SWM - Mark Moore

Schweitzer-Mauduit International, Inc Business and Equity Evaluation Project Members Allyson Buchanan Casey Daniel Britt Fisher Whitney Garnett Heather Hignojos Seth Schulz allyson.buchanan@ttu.edu casey.daniel@ttu.edu britt.t.fisher@ttu.edu whitney.garnett@ttu.edu heather.n.hignojos@ttu.edu seth.schulz@ttu.edu 1

Table of ContentsExecutive Summary…………………………………………………………………………...………8Industry Analysis……………………………………………………………………………10Accounting Analysis………………………………………………………………………...12Financial Analysis……………………………………………………………………………14Valuation Analysis…………………………………………………………………………..16Company Overview…………………………………...........................................................17Industry Overview…………………………………………………………………………............19Five Forces Model…………………………………………………………………………………….20Rivalry Among Existing Firms……………………………………………………………21Industry Growth……………………………………………………………..........22Concentration……………………………………………………………………….22Degree of Differentiation…………………………………………………………23Switching Costs……………………………………………………………………..24Economies of Scale…………………………………………………………………24Learning Economies………………………………………………………………..25Fixed Variable Costs……………………………………………………………….26Excess Capacity……………………………………………………………………..27Exit Barriers………………………………………………………………………….28Conclusion………………………………………………………………………..….28Threat of New Entrants……………………………………………………………….…...29Scale Economies…………………………………………………………………….29First Mover Advantage…………………………………………………………….……….31Excess to Channels of Distribution…………………………………………….32Relationships………………………………………………………………………..32Legal Barriers………………………………………………………………………..33Conclusion……………………………………………………………………………34Threat of Substitute Products……………………………………………….…………..342

Buyers Willingness to Switch…………………………………….……………..35Relative Price and Performance…………………………………………….….36Conclusion……………………………………………………………………………36Bargaining Power of Buyers………………………………………………………………36Switching Costs……………………………………………………………………..37Differentiation……………………………………………………………………….38Cost and Quality Importance……………………………………………………39Number of Buyers……………………………………………………..…………...40Volume per Buyer…………………………………………………………………..41Conclusion……………………………………………………………………………42Bargaining Power of Suppliers…………………………………………………………..42Switching Costs…………………………………………………………...............42Differentiation……………………………………………………………………….43Cost and Quality Importance……………………………………………………43Number of Suppliers/Volume per Supplier…………………………………..44Conclusion……………………………………………………………………………44Analysis of Key Success Factors for the Value Creation in the Industry………….…..44Cost Leadership……………………………………………………………………………...45Economies of Scale…………………………………………………………………….……45Low Cost Distribution…………………………..………………………………..............46Efficient Production…………………………………………………………….…………..46Research and Development…………………………………………………….............47Differentiation……………………………………………………………..………………...47Conclusion………………………………………………………………………………….…48Competitive Advantage Analysis………………………………………………….……………..48Economies of Scale…………………………………………………………………….……49Efficient Production…………………………………………………………………………503

Low Input Costs………………………………………………………………………..……51Research and Development…………………………………………………….............52Conclusion………………………………………………………………………….…………53Structure of Formal Accounting Analysis……………………………………………............53Key Accounting Policies…………………………………………………………............54Type 2 Key Accounting Policies……………………………………………………….…55Goodwill…………………………………………………………………….…………55Foreign Currency………………………………………………………….………..56Pension/Postretirement Benefits…………………………………….………..57Research and Development……………………………………………......……59Accounting Flexibility…………………………………………………………………………..…..60Goodwill………………………………………………………………………….….…….…..61Foreign Currency…………………………………………………………………..………..62Pension/Postretirement Benefits…………………………………………..…………..63Research and Development………………………………………………….………..…64Evaluation of Accounting Strategy…………………………………………………….………..65Goodwill…………………………………………………………………………..…………...65Foreign Currency…………………………………………………………………………….66Pension/Postretirement Benefits………………………………………….……………67Research and Development………………………………………………………………70Conclusion……………………………………………………………………….……………71Quality of Disclosure………………………………………………………………………………..72Goodwill…………………………………………………………………………….…………72Foreign Currency…………………………………………………………………………….73Pension/Postretirement Benefits……………………………………………………….74Research and Development…………………………………………………..………….74Quantitative Analysis……………………………………………………………………………….75Sales Manipulation Diagnostic…………………………………………….…………….75Net Sales/Cash From Sales…………………………………………….………..764

