January 26, 2006. This Amendment also increased the amount available to us under the 364-day revolving credit facility in U.S. dollars from $10.0 million to $15.0 million and reduced the amount available to us in euros from 12.0 million to 8.0 million.
Although our Indonesian operation, which was acquired in February 2004, is located in Medan on the island of Sumatra, its operations and sales were fortunately not affected by the earthquake and tsunami that struck Indonesia in late December.
Consistent with recent historical trends, worldwide cigarette consumption is expected to increase at a rate of approximately one-half to one percent per year. The anticipated decline in the production of cigarettes in developed countries is expected to be more than offset by increased cigarette production in developing countries that currently represent approximately 70 percent of worldwide cigarette production. Age demographics and expected increases in disposable income will support the increased consumption of cigarettes in developing countries. In addition, the litigation environment is different in most foreign countries compared with the United States, having less of an impact on the pricing of cigarettes, which, in turn, affects cigarette consumption. Cigarette production in the United States is expected to continue to decline as a result of a decline in domestic cigarette consumption caused by increased cigarette prices, health concerns and public perceptions. As well, cigarette consumption has declined in France and Germany following recent tax increases on cigarette sales in those countries.
The cigarette paper market in western Europe has recently become more competitive, with pressure on both sales volumes and selling prices, caused by reduced cigarette consumption in several large European markets and new cigarette paper manufacturing capacity that was added in western Europe in mid-2004.
In developing countries, there is a trend toward consumption of more sophisticated cigarettes, which utilize higher quality tobacco-related papers, such as those we produce, and reconstituted tobacco leaf. This trend toward more sophisticated cigarettes reflects increased governmental regulations concerning tar delivery levels and increased competition from multinational cigarette manufacturers.
Based on these trends, we expect worldwide demand for our products to continue to increase, with a shift from developed countries to developing countries. As a result, we are increasing some of our production capacity in developing countries such as Brazil, Indonesia and the Philippines.
Our accompanying financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which require management to make estimates that affect the amounts of revenues, expenses, assets and liabilities reported and disclosure of contingencies. Following are 3 critical accounting matters, which are very important to the portrayal of our financial condition and results and required managements most difficult, subjective or complex judgments. We discussed with the Audit Committee of the Board of Directors the estimates and judgments made for each of these items and our accounting for and presentation of these items in the accompanying financial statements. The accounting for these matters was based on current facts and circumstances which, in our judgment, hold potential for change which could affect our future estimates such that future financial results could differ materially from financial results based on managements current estimates.
Our critical accounting policies and estimates arise in conjunction with the following:
· income tax expense and accruals
· pension benefits expense and accruals
· litigation contingencies
Accounting for Income Taxes
We use the asset and liability method of accounting for income taxes. Under this method, income tax expense is recognized for the amount of taxes payable or refundable for the current year and for deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entitys financial statements or tax returns. We must make assumptions, judgments and estimates to determine our current provision for income taxes and also our deferred tax assets and liabilities and any valuation allowance to be recorded against a deferred tax asset. Our judgments, assumptions and estimates relative to the current provision for income taxes take into account current tax laws, our interpretation of current tax laws and possible outcomes of current and future audits conducted by foreign and domestic tax authorities. Changes in tax law or our interpretation of tax laws and the resolution of current and future tax audits could significantly impact the amounts provided for income taxes in our consolidated financial statements. Our assumptions, judgments and estimates relative to the value of a deferred tax asset take into account predictions of the amount and category of future taxable income. Actual operating results and the underlying amount and category of income in future years could render our current assumptions, judgments and estimates of recoverable net deferred taxes inaccurate. Any of the assumptions, judgments and estimates mentioned above could cause our actual income tax obligations to differ from our estimates, thus materially impacting our financial position and results of operations.
