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Schweitzer-Mauduit International 10-Q 2006
UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the quarterly period ended September 30, 2006 OR o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the transition period from to 1-13948 SCHWEITZER-MAUDUIT INTERNATIONAL, INC. (Exact name of registrant as specified in its charter)
1-800-514-0186 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 whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. Large accelerated filer o Accelerated filer x Non-accelerated filer o Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x There were 15,452,287 shares of Common Stock, par value $0.10 per share, of the registrant outstanding as of November 6, 2006.
TABLE OF CONTENTS
ITEM 1. FINANCIAL STATEMENTSSCHWEITZER-MAUDUIT INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (dollars in millions, except per share amounts) (Unaudited)
The accompanying notes are an integral part of these consolidated financial statements. 1 SCHWEITZER-MAUDUIT INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (dollars in millions, except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements. 2 SCHWEITZER-MAUDUIT INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS) (dollars in millions, except per share amounts) (Unaudited)
The accompanying notes are an integral part of these consolidated financial statements. 3 SCHWEITZER-MAUDUIT INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOW (dollars in millions) (Unaudited)
The accompanying notes are an integral part of these consolidated financial statements. 4 Note 1. GENERAL Nature of Business Schweitzer-Mauduit International, Inc., or the Company, is a multinational diversified producer of premium specialty papers headquartered in the United States of America and is the world’s largest supplier of fine papers to the tobacco industry. The Company manufactures and sells paper and reconstituted tobacco products to the tobacco industry as well as specialized paper products for use in other applications. The primary products include cigarette, plug wrap and tipping papers used to wrap various parts of a cigarette, 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. The Company is the premier manufacturer of high porosity papers, which are used in manufacturing ventilated cigarettes, and the leading independent producer of RTL used in producing blended cigarettes. The Company conducts business in over 90 countries and currently operates 11 production locations worldwide, with production facilities in the United States, France, the Philippines, Indonesia, Brazil and Canada. The Company has a 50 percent equity interest in a joint venture to manufacture and sell tobacco-related papers in China. The Company’s manufacturing facilities have a long history of producing paper, which dates back to 1545. The Company’s domestic mills led the development of the North American tobacco-related papers manufacturing industry, which was originated by Peter J. Schweitzer, Inc. and began as an importer of cigarette papers from France in 1908. Basis of Presentation The accompanying unaudited consolidated financial statements and the notes thereto have been prepared in accordance with the instructions of Form 10-Q and Rule 10-01 of Regulation S-X of the Securities and Exchange Commission, or the SEC, and do not include all of the information and disclosures required by accounting principles generally accepted in the United States of America, or GAAP. However, such information reflects all adjustments (consisting of normal recurring adjustments) which are, in the opinion of management, necessary for a fair statement of results for the interim periods. The results of operations for the three and nine months ended September 30, 2006 are not necessarily indicative of the results to be expected for the full year. The unaudited consolidated financial statements included herein should be read in conjunction with the audited consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 as filed with the SEC on March 7, 2006. Principles of ConsolidationThe consolidated financial statements include the accounts of Schweitzer-Mauduit International, Inc. and wholly owned, controlled majority-owned and financially controlled subsidiaries. Minority interest represents minority stockholders’ proportionate share of the equity in LTRI Industries S.A., or LTRI, and Schweitzer-Mauduit do Brasil S.A., or SWM-B. The Company’s share of the net loss of its 50 percent owned joint venture in China is included in the consolidated income statement as “Loss from equity affiliates.” All significant intercompany balances and transactions have been eliminated. Use of EstimatesThe preparation of financial statements in conformity with GAAP requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. Estimates are used for, but not limited to, inventory valuation, depreciable lives, sales returns, receivables valuation, pension, postretirement and other benefits, taxes and contingencies. Actual results could differ materially from those estimates. 