Net Sales/Accounts Receivable…………………………………………………77Net Sales/Inventory………………………………………………………..……..80Expense Manipulation Diagnostics…………………………………………………….……..…82CFFO/OI………………………………………………………………………..……..82CFFO/NOA……………………………………………………………………..……..84Asset Turnover…………………………………………………………….….…….86Total Accruals/Sales……………………………………………………………….87Pension Expenses/SGA Expenses……………………………………..……….89Expense Diagnostic Conclusion…………………………………………..…….91Potential Red Flags………………………………………………………………………………….92Undo Accounting Distortions……………………………………………….…………………….92Financial Ratio Analysis…………………………………………………………………………..103Liquidity Ratio Analysis ……………………………………………………………………….103Current Ratio ………………………………………………………………………………103Quick Asset Ratio …………………………………………………………………………105Working Capital Turnover ………………………………………………………………107Accounts Receivable Turnover ……………………………………………………......108Days Sales Outstanding ……………………………………………………….………..109Inventory Turnover ………………………………………………………………….......111Days Supply of Inventory ………………………………………………………….......113Conclusion…………………………………………………………………………………..114Profitability Ratio Analysis ……………………………………………………………..…....116Gross Profit Margin …………………………………………………………………….…116Operating Expense Ratio ……………………………………………………………….118Operating Profit Margin …………………………………………………………………119Net Profit Margin ………………………………………………………………………….121Asset Turnover …………………………………………………………………………….122Return on Assets …………………………………………………………………………1245

Return on Equity …………………………………………………………………………125Internal Growth Rate …………………………………………………………………..127Substantial Growth Rate ………………………………………………………………128Conclusion………………………………………………………………………………….130Capital Structure Ratio Analysis ………………………………………………………………131Debt/Equity Ratio ……………………………………………………………………….132Times Interest Earned ………………………………………………………………….133Debt Service Margin ………………………………………………………………….…135Altman’s Z-Score………………………………………………………………………….136Conclusion………………………………………………………………………………….137Forecasting Financial Statements……………………………………………….………….138Income Statement ………………………………………………………….……..……138Restated Income Statement…………………………………………………….……142Balance Sheet ………………………………………………………………………………..…..144Statement of Cash Flows ………………………………………………………..……147Estimated Cost of Capital ………………………………………………………………..…….149Cost of Equity……………………………………………………………………………..149Size Adjusted Cost of Equity ……………………………………………………..…..151Alternative Cost of Equity ..………………………………………………………..….151Cost of Debt ……………………………………………………………………..……..…152Weighted Average Cost of Capital (WACC) …………………………………...…..154Method of Comparables…………………………………………………………….……………156P/E Trailing ………………………………………………………………………….…… 157P/E Forecasted ………………………………………………………………………….. 158Price to Book……………………………………………………………………………....159Dividends to Price ………………………………………………………………………..160Price Earnings Growth …………………………………………………………………. 161Price/EBITDA………………………………………………………………………….…...1626

Enterprise/EBITDA…………………………………………………………………….….163Free Cash Flows……………………………………………………………………………164Conclusion……………………………………………………………………………........ 165Intrinsic Valuation Models ......................................................................................165Discounted Dividends Model……………………………………………………….…..166Discounted Free Cash Flow……………………………………………………….…….168Residual Income…………………………………………………………………….……..169Abnormal Earnings Growth Model……………………………………………….……172Long-Run Residual Income……………………………………………………………..175Analyst Recommendation………………………………………………………………………..182Appendices…………………………………………………………………………………………..185Work Cited……………………………………………………………………………………………2247

Industry AnalysisSchweitzer-Mauduit International, Inc. is the largest tobacco related paper productsproducer nationwide. The company has been producing paper dating back to 1545, and notuntil the early 1900’s did they start producing tobacco related paper. This new venture hasbecome a major factor in its operations and consumes 90% of its sales. With operations in theUnited States, France, Brazil, Indonesia, the Philippines, a joint venture in China, and a recentlyadopted expansion in Asia, SWM has captured a highly successful market structure, whichconducts sales in 90 different countries. Considering how cigarettes have continuously stayedhigh in demand, differentiation is a major factor in SWM’s products. They differ from theircompetitors, Alliance One and Universal Corporation, in the tobacco area. While Alliance Oneand Universal maintain a steady leaf tobacco production, SWM has provided innovative servicesby being the sole producer of reconstituted tobacco leaf (RTL). They are also the leadingmanufacturer of lower ignition propensity (LIP) cigarette paper, which has grown over 50% in2009 due to regulatory-mandated adoptions. SWM’s technology, research and developmentexpertise for RTL and LIP has significantly lowered their operating costs, and has also providedsafer cigarettes by reducing tar, carbon monoxide, and the amount of nicotine.It is difficult to compare SWM to its competitors because Alliance One and Universalboth only sell, package, store, and supply leaf tobacco, while SWM specializes in many differentareas of the tobacco industry. All three companies do not make cigarettes, they simply produceand supply the tobacco, and in SWM’s case, tobacco related paper products. By evaluating thefive forces model, a clearer picture of competition among the industry is created.10