We record and maintain income tax valuation allowances as necessary to reduce deferred tax assets to an amount which is estimated more likely than not to be realizable in accordance with Financial Accounting Standards Board, or FASB, Statement of Financial Accounting Standards, or SFAS, No. 109, Accounting for Income Taxes. We have available net operating loss carryforwards, excess foreign tax credit carryforwards, alternative minimum tax credit carryforwards and other various tax credits in the jurisdictions in which we operate, for which we have recorded deferred tax assets totaling $26.3 million as of December 31, 2004. Certain of these potential future benefits are not expected to be utilized in a manner beneficial to our financial results prior to their expiration. As a result, as of December 31, 2004, we
have $5.8 million of valuation allowances against certain of the deferred tax assets, as follows (dollars in millions):
Under current tax laws governing jurisdictions in which we have net operating loss carryforwards, or NOLs, remaining NOLs in France carry forward indefinitely and NOLs in Spain expire 10 years subsequent to the year generated. We expect sufficient future taxable income in France to fully utilize the French NOLs, which carry forward indefinitely and for which no valuation allowances have been recorded as of December 31, 2004. The remaining NOLs at December 31, 2004 in Spain will fully expire in 2014 if not utilized against taxable income in Spain. Valuation allowances related to NOLs in Spain totaled $2.8 million as of December 31, 2004, fully reserving the related deferred tax asset in Spain, since we believe that it is reasonably likely that we will not generate taxable income in Spain prior to the expiration of these NOLs, as SM-Spain only functions as the primary foreign investment holding company for us.
We receive credits in our U.S. federal income tax return for income taxes paid in foreign jurisdictions. Income from foreign sources, including dividend income paid from foreign subsidiaries, is included in taxable income of the U.S. parent. In some cases, the amount of credits realized in the tax return is more or less than the tax owed on the foreign source income. When the amount of credits exceeds the amount of taxes owed on that foreign source income, foreign tax credit carryforwards are generated. When the credits are less than the tax owed, unexpired credit carryforwards from prior years can be utilized in certain circumstances. These circumstances are dependent upon both foreign source and domestic taxable income. Due to the recent low level of the U.S. business units profitability, we have implemented certain income tax elections to accelerate taxable income or to delay deductions in order to maintain positive domestic taxable income (e.g. our election to capitalize research costs in the year incurred for U.S. income tax purposes and amortize over a 10 year life, as opposed to taking the income tax deduction in the year incurred). However, many such actions cannot be repeated in future years and certain of those elections may make it more difficult to have positive domestic taxable income in future periods. The profitability of our U.S. business operations must improve to provide us an opportunity to utilize foreign tax credit carryforwards in the future in a manner that will be beneficial to our financial results. However, the American Jobs Creation Act of 2004, enacted during October 2004, increased the carryforward period of foreign tax credits from 5 to 10 years. Based on this extension of the carryforward period, together with the current and forecasted profitability of our U.S. business operations and the requirements of the foreign source income and credit calculations, we currently believe that we will partially utilize the foreign tax credit carryforwards in an earnings beneficial manner prior to their expiration and, therefore, we have partially reserved these deferred tax assets as of December 31, 2004 with $1.8 million of valuation allowances, reducing the net deferred tax asset to an amount that we estimate we will be able to realize. We regularly update our estimates of domestic taxable income in order to evaluate whether the facts and circumstances have changed such that we must change our valuation allowances on these deferred tax assets.
Likewise, our carryforwards of federal research credits, U.S. state tax credits and Canadian provincial tax credits require applicable taxable income in the respective tax returns in order to be utilized prior to their expirations. We expect that we will be able to fully utilize our federal research credits, which have a 20 year
carryforward period, and Canadian provincial tax credits prior to their expiration. However, we do not currently expect sufficient future taxable income in our U.S. state income tax returns to be able to utilize all of our state tax credits prior to their expiration, primarily in New York and New Jersey, where the carryforward periods are 15 and 7 years, respectively, and credit utilization is limited to 50 percent of the income tax liability. As a result, we have $1.2 million of valuation allowances reducing our deferred tax assets to amounts that we estimate we will be able to realize. We regularly update these estimates in order to evaluate whether the facts and circumstances have changed such that we must change our valuation allowances on these deferred tax assets.