5 Reclassifications Certain prior year amounts in the Consolidated Statements of Cash Flow have been reclassified to conform to the current year financial statement presentation. Historically, amounts relating to changes in currency translation had been included in changes in operating working capital. These amounts had not been significant when aggregated. However, recent increases in working capital and fluctuations in foreign currency exchange rates have increased the value related to each category of working capital. Such currency translation amounts are now excluded from changes in operating working capital and are reported separately. The net effects of the reclassifications on the Consolidated Statements of Cash Flow were to increase Cash Provided by Operations by $0.6 million for the nine months ended September 30, 2005, increase Cash Used for Investing by $0.6 million for the nine months ended September 30, 2005, and on a separate line report the Effect of Exchange Rate Changes on Cash, which had no effect for the nine months ended September 30, 2005. Share-Based Incentive Compensation Accounting Prior to Adoption of SFAS 123R Prior to the January 1, 2006 adoption of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” or SFAS 123R, which revised SFAS 123, “Accounting for Stock Based Compensation,” and superseded Accounting Principles Board Opinion No. 25, or APB 25, “Accounting for Stock Issued to Employees,” the Company accounted for stock-based compensation using the intrinsic value method under APB 25 and related Accounting Interpretations thereof as permitted by SFAS 123. SFAS 123 provided entities a choice of recognizing related compensation expense by adopting a fair value based method of accounting for stock compensation, including stock options to employees, or to measure compensation using the intrinsic value method under APB 25. Prior to January 1, 2006, the Company elected to continue to measure compensation cost for stock compensation based on the intrinsic value method under APB 25. Payments in the form of the Company’s shares made to third parties, including outside directors, were and still are recorded at fair value based on the market value of the Company’s common stock at the time of payment. Under APB 25, because the exercise price of employee stock options equaled the market price of the underlying stock on the date of grant, no compensation expense was recognized. SFAS 123, as amended by SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” required presentation of pro forma net income and earnings per share as if the Company had accounted for its employee stock compensation under the fair value method of that statement. For purposes of the pro forma disclosures, the estimated fair value of the stock compensation was amortized to expense over the vesting period. Under the fair value method, the Company’s net income and earnings per share would have been the pro forma amounts indicated below (dollars in millions, except per share amounts):
Summary of Impact of SFAS 123R As a result of adopting SFAS 123R on January 1, 2006, the Company’s net income for the three and nine month periods ended September 30, 2006 were both lower by less than $0.1 million than what would have been reported under APB 25. Excess tax benefits recognized related to stock-based awards for the three and nine months ended September 30, 2006 were none and $0.4 million, respectively, and were none and $0.8 million, respectively, for the three and nine months ended September 30, 2005. Prior to the adoption of SFAS 123R, the Company presented all excess tax benefits resulting from the exercise of stock-based awards as operating cash flows in the Consolidated 6 Statements of Cash Flow. SFAS 123R requires the amounts of cash flow resulting from the tax benefits in excess of the compensation cost recognized (excess tax benefits) to be classified as financing cash flows. Also, in connection with past awards of restricted stock, $0.3 million of unamortized compensation expense previously recognized as a reduction of stockholders’ equity in accordance with SFAS 123 was eliminated against additional paid-in-capital as of January 1, 2006 in accordance with SFAS 123R. In prior years, the Company transitioned the primary form of its stock-based compensation from stock options to restricted stock, including the substitution of restricted stock for stock options for the equity component of the Long-Term Incentive Plan, or LTIP, beginning in 2006. Also, on December 9, 2005, the Board of Directors accelerated vesting of certain unvested and “out-of-the-money” stock options previously awarded to employees and officers that had exercise prices above $30.00 per share. As a result, options to purchase approximately 300,000 shares of the Company’s common stock vested immediately, but no underlying shares will be transferable by the Company’s officers prior to the original vesting schedule except in the event of an officer’s termination of employment. Accelerated stock options held by the Company’s officers represented approximately 90 percent of the total accelerated options. As a result of the transition by the