Competitive ForceRivalry Among Existing FirmsThreat of New EntrantsThreat of Substitute ProductsBargaining Power of CustomersBargaining Power of SuppliersDegree of CompetitionHighLowLowHighLowThe tobacco industry competes on both cost leadership and differentiation. SWM’scompetitors mainly compete on cost due to the homogenous product, whereas SWM hasdeveloped a differentiation strategy with RTL and LIP uses. The key success factors for SWMinclude low input costs, economies of scale, superior product quality, and strong customerrelationships. SWM has optimized its cost structure by expanding their productions to lower-costregions, and has specialized in product quality through its research and development.11

Accounting AnalysisAn accounting analysis is crucial in determining the true value of a firm. In order toeffectively do this the key accounting policies of the firm must be looked at, as well as thevalidity and transparency of these accounting policies. This is done by evaluating the level ofdisclosure that a firm offers throughout their financial statements. Disclosure deals with theaccuracy and the amount of information that a firm chooses to divulge. This is importantbecause firms have the ability to skew figures that should be reported in an accurate report ofaccounting figures. Managers find this advantageous because they can intentionally make theircompany appear to be in a better, stronger state than what they really are. By using theminimums set forth by the SEC, firms can legally choose to keep certain information from thepublic. However, a firm that desires to provide the minimum level of disclosure should becarefully evaluated because there may be red flags throughout their accounting policies.The four key accounting policies that Schweitzer-Mauduit uses are goodwill, foreigncurrency risk, pensions and other post retirement benefits, and research and development.Schweitzer-Mauduit does a fairly good job of disclosing large amounts of information. Thedisclosure of goodwill throughout the industry is relatively okay. Schweitzer-Mauduit’spercentage of goodwill to property, plant and equipment for the 5 years do not come close tobeing over 20%; however, they are less than 2%. This shows why they have not had to impairgoodwill for the last 5 years, and shows a good level of disclosure. That being said, the otherfirms represent goodwill as an asset on the balance sheet but do not go much further beyondthat. Because Schweitzer-Mauduit and its competitors do a substantial amount of business ofoverseas, foreign currency risk is an obvious concern. Schweitzer-Mauduit provides investorswith a high amount of disclosure about its foreign currency risk and how they manage it. Theydo a good job of discussing their hedging positions and how it affects the company. Thedisclosure of pension and other post retirement benefits was disclosed at an average basis forSchweitzer-Mauduit and throughout the industry. Schweitzer-Mauduit lumps these two togetherin the liability section of their balance sheet, as well as when discussing the two. Schweitzer-Mauduit also does not disclose much about discount rates used. Schweitzer-Mauduit disclosesquite a bit of information in their research and development section as far as how and where12

they spend money devoted to R & D. They also talk specifics about certain plants devoted tostrictly R & D. This is the case because they want investors to see that they are highlycompetitive when it comes to being the front-runner in the industry. The only way to reallyaccomplish this in the tobacco and specialty paper industry is to have a good research anddevelopment department. Schweitzer-Mauduit clearly does a better job than its competitors inthe industry when it comes to the disclosure of research and development.Quality ofDisclosureGoodwill Foreign CurrencyRiskPensions and PRBenefitsResearch andDevelopmentSchweitzer-Low High Average HighMauduitIndustry Low Average Average LowAfter completing the quantitative assessment of the accounting policies it is evident thatSchweitzer-Mauduit is for the most part in the clear of any accounting distortions and alwaysdiscloses better than the industry about its accounting policies.13

Financial AnalysisFinancial analysis uses several different ratios in order to measure the liquidity,profitability, and viability of a firm. We use different financial ratios to discover how Schweitzer-Mauduit is performing compared to its competitors, as well as the industry. The three categoriesof the financial ratios include liquidity, profitability, and capital structure ratios. Liquidity ratiosare used to evaluate how well a firm is able to meet its short-term liabilities; how fast they canturn their assets into cash to pay off current debt. We used eight different ratios to measureliquidity: current ratio, quick ratio, working capital turnover, accounts receivable turnover, days’sales outstanding, inventory turnover, and days’ supply of inventory. After completing theliquidity ratios, we concluded that Schweitzer-Mauduit performed on average with the industry.This is good because it shows that SWM is paying off its short-term commitments with thespeed of the industry.The next category is profitability ratios. Profitability ratios are used to constructinformation necessary to determine a firm’s ability to generate profit. They set a basis ofperformance of a firm. We used nine different ratios to evaluate profitability: gross profitmargin, operating expense, operating profit margin, net profit margin, asset turnover, return onassets, and return on equity, internal growth rate, and sustainable growth rate. The overallperformance of Schweitzer-Mauduit is slightly under performing when compared to the industry.The third and final category is the capital structure ratios. Capital structure ratios areused to evaluate a how a firm finances its operating and investment activities. They reflect howwell a company is using its debt and equity to finance its operations and manage its credit risk.The three ratios used are times interest earned, debt-to-service margin, and debt-to-equityratio. We also use Altman’s z-score to analyze the risk the firm has to becoming bankrupt.Schweitzer-Mauduit has the lowest debt-to-equity ratio in the industry and a low ratio in timesinterest earned, but had a stable debt-to-service margin. The Altman’s z-score showed thatSchweitzer-Mauduit has fallen into the “gray area”, giving them high interest rates. SWM mustimprove sales or lower debt in order to stray away from bankruptcy in the future.14