Under current U.S. tax law, federal alternative minimum tax, or AMT, credit carryforwards have no expiration. We believe that profitability will improve in our U.S. operations in future years. Since the federal AMT credit carryforwards have no expiration, we believe it is more likely than not that we will be able to realize the full benefit of these credits in future years, and thus we do not believe any valuation allowance against these deferred tax assets is appropriate as of December 31, 2004.
In summary, of our valuation allowances at December 31, 2004, $2.8 million relates to NOLs in Spain, $1.8 million relates to foreign tax credit carryforwards for purposes of U.S. federal income taxes and $1.2 million relates to U.S. state credits. We do not expect to generate taxable income in Spain prior to expiration of NOLs in that jurisdiction. The $1.8 million related to foreign tax credits and the $1.2 million related to state tax credits are dependent upon taxable income in the United States. We do anticipate increased profitability in the United States in the future, but not in sufficient enough amounts to fully realize these deferred tax assets in a beneficial manner prior to the expiration of the underlying credits. It is possible that our estimates of future profitability in the United States could change from our current estimates based on business results or actions taken by us which effect taxable income. While we do not currently believe it is likely that a material change will occur, it is possible that changes in these factors, changes in the level of foreign source income or a change in the likelihood of foreign tax credit utilization in an earnings beneficial manner, could result in an adjustment of our valuation allowances in future periods. Due to the number of uncertain factors and the complexities of the calculations, it is not possible to reasonably estimate what future impact could occur.
While we believe it is more likely than not that we will be able to realize the $20.5 million of estimated net deferred income tax benefits, it is possible that the facts and circumstances on which our estimates and judgments are based could change, which could result in additional income tax expense in the future to increase the associated valuation allowances. However, we continue to evaluate possible methods to favorably utilize those assets that are reserved and, therefore, it is also possible that changes in the facts and circumstances on which our estimates and judgments are based could benefit us in the future by some of the $5.8 million of deferred tax assets reserved as of December 31, 2004.
For additional information regarding income taxes and valuation allowances, see Note 4 of the Notes to Consolidated Financial Statements.
We recognize the estimated compensation cost of employees pension benefits over their approximate period of service to us in accordance with SFAS No. 87, Employers Accounting for Pensions. Our earnings are impacted by amounts of expense recorded related to pension benefits, which primarily consist of U.S. and French pension benefits. Each years recorded expense is an estimate based on actuarial calculations of our accumulated and projected benefit obligations for our various plans.
The calculations of pension benefit obligations and expenses require decisions about a number of key assumptions that can significantly affect liability and expense amounts, including the discount rate used to calculate plan liabilities, the expected long-term rate of return on plan assets and the projected rate of future compensation increases. We evaluate these assumptions at least once each year, or as facts and
circumstances dictate, and make changes as conditions warrant. We determine these actuarial assumptions, after consultation with our actuaries, on December 31 of each year to calculate liability information as of that date and pension expense for the following year. Changes to these assumptions will increase or decrease our reported income, which will result in changes to the recorded benefit plan assets and liabilities. We believe that our selections for these key actuarial assumptions are reasonable estimates for our plans and experience.
Our U.S. employee pension plans accounted for approximately 70 percent of our total pension plan assets and total accumulated benefit obligations, as of December 31, 2004.
The table below shows the assumptions that we used and will use to calculate U.S. pension expenses for the years shown:
The discount rates used for our determination of projected benefit obligations and accumulated benefit obligations for our U.S. employee pension plans fluctuate from year to year based on current market interest rates for high-quality fixed-income investments. We also evaluate the expected average duration of our pension obligations in determining our discount rate. The discount rate assumption is determined based on the internal rate of return for a portfolio of high quality bonds (Moodys Aa Corporate bonds) with maturities that are consistent with projected future plan cash flows. A change in the discount rate assumption of 0.25 percent would change our estimated 2005 U.S. pension expense by approximately $0.3 million.