Company to the use of restricted stock instead of stock options as the primary form of stock-based compensation and the acceleration of vesting of certain unvested and “out-of-the-money” stock options in December 2005, the impact of the adoption of SFAS 123R on the Company’s financial statements was not material. Accounting After Adoption of SFAS 123R Employee Stock Options The Company’s Equity Participation Plan expired in 2005 and was not renewed. Stock options are not expected to be granted after 2005. The exercise price of each of the Company’s employee stock option grants was equal to the average of the high and low market price on the date of grant. Under the Company’s stock option plan, the stock option’s maximum term was 10 years from the date of grant. Awards vested 30 percent, 30 percent and 40 percent over each of the first 3 years, respectively. Under APB 25, no compensation expense was recorded for stock options. Under SFAS 123R, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model. The Company used the fair value of each option grant on the date of grant in the determination of pro forma expense amounts reflected in past disclosures in accordance with SFAS 123. The unamortized balances of those pro forma fair value amounts are being recorded as expense beginning January 1, 2006 in accordance with SFAS 123R. A summary of the status of stock options outstanding as of September 30, 2006 and changes during the nine months then ended is presented below:
As of September 30, 2006, there was $0.1 million of unrecognized compensation cost related to outstanding stock options to be recorded during the remainder of 2006, 2007 and 2008 in accordance with SFAS 123R. Restricted Stock The Company’s restricted stock grants generally vest upon completion of a specified period of time. The fair value of each award is equal to the share price of the Company’s stock on the date of grant. This cost is recognized over the vesting period of the respective award. As of September 30, 2006, there was $0.7 million of unrecognized compensation cost related to outstanding restricted stock. A summary of outstanding restricted stock awards as of September 30, 2006 and 2005 and changes during the nine months ended is summarized below: 7
Restricted Stock Plan Performance Based Shares The Company’s LTIP for key executives includes an equity-based award component equal to 50 percent of the total award opportunity that is provided through the Company’s Restricted Stock Plan, or RSP. The objectives under the LTIP are established for multiple years at the beginning of a performance cycle and are intended to focus management on longer-term strategic goals. The Compensation Committee of the Board of Directors designates participants in the LTIP and RSP and determines the equity-based award opportunity in the form of restricted stock for each performance cycle, which is generally measured on the basis of a 3-year performance period. Performance is measured on a cumulative basis and a portion of each performance cycle’s restricted stock award opportunity may be earned annually. The restricted shares are issued and outstanding when the number of shares becomes fixed, after the annual performance is determined, and such awards vest at the end of the performance cycle. The Company recognizes compensation expense over the performance period based on the fair value of the award, with compensation expense being adjusted cumulatively based on the expected level of achievement of performance goals and the Company’s stock price. For the number of common and potential common shares outstanding used in the calculation of diluted net income per common share for the three and nine month periods ended September 30, 2006, unamortized compensation expense associated with the equity-based LTIP award opportunity is treated as proceeds used to purchase shares in the treasury stock method of calculating the number of shares. As a result, the net increase in the average number of common and potential common shares outstanding for the three and nine month periods ended September 30, 2006 was none and 4,324, respectively. Recent Accounting PronouncementsIn November 2004, the Financial Accounting Standards Board, or FASB, issued FASB Statement No. 151, “Inventory Costs — an amendment of ARB No. 43, Chapter 4,” or SFAS 151. SFAS 151 amends the guidance in Accounting Research Bulletin No. 43, or ARB 43, Chapter 4, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage). SFAS 151 requires that these costs be recognized as current period charges regardless of whether they are abnormal. In addition, SFAS 151 requires that allocation of fixed production overheads to the costs of manufacturing be based on the normal capacity of the production facilities. The Company’s adoption of this new accounting standard effective January 1, 2006 had no material impact on the accompanying financial statements. In May 2005, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections,” or SFAS 154, which replaces Accounting Principles Board No. 20, “Accounting Changes,” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements.” SFAS 154 applies to all voluntary changes in accounting principles and requires retrospective application (a term defined by the statement) to prior periods’ financial statements, unless it is impracticable to determine the effect of a change. It also applies to changes required by an accounting pronouncement that does not include specific transition provisions. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company has adopted this new accounting standard effective January 1, 2006. Since it applies to accounting changes and corrections of errors that occur after January 1, 2006, there was no impact on the Company’s consolidated financial position or results of operations. In July 2006, the FASB issued Interpretation No. 48, or FIN 48, “Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109.” This Interpretation is effective for years beginning after December 15, 2006. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The new FASB standard also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The Company is currently in the process of reviewing this guidance to determine its impact on the Company’s consolidated financial position and results of operations and will implement FIN 48 in the first quarter of 2007. 8 In September 2006, the SEC issued Staff Accounting Bulletin No. 108, or SAB 108 – “Financial Statements – Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in the Current Year Financial Statements.” The purpose of SAB 108 is to provide requirements related to financial statement presentation and financial statement restatement for a discovered prior period misstatement. SAB 108 is effective for fiscal years ending after November 15, 2006. The Company does not expect the adoption of SAB 108 to have a material impact on the accompanying financial statements. In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements,” or SFAS 157, which is effective for financial statements issued for the fiscal year beginning after November 15, 2007. SFAS 157 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” SFAS 157 also expands disclosure requirements to include: (a) the fair value measurements of assets and liabilities at the reporting date, (b) segregation of assets and liabilities between fair value measurements based on quoted market prices and those based on other methods and (c) information that enables users to assess the method or methods used to estimate fair value when no quoted price exists. SFAS 157 applies to fiscal years and interim periods beginning after November 15, 2007. The Company is currently in the process of reviewing this guidance to determine its impact on the Company’s consolidated financial position and results of operations. In September 2006, the FASB issued Statement No. 158, “Employers Accounting for Defined Benefit Pension and Other Postretirement Plans – An Amendment of FASB Statements No. 87, 88, 106 and 132R,”or SFAS 158, which requires an employer to: (a) recognize in its statement of financial position an asset for a plan’s overfunded status or a liability for a plan’s underfunded status, (b) measure a plan’s assets and obligations that determine its funded status as of the end of the employer’s fiscal year (with limited exceptions) and (c) recognize as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period. The requirement to recognize the funded status of a benefit plan and associated disclosure requirements are effective as of the end of the fiscal year ending after December 15, 2006. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position is effective for fiscal years ending after December 15, 2008. The Company is currently in the process of reviewing this pronouncement to determine its impact on the Company’s consolidated financial position and will implement SFAS 158 effective with its December 31, 2006 financial statements. NOTE 2. NET INCOME PER SHAREBasic net income per common share is computed based on net income divided by the weighted average number of common shares outstanding. Diluted net income per common share is computed based on net income divided by the weighted average number of common and potential common shares outstanding. Potential common shares during the respective periods are those related to stock options outstanding, restricted stock outstanding, directors’ accumulated deferred stock compensation, which may be received by the directors in the form of stock or cash, and restricted stock estimated to be earned as part of the LTIP. A reconciliation of the average number of common and potential common shares outstanding used in the calculations of basic and diluted net income per share follows (in thousands):
9 Certain stock options outstanding during the periods presented were not included in the calculations of diluted net income per share because the exercise prices of the options were greater than the average market prices of the common shares during the respective periods. The average number of share equivalents resulting from these anti-dilutive stock options not included in the computations of diluted net income per share for the three and nine month periods ended September 30, 2006 were approximately 954,000 and 644,600, respectively, and for the three and nine month periods ended September 30, 2005 were approximately 381,000 and 251,100, respectively. NOTE 3. INVENTORIES The following schedule details inventories by major class (dollars in millions):