The next part of our financial analysis is to forecast the financial statements ofSchweitzer-Mauduit for the next 10 years. This is done to see how well they will progress in thefuture. We forecasted the income statement, balance sheet, and statement of cash flow. Wealso forecasted a restated income statement because the research and development expensewas capitalized. It is important to forecast the income statement first because the basis of allforecasting stems around a firm’s sales growth rate. We start out forecasting the incomestatement by computing the future sales growth of the firm. After reviewing current and pasttrends in the economy, we concluded that sales would be as follows for 2009 to 2018,respectively: -2%, 6%, 5%, 5%, 4%, 4%, 4%, 3.5%, 3.5%, 3.5%. We then used a commonsize income statement to compute the rest of the figures. The income statement and balancesheet are directly linked by the asset turnover ratio, which we forecasted to be 1.0. Lastly, thestatement of cash flow was forecasted by using the CFFO/OI ratio to link it to the incomestatement. This is the last to forecast simply because it is the hardest statement to forecast andthe least reliable.The last part of our financial analysis is the estimation of the cost of capital. The cost ofcapital is what investors expect to receive if they choose to invest in a firm. We began byfinding the cost of equity and cost of debt. In order to find the beta for Schweitzer-Mauduit, weran a linear regression analysis, which estimated the beta to be 1.49. This beta remained stableover time and was used in the capital asset pricing model (CAPM) to find our cost of equity of12.32%. The cost of debt of 3.57% was calculated by taking the weights of each line item onthe liability portion of the balance sheet, both current liabilities and long term liabilities, andmultiplying them by the interest rate designated to each liability. Finally, we used the cost ofequity and cost of debt to calculate the weighted average cost of capital (WACC), which wasfound to be 6.9%.15

Valuation AnalysisThere are two valuation analyses to perform in order to determine Schweitzer-Mauduit’svalue; the methods of comparables and the intrinsic valuation. The methods of comparables area set of ratios used to develop current stock prices. However, the analysis is not back by theory,therefore cannot be relied on too much. We calculated average industry prices, excluding SWM,and set SWM equal to that in order to derive its comparable price. This was performed similarto other ratios. The comparables prices were then compared to SWM’s observed price of $50.95on November 2, 2009. We used a 15% fairly valued interval, meaning anywhere in between$43.31 and $58.60 is considered fairly valued. Any price above $58.60 would mean SWM isundervalued, and any price below $43.31 would mean SWM is overvalued. The methods ofcomparables have many flaws, which is why we were not able to calculate some of the ratios.This was also because most of SWM’s competitors did not have numbers to go off of, or theywere negative. Usually because of this we would not take into account what the ratios havedetermined the value to be, but they ended up being true to SWM’s value as being highlyovervalued.The second valuation analysis is the intrinsic analysis, which is much more precisecompared to the methods of comparables. Each model is backed by financial theory and servesas a sufficient way to determine SWM’s value. The five models analyzed include the discounteddividends model, discounted free cash flows model, residual income model, long run residualincome model, and the abnormal earnings growth model. The discounted dividends and thediscounted free cash flows models both were the least reliable because they use dividends asthe main figure to forecast. Dividends are paid on management’s discretion; therefore it is hardfor one outside the company to forecast. The next three models are of high explanatory power,which is where most would determine a firm’s value. All of the models create a model shareprice that is brought up to time consistent prices as of November 2, 2009. These prices arecompared to the observed price of $50.95 the same way they were compared in the methods ofcomparables; a 15% fairly valued interval. In the case of SWM, all five models have shown thefirm to be highly overvalued. This being said, we are confident in saying that Schweitzer-Mauduit is an overvalued company.16