The assumed long-term rate of return on plan assets is determined by evaluating historical and projected returns for benchmark equity and fixed income market indices as well as the projected investment mix of our pension assets. Actual rates of return (loss) earned on U.S. pension plan assets, net of expense, for each of the last 7 years, the period of time we have managed our pension assets were:
We changed our target U.S. pension asset investment mix during 2003 and increased our expected return on plan assets to 9.0 percent for 2004. We utilized a Monte Carlo simulation analysis on the target U.S. pension asset investment mix to determine our expected return on plan assets for both 2004 and 2005. For 2005, we will maintain the expected rate of return on plan assets at 9.0 percent, the same as for 2004. The current asset allocation policy of our U.S. employee pension plan targets an allocation of 65 percent in equity securities, 25 percent in fixed income securities and 10 percent in other investments. A change in the long-term rate of return on plan assets assumption of 0.50 percent would change the estimated 2005 U.S. pension expense by approximately $0.3 million.
The rate of annual compensation increase is directly related to negotiated union contracts for our U.S. hourly employees and wage adjustment guidelines for our U.S. salary employees.
Despite our belief that the estimates are reasonable for these key actuarial assumptions, future actual results will likely differ from our estimates, and these differences could materially affect the future financial statements either favorably or unfavorably. Additionally, it is possible that assets of our plans
could decline as a result of negative investment returns, which combined with increasing amounts of accumulated benefit obligations, could result in us being required to make significant cash contributions to the plans in future periods.
For additional information regarding pension plan assets, benefit obligations and accounting assumptions, see Note 5 of the Notes to Consolidated Financial Statements.
We evaluate contingencies in accordance with SFAS No. 5, Accounting for Contingencies. Accordingly, when a material loss contingency exists, we accrue an estimated loss when the likelihood that the future event or events will confirm the loss or impairment of an asset or the incurrence of a liability is probable and the amount of loss can be reasonably estimated. If no accrual is made for a material loss contingency because both of the above conditions are not met, or if an exposure to loss exists materially in excess of an accrual that is made, disclosure regarding the contingency is made when there is at least a reasonable possibility that a loss or additional loss may have been incurred.
As described in detail under Litigation in Part I, Item 3, Legal Proceedings, SWM-B received 2 assessments from the taxing authorities of the State of Rio de Janeiro, Brazil related to ICMS taxes, or the Assessment. As of December 31, 2004, the Assessment totaled approximately $14.0 million, of which approximately $6.4 million is covered by an indemnification agreement with the former owner of the predecessor of SWM-B, for a net exposure of approximately $7.6 million. In 2001, the courts granted SWM-B relief from having to bond the potential tax liability while we challenge the Assessment. In August and November 2003, the court hearing the challenges in the State of Rio de Janeiro ruled in SWM-Bs favor in its suits to vacate the Assessment, affirming the bases of SWM-Bs legal challenges of the Assessment. While the favorable decisions by the court with respect to the Assessment provide further support for SWM-Bs positions, these decisions were automatically appealed, as provided for under Brazilian legislation for cases involving an adverse financial outcome for the government in lower courts. In June 2004, the 1st Civil Chamber of the Court of Appeals of the State of Rio de Janeiro granted the appeal of the lower courts decision annulling 1 of the Assessments against SWM-B. The appellate court reached its decision based on a majority vote of the 3-judge panel, with 1 judge issuing a written dissenting opinion. In June 2004, SWM-B filed a motion and supporting brief with the appellate court for a rehearing en banc. In August 2004, the 9th Civil Chamber of the Court of Appeals of the State of Rio de Janeiro denied the State of Rio de Janeiros appeal of the lower courts decision annulling the other assessment against SWM-B. The State of Rio de Janeiro automatically appealed this favorable decision.
SWM-B continues to vigorously contest the Assessment and believes the final resolution of this matter may entail judicial proceedings up to and including presentation of the matter to the Supreme Court of Brazil and is not likely to be finally resolved for several years. Our current evaluation of the matter is that SWM-B is more likely than not to prevail in its challenge of the Assessment under the facts and law as presently understood and no reserve has been provided for this contingent liability. However, there is a reasonable possibility that SWM-B will ultimately be required to pay all or a portion of this contingent liability, which could adversely impact our future financial results or financial condition.