NOTE 4. RESTRUCTURING EXPENSE The Company initiated restructuring activities during 2006 which are expected to improve its competitiveness and profitability as well as the present imbalance between sales demand and paper production capacity in the United States and France. The following table summarizes the associated cash and non-cash pretax restructuring expense totaling $12.4 million for the third quarter and $16.3 million for the first nine months of 2006 (dollars in millions):
Restructuring liability reserves related to the cash restructuring expense for 2006 not yet paid were classified in accrued expenses as a current liability on the Consolidated Balance Sheet and are summarized as follows (dollars in millions):
At the Lee Mills facility in Massachusetts, the Company initiated restructuring activities in 2006 to reduce paper machine operations and employment levels. As a result of these decisions, the Company recorded $1.8 million and $5.0 million of restructuring expense for the three and nine months ended September 30, 2006, respectively. Third quarter restructuring expense included $1.7 million for accelerated depreciation and other non-cash costs and $0.1 million for severance and other cash costs. Year-to-date restructuring expense consisted of $4.4 million for accelerated depreciation and other non-cash costs and $0.6 million for severance and other cash costs. 10 During the third quarter of 2006, as a result of announced restructuring that included planned reductions in paper machine operations and employment levels at the Company’s Papeteries de Mauduit S.A.S., or PdM, facility in France, the minimum severance liability mandated by French law was recorded in accordance with FASB Statement No. 112, “Employers’ Accounting for Postemployment Benefits – An Amendment of FASB Statements No. 5 and 15.” The Company plans to record any additional severance liability as a result of negotiations and amortize this incremental severance cost to expense over the affected employees’ remaining service period in accordance with FASB Statement No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” or SFAS 146. When known, the Company will record incremental severance liability for voluntary retirements in accordance with FASB Statement No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Plans and for Termination Benefits” and amortize this incremental cost to expense over the affected employees’ service period. Third quarter restructuring expense totaled $0.2 million for accelerated depreciation and $10.4 million for severance and other cash costs, including amounts fully expensed for the minimum PdM severance liability mandated by French law. Year-to-date restructuring expense consisted of $0.7 million for accelerated depreciation and $10.6 million for severance and other cash costs. Events Subsequent to September 30, 2006 Not Reflected in the Accompanying Financial Statements. On October 18, 2006, the first meeting among PdM management, unions and the Work’s Council occurred related to the planned restructuring. The negotiations with PdM’s unions and Work’s Council are proceeding under a mutually agreed upon schedule and protocol. The negotiations are expected to conclude by mid-December 2006. The proposal from the Company calls for the shutdown of 2 paper machines and the reduction of 209 employees, or approximately one-fourth of the PdM workforce. The reductions are proposed to occur in essentially 2 equal phases during the first and fourth quarters of 2007. At this meeting, PdM offered severance payments in excess of the French legal minimum. Approximately $9 million of estimated additional severance liability, which is incremental to that recorded in the third quarter, will be recorded during the fourth quarter. This incremental severance amount will be amortized to restructuring expense over the affected employees’ remaining service periods during 2006 and 2007 in accordance with SFAS 146. The estimated amount of severance liability could change, dependent upon the results of negotiations and the mix of employees that leave through early retirement or other voluntary means versus involuntary separation. NOTE 5. COMMITMENTS AND CONTINGENCIES Litigation The Company is involved in various legal proceedings and disputes (see Note 7, Commitments and Contingencies, of the Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005). There have been no material developments to these matters during 2006, except in the Brazil tax assessment number 2001.001.064544-6, or Assessment 2, concerning Imposto sobre Circulacão de Mercadorias e Servicos, or ICMS. Superior Tribunal of Justice Judge Denise Arruda previously granted the Company’s petition for a preliminary injunction staying execution of the ICMS tax assessment by the State of Rio de Janeiro. On October 20, 2006, following