Company OverviewSchweitzer-Mauduit International, Inc. was formed as a wholly owned subsidiary in theKimberly-Clark Corporation on December 1, 1995. They produce tobacco paper and is the“world's largest supplier of fine papers to the tobacco industry,” (SWN 10-k). The basis ofSchweitzer-Mauduit is the 9 mills it has acquired nationwide since Peter J. Schweitzer startedimporting cigarette paper into the United States from France in 1908. These 9 mills have beenleading paper manufacturers, as well as producing other products over the past 464 years.Headquartered in Alpharetta, Georgia, Schweitzer-Mauduit has extended their operations fromthe United States to France, Brazil, Indonesia, the Philippines and China. Stemming fromcigarette paper, Schweitzer-Mauduit also manufactures premium specialty paper for printing,writing, labeling, and even paper for drinking straws.Peter J. Schweitzer’s family-owned business started in New Jersey by importing cigarettepaper from France and expanding the manufacturing to specialty paper for various productsover a decade later. Schweitzer led the tobacco paper industry in North America to becomewhat it is today.The two main divisions of Schweitzer-Mauduit include tobacco industry products andcommercial and industrial products. Within the divisions, several raw materials must bepurchased to manufacture their products that include wood pulp, tobacco leaf by-products,cellulose fibers, flax straw and calcium carbonate. Schweitzer-Mauduit is now dominating thepaper manufacturing industry from all over the world. The tobacco industry contributed to 90percent of their net sales from 2006 through 2008. Their major customers include Philip MorrisUSA Inc., Philip Morris International, British American Tobacco (BAT), and JTI. Thesecompanies accounted for 60 percent of the Company’s 2008 net sales. “Since January 1, 1993,the company has been the single source of supply of cigarette papers to Altria Group's U.S.cigarette manufacturing operations, or Philip Morris USA,” (Schweitzer-Mauduit 10-K). They areknown for being the largest cigarette and cigar related paper manufacturers in the industry(fundinguniverse.com). Schweitzer-Mauduit’s main competitors include Universal Corporation(UVV), and Alliance One International, Inc. (AOI), which are mainly leaf tobacco manufacturers.17

Total Assets & Net Sales2004 2005 2006 2007 2008Total Assets $717.60 $691.30 $697.10 $775.00 $728.70Net Sales $657.50 $669.80 $655.20 $714.80 $767.90In Millions Schweitzer-Mauduit 10_KThe above tables are taken from Schweitzer-Mauduit’s 10-k. In the first table, SWM’s netsales are shown to be increasing throughout the five years, which could be due to newadoptions of reconstituted tobacco leaf (RTL) in upcoming markets. RTL is in 10-15% ofAmerican cigarettes, which is a large segment of SWM’s sales.The second table breaks the net sales into the different areas of operations; France, theUnited States, and Brazil. As you can see, SWM has conducted over 62% of its sales in foreignmarkets. One reason for this is because they market their product in 90 different countries. The18

table also shows that SWM’s sales have grown 9.1% from 2006 to 2007. This could be thestarting of a good sales growth trend.Industry OverviewThe tobacco industry may not be the healthiest business, but it has been growing at ahigh rate in the consumer goods market. It provides specific services to people worldwide,however it must be broken down to evaluate the inner segments of the tobacco industry. Theoverall tobacco commerce is one of a kind and has precise materials that are used in theproduction of tobacco products. The products in this market include cigarettes, cigars andcontainers. In order to make these products, firms must also use other industries like papermanufactures. Certain paper industries make tobacco related papers in order for the tobaccocompanies to create cigarettes, cigars, etc. These two industries intertwine with one anotherwhen it comes to the production process. Considering that there are many different firms in thetobacco market, it adds pressure to produce differentiation and competition. However, thetobacco related paper industries have very few firms in their industry, which makes it easy tocompete on product differentiation and innovation. When looking at different tobacco products,it is evident that the prices are similar. What firms need to look at are the industries behind theproducts that help the creation, the paper producers. The cigarette paper manufacturerscompete on creating new ideas for a safer cigarette, as well as a better image for their tobaccoproducts.There are many competitors in the tobacco industry including Marlboro, Parliaments andCamel. It is difficult to find the competitors in the tobacco related paper industry, because mostof them are foreign and do not conduct business in the United States. Schweitzer-Mauduit(SWM) is the largest tobacco related paper producer in the United States, and mainly competeswith Universal Corporation (UVV) and Alliance One (AOI). These two companies both stock, sell,package, and produce leaf tobacco. They are main competitors because SWM has beenproducing reconstituted tobacco leaf (RTL), which is made from by-tobacco products and ismuch safer and cheaper than normal tobacco. All of these companies do not make and sellcigarettes, they simply manufacture products that are sold to cigarette companies and used inits products process.19