In February 2004, SWM-B filed suit against the State of Rio de Janeiro to recover ICMS credits previously reversed in 2000 following receipt of the Assessment. After the Assessment was filed against us, SWM-B changed its procedures and did not utilize ICMS tax credits through the end of production and sale of immune papers during 2001. As a result of the favorable developments during 2003 mentioned above with respect to the Assessment, SWM-B petitioned the court for permission to offset approximately $1.5 million of overpaid ICMS taxes against current tax liabilities. During March 2004, the court rejected SWM-Bs claim, which decision SWM-B has appealed. Although SWM-B believes it has a reasonable chance of success in this case, no asset has been recorded for this potential recovery.
In December 2004, FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, or SFAS 123R, which replaces SFAS No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS 123R requires the measurement of all share-based payments to employees, including grants of employee stock options, using a fair-value-based method and the recording of such expense in our consolidated statements of income. The accounting provisions of SFAS 123R are effective for reporting periods beginning after June 15, 2005. This statement requires companies to calculate the fair value of stock options granted to employees, and amortize that amount over the options vesting period as an expense through the income statement. The pro forma disclosures previously permitted under SFAS 123 will no longer be an alternative to financial statement recognition. See Note 2 of the Notes to Consolidated Financial Statements for the pro forma net income and net income per share amounts for fiscal 2002 through fiscal 2004, where we used a fair-value-based method under SFAS 123 to measure compensation expense for employee stock incentive awards. We are evaluating the requirements under SFAS 123R and expect to begin expensing stock options in the third quarter of 2005, which is expected to increase 2005 non-cash operating expenses by approximately $1 million, using similar assumptions and methodology as disclosed in Note 2 of the Notes to the Consolidated Financial Statements.
In December 2004, the FASB issued FASB Staff Position No. FAS 109-1, or FAS 109-1, Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004. The American Jobs Creation Act, or AJCA, introduced a special 9 percent tax deduction on qualified production activities. FAS 109-1 clarified that this tax deduction should be accounted for as a special tax deduction in accordance with SFAS No. 109 and not as a tax rate change. We do not expect the adoption of this new tax provision to have a material impact on our consolidated financial position, results of operations or cash flows.
In December 2004, the FASB issued FASB Staff Position No. FAS 109-2, or FAS 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creations Act of 2004. The AJCA introduced a limited time 85 percent dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer, or Repatriation Provision, provided certain criteria are met. FAS109-2 provides accounting and disclosure guidance for the Repatriation Provision. Although FAS 109-2 is effective immediately, we do not expect to be able to complete our evaluation of the Repatriation Provision until after Congress or the Treasury Department provides additional clarifying language on key elements of the provision. In January 2005, the Treasury Department began to issue the first of a series of clarifying guidance documents related to this provision. We expect to complete our evaluation of the effects of the Repatriation Provision during the second quarter of 2005. The range of possible amounts that we are considering for repatriation under this provision is between $0 and $30 million. While we estimate that the related potential range of additional income tax is between $0 and $2 million, this estimate is subject to change following technical correction legislation that we believe is forthcoming from Congress.
We reported net sales of $657.5 million in 2004 compared with $566.9 million in 2003. The increase of $90.6 million, or 16 percent, consisted of the following (dollars in millions):
· An increase of $30.1 million, or 5 percent, in net sales relating to changes in currency exchange rates. This was a direct result of a stronger euro versus the U.S. dollar. The euro was approximately 10 percent stronger against the U.S. dollar, averaging 1.25 euros per dollar in 2004 as compared with 1.14 during 2003. The Brazilian real was on average approximately 5 percent stronger versus the dollar.
· An increase of $27.2 million, or 5 percent, relating to increased sales volumes resulting from internal sales growth. Sales volumes increased by 8 percent, excluding sales of the acquired Indonesian operation.
· Sales volumes of the French segment, excluding Indonesia, increased 11 percent, primarily as a result of increased RTL sales associated with the new RTL production line that began operation during the fourth quarter of 2003.