a hearing on whether to make the preliminary injunction permanent pending resolution of the ICMS tax assessment on the merits, Judge Arruda decided that the Superior Tribunal of Justice did not have jurisdiction over the constitutional question presented and that it should be heard by the Supreme Court of Brazil. Consequently, the judge vacated the preliminary injunction. This court decision does not apply to the similar Brazil tax assessment number 2001.001.115144-5, or Assessment 1. Regarding this recent court decision in Assessment 2, the Company has entered with a request for plenary examination of the injunction by the Superior Tribunal of Justice. The Company expects that it could be up to one year before this matter is heard by the Superior Tribunal of Justice sitting in plenary session. While it is technically possible for the State of Rio de Janeiro to commence execution on Assessment 2, because there is no preliminary injunction in force, the Company does not believe that is likely. If such administrative execution were to be initiated by the State of Rio de Janeiro, SWM-B would be obligated to provide security for payment of the initial litigation amount, plus monetary correction and penalties estimated at September 30, 2006 to equal the Reais equivalent of $6.3 million. This security may be provided in the form of a cash deposit, enrollment of assets or a bond. In conjunction with providing security for the potential liability, the Company would seek a preliminary injunction based on such an administrative deposit. If the fiscal authority does not initiate the administrative execution, the plenary decision of the Superior Tribunal of Justice is a condition precedent to further judicial appeals. In the event that such a judgment is negative to SWM-B, an appeal to the Supreme Court of Brazil will be initiated. 11 SWM-B continues to vigorously contest these Assessments and believes that these Assessments will ultimately be resolved in its favor. However, since the final resolution involves presentation of these matters to the Supreme Court of Brazil, they are not likely to be finally resolved for several years. No liability has been recorded on the Company’s consolidated financial statements for these Assessments based on its evaluation that SWM-B is more likely than not to prevail in its challenge of these Assessments under the facts and law as presently understood. Environmental Matters The Company’s operations are subject to federal, state and local laws, regulations and ordinances relating to various environmental matters. The nature of the Company’s operations exposes it 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 the Company has incurred in the past several years, and will continue to incur, capital and operating expenditures in order to comply with environmental laws and regulations, the Company believes that its future cost of compliance with environmental laws, regulations and ordinances, and the exposure to liability for environmental claims and its obligation to participate in the remediation and monitoring of certain hazardous waste disposal sites, will not have a material adverse effect on 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 the Company (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 the Company’s financial condition or results of operations. The Company incurs spending necessary to meet legal requirements and otherwise relating to the protection of the environment at its facilities in the United States, France, the Philippines, Indonesia, Brazil and Canada. For these purposes, the Company anticipates that it will incur capital expenditures of approximately $1 million in 2006 and approximately $2 to $3 million in 2007, of which no material amount is the result of environmental fines or settlements. The foregoing capital expenditures are not expected to reduce the Company’s ability to invest in other appropriate and necessary capital projects and are not expected to have a material adverse effect on the Company’s financial condition or results of operations. NOTE 6. POSTRETIREMENT AND OTHER BENEFITS The Company sponsors pension benefits in the United States, France, the Philippines and Canada and postretirement healthcare and life insurance benefits in the United States and Canada. The Company’s Canadian and Philippines pension and postretirement benefits are not significant and therefore are not included in the following disclosures. During May 2006, the Company implemented the terms of its last and final offer following an impasse in negotiations with the United Steelworkers of America on a collective bargaining agreement for the Lee Mills that had been extended since its original expiration date of July 31, 2005. Pursuant to the terms of the offer that was unilaterally implemented by the Company, all affected hourly employees at the Lee Mills were notified that the further accrual of benefits under their defined benefit pension plan would be frozen as of July 17, 2006. Consequently, hourly employees at the Lee Mills do not earn any additional benefits for future service (years or earnings) under the