They also have been coming up with new ways to make healthy tobacco products,which is where some of the competition remains. Since the tobacco companies are highlylooked down upon for their health hazards, improvement for safer tobacco related paperproducts are a major competition area for the paper manufacturers. Overall, both paper andtobacco industries are highly competitive in their own ways and are striving to become the best.Five Forces ModelThe five forces model allows investors and other analysts to investigate an industry andwhat makes the industry profitable. By using the five forces model an analyst can closelyanalyze a firm’s competitors, and what strategies they use to sustain their level of profitability.The five forces model begins with examining the rivalry among the firms that are alreadyestablished in the industry. This analysis provides an investor with an in-depth look at theindustries growth and profitability levels, as well as how many competitors are in the industryand how easy it is to enter and exit the industry. The second level of the five forces model is tolook at the threat of new entrants in to the industry. This model explains whether competitivefirms may still enter the industry and become profitable or if there is a low concentration offirms. The threat of substitute products is the next model to study. This discusses whether themarket can be easily attained by another firm already established in the industry. Anotherimportant aspect of the model is the bargaining power of buyers and suppliers. If either ofthese two has a high bargaining power over the firm, the firm could lose mass amounts ofprofits. Every aspect of the five forces model is very important to examine in order to get allthe information about a firm and the industry it operates in.20

Competitive ForceDegree of CompetitionRivalry Among ExistingFirmsThreat of New EntrantsThreat of SubstituteProductsBargaining Power ofCustomersBargaining Power ofSuppliersHighLowLowHighLowThe paper and tobacco industry have a very low concentration due to how the companies doroughly the same thing. There is little differentiation or reverse engineering leading to newtechnological advancements in the industry.Rivalry Among Existing FirmsRivalry among existing firms greatly affects the amount of market share that firms in theindustries are able to maintain. Low concentration industries with very few firms and littledifferentiation in the consumer paper and tobacco industry will most likely compete on cost. Onthe other hand, firms in highly concentrated industries will compete on differentiation. With theconsumer paper and tobacco industry reaching revenues of almost $40 billion in the UnitedStates, competition between the existing firms is very high.In the consumer paper and tobacco industry, Schweitzer–Mauduit International, AllianceOne International, and Universal International all compete in the market very aggressively. Witha lack of differentiation and reverse engineering in the industry, competition is extremely high.Firms are able to compete by “reducing prices or on non-price dimensions such as innovation orbrand image,” (Palepu and Healy). The factors that influence these decisions are the industry21

growth levels, concentration, differentiation, switching costs, scale/learning economies, fixedvariable costs, excess capacity, and exit barriers.Industry GrowthIndustry growth rates are vital to companies for the main reason of expansion. If theindustry is growing very rapidly, then firms within the industry do not need to compete overmarket share. However, during sluggish times firms within the industry must compete overevery piece of the market they can get. Industry growth rates can help firms evaluatecompetitors and can play an important role in mergers. The following chart shows the industrygrowth rates over the past five years.YearIndustry Growth2004 21%2005 20%2006 23%2007 1%2008 5%This chart shows that there has been steady growth from 2004 to 2006. However, theyears of 2007 and 2008 had experienced a time of decline. This may be contributed to therecent increase in taxes and legislation on tobacco and tobacco related products.Concentration and Balance of CompetitorsOne of the most important ways for firms to maintain a steady revenue stream duringsluggish times is to expand and acquire other firms in the industry. By merging and attainingother firms, already established firms are able to sustain a steady concentration in the industry.Therefore, preserving stability and preventing firms from setting prices establishes a monopoly.22

The size of the firms in the industry helps determine the amount of competition among thefirms.The paper and tobacco industry have a very low concentration due to how thecompanies do roughly the same thing. There are very few ways of differentiation leading tonew technological advantage.Degree of DifferentiationThe degree of differentiation can allow firms to obtain a large competitive advantageover others in the industry. The consumer paper and tobacco market delivers a veryhomogenous product; the prices, quality, and variety differ very little from one firm to the next.However, some differentiation has been achieved. Differentiation is most often accomplishedthrough variations in tobacco quality and flavors. For instance, tobacco companies like Camelhave introduced “Camel Turkish Blend Flavors”, which taste different than a normal cigarette.(camel.com) There have also been new prototypes that allow the consumer to crush the end ofa cigarette to transform it into a menthol cigarette.However most of the differentiation is related to the marketing of the product. Firms inthe industry normally allocate less than ten percent of sales to research and development. Thelow levels of differentiation in the products indicate that firms in the consumer paper andtobacco industry must compete on cost leadership to be successful in the market.23

Market Share Per Company (In Millions) 70% 60% 50% 40% 30% 20% 10% 0% 2005 2006 2007 2008 2009 Alliance One International Universal International Schweitzer-­‐Maudit The graph depicted above infers that most of the top firms in the industry havemaintained a steady amount of market share. The recent drop off of market share can beattributed to the government capping the amount of tobacco products firms are allowed toproduce. This has allowed some of the smaller firms to grasp more of the market, while makingsome of the large firms suffer.Switching CostsSwitching costs are extremely low in the paper and tobacco industry. A bulk of theindustry’s inventory is tobacco related products and there are few products that differ that canbe prepared with the raw materials. This makes for very low switching costs in the industry.The fact that an average cost to produce a cigarette is roughly ten cents makes switchingsupplies very simple. Furthermore, these low switching costs lead to high price competition inthe industry.Economies of ScaleLarger companies are normally more successful than smaller companies in achieving alevel of economies of scale, because they are able to produce products more rapidly andefficiently. One method to achieve economies of scale is to have a large amount of assets. Thechart below displays the amount of assets of the main competitors of the consumer paper andtobacco industry.24