· Brazil experienced increased sales volumes of 9 percent, attributable to increased sales of tobacco-related papers.
· Sales volumes in the United States declined by 2 percent due to lower North American market demand and changes in the product mix produced in the U.S. mills.
· Higher average selling prices and improved product mix contributed $26.1 million, or 5 percent. New products developed for the United States, including papers for lower ignition propensity cigarettes, allowed for sales growth due to product mix and pricing. Higher average selling prices were in part related to recovery of inflationary cost increases.
· Acquisition of the Indonesian operation in February 2004 contributed $7.2 million, or 1 percent.
Sales of tobacco-related products accounted for 93 percent of net sales for the year ended December 31, 2004, consistent with the prior year.
French segment net sales increased $74.1 million, or 21 percent, from 2003 to 2004. The increase in sales volumes, in large part due to increased capacity in the Spay, France mill of LTR Industries, provided the majority of this increase. This project provided for a third RTL production line and supporting equipment with annual production capacity of approximately 33,000 metric tons, which increased the total annual production capacity at the Spay mill to approximately 80,000 metric tons. Additional increased net sales resulted from favorable currency exchange rates, a direct result of a stronger euro versus the U.S. dollar, and improved average selling prices.
The U.S. segment realized increased net sales of $13.4 million, or 7 percent, compared with 2003. Net sales of the U.S. segment increased as a result of increased selling prices, due to a partial recovery of inflationary cost increases, and a more favorable mix of products. In the Spotswood, New Jersey mill, the U.S. business continued to produce and sell cigarette paper for lower ignition propensity cigarettes. A law that implemented fire safety standards for cigarettes in the State of New York took effect on June 28, 2004. Since that date, all cigarettes sold in New York are required to be capable of meeting a test standard of self-extinguishing at least 75 percent of the time when they are not being smoked. This new law positively impacted the sales volume of cigarette paper for lower ignition propensity cigarettes.
Brazil realized an increase in net sales of $5.3 million, or 12 percent, compared with 2003. The Brazilian segments sales increase was primarily due to increased sales volumes of tobacco-related papers, partially offset by decreased sales volumes of commercial and industrial papers.
The decline in our gross profit margin was related to increased wood pulp, purchased energy and labor expenses as well as a higher amount of pre-operating and start-up costs in 2004. The U.S. list price of northern bleached softwood kraft pulp, a bell-weather pulp grade, increased from an average market list price of $555 per metric ton in 2003 to $640 per metric ton in 2004, a 15 percent increase. Year-over-year, higher per ton wood pulp costs had an unfavorable impact of $4.7 million. Purchased energy costs increased $2.0 million compared with full year 2003. Higher energy costs were experienced in the U.S. business segment related to higher natural gas, fuel oil and electricity costs. Additionally, the stronger euro compared with the U.S. dollar put pressure on the gross profit margin since most of the costs in the French operations are incurred in euros while approximately 25 percent of the sales of the French operations are in U.S. dollars.
In 2004, pre-operating and start-up costs totaling $3.1 million were incurred in the United States and Brazil related to rebuilt paper machines in support of our global sourcing strategy for cigarette papers and an additional $0.6 million of start-up costs were incurred in France related to the new RTL production line. $2.3 million of pre-operating and start-up costs were incurred in 2003 associated with the new RTL production line.
Nonmanufacturing expenses were $9.4 million, or 17 percent, higher than in 2003, primarily due to increases in general and selling expenses. Higher general expenses of $4.4 million included increased costs for employee compensation, benefits and outside services, related in part to Sarbanes-Oxley Act Section 404 compliance activities, which totaled $1.3 million in 2004, in addition to $1.2 million of Paris, France office closure expenses. The $4.0 million increase in selling expense was largely associated with increased sales volumes in France. Changes in exchange rates contributed to higher nonmanufacturing expenses in France.