defined benefit plan beginning July 17, 2006. This termination of the accrual of additional benefits for future service qualified this action for curtailment under FASB Statement No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” or SFAS 88. This action is expected to reduce the Company’s future annual pension expense and pension fund contribution requirements. The plan has not been terminated, and benefits accrued as of July 17, 2006 will continue to be paid in accordance with the plan terms. Allowable contributions and the matching percentage for the defined contribution, or 401(k), plan for the Lee Mills hourly employees has been modified to partially offset the employee pension benefit reduction. The Lee Mills action necessitated a remeasurement of the Company’s accumulated benefit obligation of 2006 under the U.S. pension plan and resulted in a curtailment gain of $0.1 million during the second quarter. As part of this remeasurement, the Company increased its discount rate assumption from 5.75 percent to 6.50 percent to reflect changes in the market interest rates. Other actuarial assumptions (primarily asset returns, wage rate increases, plan population, retirement assumptions, mortality table and cash balance crediting rate) remained consistent with those previously disclosed. In July 2005, the decision was made and communicated to all affected U.S. salaried employees that benefits related to the Company’s defined benefit pension plan in the United States would be frozen as of December 31, 2005. This 12 action is expected to reduce the Company’s annual pension expense and pension fund contribution requirements. The plan was not terminated and benefits accrued as of December 31, 2005 will continue to be paid in accordance with the plan terms. Allowable contributions and the Company’s matching percentage for its defined contribution, or 401(k), plan were modified to partially offset the employee benefit reduction. The 2005 action included suspending the defined benefit pension plan so U.S. salaried employees do not earn additional benefits for future service (years or earnings) beginning January 1, 2006. This suspension of additional benefits for future service qualified this action for curtailment under SFAS 88. This action necessitated a remeasurement of the Company’s accumulated benefit obligation under the Company’s U.S. pension plan and resulted in a curtailment gain in the third quarter of 2005 of $0.8 million ($0.5 million after tax). As part of the Company’s remeasurement, it decreased its discount rate assumption from 5.75 percent to 5.25 percent to reflect changes in the market interest rates. Turnover and retirement assumptions were modified to reflect a demographic assumption study of the Company. Additionally, the mortality table assumption was also reviewed and updated to a more current mortality table. Annual rate of return and wage rate increase assumptions remained consistent with those previously disclosed. In accordance with SFAS 88, the Company calculated its curtailment gains by first remeasuring its plan assets and projected benefit obligation, or PBO, as of the date of each of the curtailments, excluding the effects of the curtailments, but including the effects of the changes in assumptions. The Company then had the respective plan assets and PBOs measured using the effects of the curtailments. This enabled the effects of the curtailments on the respective PBO to be isolated, without affecting the measurement for any change in the actuarial assumptions since the prior measurement date. The components of net pension and postretirement healthcare and life insurance benefit costs for U.S. employees for the three and nine month periods ended September 30, 2006 and 2005 were as follows (dollars in millions):
The components of net pension costs in France for the three and nine month periods ended September 30, 2006 and 2005 were as follows (dollars in millions):
The Company contributed $5.0 million and $9.4 million to its pension plans through the first nine months of 2006 and 2005, respectively. The timing of pension contributions, if any, for the remainder of 2006 has not yet been 13 determined, as no 2006 pension contributions are legally required. The Company expects total pension contributions to be in the range of $7 to $15 million from October 2006 to the end of 2007. The Company also made a total of $1.5 million of payments related to its U.S. postretirement healthcare and life insurance benefits for the nine months ended September 30, 2006, and expects to make additional payments of less than $1 million during the remainder of 2006. NOTE 7. DEBT New Bank Credit Agreement On July 20, 2006, Schweitzer-Mauduit International, Inc. and Schweitzer-Mauduit France S.A.R.L., a wholly-owned subsidiary of the Company, entered into a new unsecured credit agreement, or the Credit Agreement, with a group of banks led by Natexis Banques Populaires, Société Générale Corporate & Investment Banking and SunTrust Robinson Humphrey, a division of SunTrust Capital Markets, Inc. to refinance its existing bank credit agreement. The Credit Agreement