Total Assets 3500 3000 2500 2000 1500 1000 500 0 2004 2005 2006 2007 2008 SWM UVV AOI BTI This chart displays how Universal Tobacco is the leader in total amount of assets. A large partof this can be attributed to the amount of out-sourcing and business that is done in othercountries requiring more plants and assets. Schweitzer-Mauduit requires the least amount ofassets, solely because they are not actively involved in the cigarette and tobacco producing orselling industry.Learning EconomiesLearning economies allow firms to gain a substantial competitive advantage overcompeting firms by encompassing extraordinary knowledge, significant research anddevelopment, and possessing patents. Patents are one of the most significant features oflearning economies, because it allows a firm to mastermind a process or a product that otherfirms are not able to duplicate without re-engineering. Most firms in the consumer paper andtobacco industry do not invest that much in research and development or in patents. No firm inthe industry has invested more than one and a half percent into research and development.Tobacco rolling and other tobacco activities have taken place since the beginning of theeighteenth century, which makes it very difficult to perfect the process any further. Cigaretteand other tobacco products have evolved very little from when they were originally created.This makes it hard to develop something that another competitive firm would want to duplicate.Learning economies have very little involvement in the consumer paper and tobacco industry.25

Fixed Variable CostsFixed and variable costs play a vital role in maximizing profits. Ideally a firm would liketo reduce their fixed costs as much as possible. Variable costs can differ depending on theamount of product a firm would like to produce, making it easier to control than their fixedcosts. With packs of cigarettes running next to nothing to produce, the consumer paper andtobacco industry must focus on their fixed costs. With nearly every firm operating in severalother countries, the amount of fixed costs can be very high. These fixed costs are the assetsthat are purchased like plant, property and equipment, as well as other long-term assets.Variable/ Fixed Cost Ratio1.3 1.25 1.2 1.15 1.1 Alliance One International Universal International Schweitzer Maudit 1.05 1 2004 2005 2006 2007 2008 The chart above shows the amount of profitability of revenues per costs of goods sold.On average, the ratio between the three companies is close to 1.19. Justifying that for everydollar spent on fixed costs, there was one dollar and nineteen cents of sales. With variablecosts representing the tobacco and paper products, the higher the ratio accounts for, the higherthe profitability. If the ratio is below one it means that a firm is paying out more in fixed coststhan less that is being produced. This means the firm is not adequately or efficiently utilizing itsassets.26

Excess CapacityExcess capacity arises in a firm when they are unable to effectively plan for customerdemand. The firm is unable to relieve itself of all the good and services for the fiscal year, andis therefore forced to either cut prices to get rid of inventory or to sit on the inventory. In thisconsumer paper and tobacco industry, firms are already competing over prices. If firms areforced to cut there already low prices, it significantly decreases the marginal profit of the firm.Ratio of Cost of Goods Sold to Plant Property and Equipment9 8 7 6 5 4 3 2 1 0 2004 2005 2006 2007 2008 SMI UVV AOI The graph depicts that Universal Corporation and Schweitzer-Mauduit have very stableand acceptable levels of excess capacity. These stable levels of excess capacity result becausethese two firms are efficient with their resources. On average, every dollar these two firmsspent on plant, property and equipment, they gained more than a dollar per cost of goods sold.However, Alliance One International has a very unstable and high level of excess capacity. Thiscan harm the profits because all of the extra inventory will become expensive to the store.However, most of the inventory in this industry can be sold off because of the low exit barriers.27

Exit BarriersCompanies will often leave one industry to pursue another industry that may be moreprofitable to the firm. Exit barriers result from the costs associated with leaving a currentindustry to moving to a new industry. In some industries there are various legal restrictions thatcan accompany the costs when leaving an industry. In the consumer paper goods and tobaccoindustry, the exit barriers would be quite significant due to the amount of internationalbusiness. These large firms have plant, property and equipment, as well as other long-termassets in several different countries that would be forced to shut down and sold off at bargainprices. Additionally, they would be forced to sell off most of the assets in the company as well,which would all have been depreciated and not fully compensated for. For large consumerpaper goods industries, it would be expensive for the firms to exit the industry for another,emphasizing the fact that the industry is based more on cost leadership as opposed todifferentiation.ConclusionIn the consumer paper and tobacco industry the rivalry among existing firms is veryhigh. A large part of this is brought about by the large number of assets that are required toenter the industry and compete with the already established firms. The industry has been inthe past several years but has steadily begun to slow down due to restrictions being applied bynational governments across the globe. Governments have began to put market restrictions onhow much tobacco can be produced by an individual firm as well as on advertising and manyother aspects of the industry. The slowing down of national economies can additionally play arole in the sluggish industry. People have been losing a lot of their disposable income forcingthem to cut back on such items as tobacco products. The low concentration of the industryadds competition as well. With not as many active firms the firms must really compete forevery piece of the market, and due to the fact that there is very little differentiation they mustcompete on other levels such as price. There are very low switching costs and little need forlearning economies in the industry because the industry has been around for so many yearsmost of the products and techniques have been mastered. However, achieving economies of28