Operating profit was $57.7 million for 2004, a $3.8 million, or 7 percent, increase from $53.9 million in 2003. Increased sales volumes, an improved mix of products sold and higher average selling prices favorably affected operating profit in 2004. These favorable factors were partially offset by increased wood pulp, labor, purchased energy, employee benefit and nonmanufacturing expenses. In addition, pre-operating and start-up costs totaling $3.1 million related to rebuilt paper machines were incurred in the United States and Brazil in 2004, as well as $1.2 million of Paris, France office closure expenses and $0.6 million of RTL production line start-up costs in France. Pre-operating and start-up costs of $2.3 million were incurred in 2003, all related to the new RTL production line in France. Sarbanes-Oxley Section 404 compliance costs of $1.3 million were also incurred during 2004.
The French segments operating profit was $60.1 million in 2004, which was an increase of $6.5 million, or 12 percent, over the $53.6 million realized in 2003. The increase was primarily due to:
· Increased production and sales volumes, largely attributable to the new RTL production line.
· Lower pre-operating and start-up expenses related to the new RTL production line in Spay, France of $1.7 million.
· Increased selling prices in combination with a more favorable mix of products sold.
· Acquisition of the Indonesian operation in February 2004.
These gains were partially offset by:
· Increased manufacturing expenses, including higher wood pulp and employee benefit and labor expenses.
· Increased nonmanufacturing costs, including $1.2 million of Paris, France office closure expenses.
U.S. operating profit decreased $1.1 million from $2.0 million in 2003 to $0.9 million in 2004. This decrease was related to:
· Increased wood pulp prices, higher purchased energy costs and increased employee benefit and labor expenses.
· Pre-operating and start-up costs totaling $2.9 million related to the operation of a rebuilt cigarette paper machine at the Spotswood, New Jersey mill and a rebuilt tipping paper machine at the Lee, Massachusetts mill.
· Lower production and sales volumes.
These unfavorable items were partially offset by:
· Higher average selling prices and an improved mix of products sold.
Brazils operating profit decreased by $0.7 million, or 13 percent, from $5.2 million in 2003 to $4.5 million in 2004. This decrease was related to:
· Increased cost of sales, including higher employee benefit and labor expenses.
· Pre-operating costs of $0.2 million related to a rebuilt cigarette paper machine, which began operation in January of 2005.
· Unfavorable currency impacts.
These unfavorable items were partially offset by:
· Higher production and sales volumes.
· Lower nonmanufacturing expenses.
Interest expense was $1.4 million higher during 2004 compared with the prior year because of increased debt levels, which have supported our recent capital projects and increased working capital requirements. The weighted average effective interest rates on our long-term revolving debt facilities, were approximately 2.5 percent in both 2004 and 2003.
Other income (expense), net in both 2004 and 2003 consisted primarily of interest income, royalty income and foreign currency transaction gains and losses. Other income of $1.5 million in 2004 was favorable compared with other expense of $0.2 million in 2003. This difference was primarily a result of foreign currency transaction gains in 2004 compared with foreign currency transaction losses in 2003.
Provision for income taxes reflected an effective income tax rate of 22 percent for 2004 compared with 23 percent for 2003. In 2004, we made favorable adjustments to valuation allowances recorded against deferred income tax assets as a result of realization of foreign tax credit carryforwards utilized in our 2003 U.S. federal income tax return and changes in our expectations as to the realization of such assets in 2004 and beyond due to changes in estimates of our U.S. income tax situation and an increase in the carryforward period of foreign tax credits from 5 years to 10 years provided in the American Jobs Creation Act of 2004. Additionally, we recorded income tax benefits from a decrease in the French statutory corporate income tax rate enacted in December 2004, which decreased from 35.3 percent for 2004 to 34.8 percent in 2005 and 34.3 percent in 2006 and beyond, that reduced the net deferred income tax liability and from the recovery of prior-year taxes in France related to a favorable November 2004 court ruling. The total of these items reduced the provision for income taxes, benefiting 2004 net income by $3.2 million.