became effective July 31, 2006 and provides for (a) additional borrowing capacity of approximately $60 million, increasing the total facilities to $195 million from $135 million, (b) a reduced number of tranches from 4 to 2, (c) extended terms, with the maturity date of the new facilities being no earlier than 5 years, (d) lower interest rate margins and (e) fewer, less restrictive financial covenant requirements. The Credit Agreement replaced the existing credit facility executed on January 31, 2002 that was scheduled to expire in January 2007. Borrowings outstanding under the Credit Agreement of $57.7 million were classified as Long-Term Debt in the Consolidated Balance Sheet at September 30, 2006 under the terms of the new Credit Agreement and management’s current intent not to repay these amounts within the next year. The Credit Agreement provides for a $95 million U.S. revolving credit facility, or U.S. revolver, and an €80 million revolving credit facility, or Euro revolver, both with 5-year terms, plus 2 one-year extension options, with the extensions at the discretion of the participating banks. The Credit Agreement contains representations and warranties which are customary for facilities of this type and covenants and provisions that, among other things, require the Company to maintain (a) a Net Debt to Equity Ratio not to exceed 1.0 and (b) a Net Debt to Adjusted EBITDA Ratio not to exceed 3.0. The increased amount of the facility and its favorable terms provide greater flexibility to pursue various strategic opportunities. Repayment of amounts drawn under the Credit Agreement may be accelerated in limited circumstances, which include events of default not timely cured and change of control events. Draws were made to repay borrowings under the existing credit agreement. Expected draws are also anticipated for (a) working capital needs (b) funding the Company’s joint venture in China and (c) other general corporate purposes. Borrowings against the Credit Agreement are expected to aggregate the U.S. dollar equivalent of approximately $10 to $30 million during the fourth quarter of 2006. Under the Credit Agreement, interest rates are at market rates, based on the London Interbank Offered Rate, or LIBOR, for U.S. dollar borrowings and the Euro Interbank Offered Rate, or EURIBOR, for euro borrowings, plus an applicable margin that varies from 0.35 percent to 0.75 percent per annum depending on the Net Debt to Adjusted EBITDA Ratio, as defined in the Credit Agreement. The Company incurs commitment fees at an annual rate of either 0.30 or 0.35 percent of the applicable margin on the committed amounts not drawn, depending on the Net Debt to Adjusted EBITDA Ratio. NOTE 8. INCOME TAXES Income (loss) before income taxes totaled a loss of $4.0 million and income of $5.8 million for the three and nine months ended September 30, 2006, respectively, and income of $9.6 million and $28.6 million for the three and nine months ended September 30, 2005, respectively. A reconciliation of income taxes computed at the U.S. federal statutory income tax rate to the provision (benefit) for income taxes is as follows (dollars in millions):
Tax benefits of foreign legal structure result from net foreign tax deductions from the restructuring of the Company’s foreign operations in 2003. As a result of reduced earnings in 2006, the proportionate effect of this item on the overall effective income tax rate is greater than in 2005. 14 NOTE 9. SEGMENT INFORMATION The Company operates and manages its businesses based on the geographical location of the primary manufacturing operations: the United States, France and Brazil. 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. While the products are similar in each segment, they vary based on customer requirements and the manufacturing capabilities of each location. 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. Tobacco industry products comprised approximately 90 percent of the Company’s consolidated net sales in the three and nine month periods ended September 30, 2006 and 2005. The non-tobacco industry products are a diverse mix of products, certain of which represent commodity paper grades produced to maximize machine operations. For purposes of the segment disclosure in the following tables, the term “United States” includes operations in the United States and Canada. The Canadian operation only produces flax fiber used as raw material in the U.S. operations. The term “France” includes operations in France, the Philippines (beginning in June 2005) and Indonesia. Since the results of the Philippine and Indonesian operations are not material for segment reporting purposes and their sales are coordinated with sales of the French operations in southeast Asia, they are included in the “France” segment. Sales of products between segments are made at market prices and elimination of these sales is referred to in the following tables as intersegment sales. Expense amounts not associated with segments are referred to as unallocated expenses. Net Sales (dollars in millions)
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