In 2003, we recorded favorable adjustments to valuation allowances recorded against deferred income tax assets. These adjustments were largely a result of the final settlement of prior-year tax audit assessments in the French operations and changes in estimates of our U.S. income tax situation, improving our ability to utilize foreign tax credits in the United States. Our U.S. income tax situation changed, in part, due to the effects of having implemented certain U.S. tax elections, including the conversion from Last-In, First-Out, or LIFO, to First-In, First-Out, or FIFO, inventory valuation for tax purposes. The net of these valuation allowance adjustments reduced the provision for income taxes, benefiting 2003 net income by $3.2 million.
Minority interest increased to $7.0 million from $4.9 million in 2003. This $2.1 million, or 43 percent, increase was directly related to increased profitability at LTRI, a French subsidiary, which produces reconstituted tobacco leaf products and has a 28 percent minority owner.
Net income for 2004 was $36.4 million, a 6 percent increase compared with net income of $34.5 million in 2003. Diluted earnings per share increased by 4 percent to $2.36 compared with diluted earnings per share of $2.28 for the prior year.
We reported net sales of $566.9 million in 2003 compared with $501.4 million in 2002. The increase of $65.5 million, or 13 percent, consisted of the following (dollars in millions):
· An increase of $43.1 million, or 9 percent, in net sales relating to changes in currency exchange rates. This was a direct result of a stronger euro versus the U.S. dollar, partially offset by a weaker Brazilian real versus the U.S. dollar.
· An increase of $13.0 million, or 3 percent, in net sales relating to increased sales volumes resulting from internal sales growth. Sales volumes increased by 3 percent.
· Sales volumes in the United States increased by 5 percent due to increased sales of both tobacco-related papers and commercial and industrial papers.
· Sales volumes of the French segment increased 3 percent, with increased sales volumes in most major grades of tobacco-related papers as well as RTL products.
· Brazil experienced sales volumes that were essentially at the 2002 level, with declines in all major grades of tobacco-related papers, mostly offset by increased sales of commercial and industrial papers.
· Higher average selling prices and an improved product mix contributed $9.4 million, or 2 percent.
Sales of tobacco-related products accounted for 93 percent of net sales for the year ended December 31, 2003, consistent with the prior year.
French segment net sales increased 21 percent, or $60.8 million, from 2002 to 2003. The increase in net sales resulted from favorable currency exchange rates, as a result of a stronger euro versus the U.S. dollar, increased sales volumes and improved average selling prices.
The U.S. segment realized increased net sales of $10.6 million, or 6 percent, compared with 2002. Net sales in the U.S. segment increased due to increased sales volumes and higher average selling prices.
Brazil realized an increase in net sales of $0.7 million, or 2 percent, compared with 2002. The Brazilian segments net sales increase was due to higher average selling prices partially offset by a weakened Brazilian real versus the U.S. dollar.
The decline in our gross profit margin from 21 percent in 2002 to 19 percent in 2003 was related to increased wood pulp, purchased energy and labor expenses as well as pre-operating and start-up costs. The U.S. list price of northern bleached softwood kraft pulp, a bell-weather pulp grade, increased from an average market list price of $490 per metric ton in 2002 to $555 per metric ton in 2003, a 13 percent increase. Year-over-year, higher per ton wood pulp costs had an unfavorable impact of $5.8 million. Purchased energy costs increased $3.3 million compared with full year 2002. Additionally, the stronger euro compared with the U.S. dollar put pressure on the gross profit margin since most of the costs in the French operations are incurred in euros while approximately 25 percent of the sales of the French operations are in U.S. dollars.
In 2003, pre-operating and start-up costs totaling $2.3 million were incurred in France related to the new RTL production line. In 2002, approximately $3 million of strike-related costs were incurred at the Spotswood, New Jersey mill.
Nonmanufacturing expenses were $5.9 million, or 12 percent, higher than in 2002, primarily due to increases in selling and general expenses. Higher selling expenses were incurred in France in support of the higher sales volumes. Higher general expenses of $2.3 million included increased costs for employee compensation and benefits. Changes in currency exchange rates also contributed to higher nonmanufacturing expenses in France.