scale in the industry is vital to a firm’s success. If firms are not able to mass produce theproduct and cut down on the marginal cost then there is little to no marginal profit for the firmto attain. The fixed to variable costs in the industry as well are very high due to the largeamount of long term fixed assets that are required to operate efficiently in the market. Most ofthe successful firms in the industry have moved overseas in order to be more successful andtherefore need more long-term assets abroad as well. Exit barriers in the industry are very highdue to the fact that the amounts of long-term assets are so astronomical, making the industryeven more competitive between the established firms.Threat of New EntrantsThe large amount of profits achieved in the consumer paper and tobacco industryattract many new firms to attempt to enter the industry. With “Schweitzer-Mauduit’s revenuereaching close to 743.5 million dollars a year and Universal reaching close to 2.66 billiondollars,” (finance. Yahoo), indicating large profit margins the industry would seem veryattractive to new entrants. New firms entering the industry could have trouble competing withthe already established firms on achieving economies of scale. A first mover advantage alreadygives the current firms in the industry a great advantage over new firms. As well as alreadyestablished distribution channels and relationships with suppliers and customers. The biggestfactor affecting new firms in the legal barriers that have recently began to harshly impact theindustry. The threat of new entrants into the consumer paper and tobacco industry is relativelylow.Scale EconomiesAn economy of scale is a theory that if a firm increases aspects of production that inreturn input costs would decrease, furthermore increasing marginal profit for the good orservice provided by the firm. Firms work to achieve an economy of scale by investing largeamounts of capital into plant, property, and equipment in order to produce more products more29

apidly and more efficiently. This will also greatly lower the plant property and equipment ratioallowing the firm to look more ideal to investors. In the consumer paper goods and tobaccoindustry it has become increasingly difficult for new entrants to gain economies of scale due tothe large amount of outsourcing that is done. Almost every firm in the industry competes on aglobal level because they are offering a global product and requiring large amounts of assets.For example, “Schweitzer-Mauduit International and its subsidiaries conduct business inapproximately 90 countries with operations in the United States, France, Brazil, the Philippines,Indonesia, Canada, and a joint venture in China.” (yahoofinance.com) Moreover, Alliance one,another big competitor already established in the industry operates in “United States, SouthAmerica, Europe, and Asia.”(yahoofinance.com) It would make it extremely difficult for a newfirm to enter the industry without larger amounts of capital to invest into these resources.Another way to achieve economies of scale is to maintain large amounts of assets. Onaverage any one of the larger firms in this industry will maintain around 1.85 billion in currentassets. For a new firm to enter the industry they would be forced to invest a large amount ofcapital and would have to reduce marginal profit to almost nothing in an attempt to receivesome long-term contracts from the major cigarette suppliers.Additionally, in the consumer paper and tobacco industry it is difficult for a firm toachieve this because there are very little differentiation levels. With cigarette smoking beingaround for hundreds of years the addictive nature of the product it is very difficult for acompetitor to reverse engineer a product to make it any better from the last. Moreover theaddictive nature of the product creates mass amounts of brand loyalty making it even moredifficult for a new firm to enter the market with a different product. The chart displayed belowshows the vast amount of capital the large firms of the consumer paper and tobacco industryinvest in to plant property and equipment.30

1400 1200 1000 800 600 400 200 0 Property Plant and Equipment (in millions) 2005 2006 2007 2008 2009 Schweitzer-Mauduit Alliance One Universal Corporation New firms attempting to enter the consumer paper and tobacco industry have a veryslim chance to achieve economies of scale. This is a result as the large amount of capital that itwould take to invest to achieve the manufacturing capabilities of the firms currently active inthe market.Another large part halting new comers from advancing in the industry is brand loyalty tothe products that are already being manufactured. With the products being active in themarket with little to no change for such extended period of times, it would be very hard for anew firm to come and reverse engineer or differentiate the product to encourage consumers tochange products.First Mover AdvantageAnother obstacle facing new entrants in the industry is first mover advantage. Firstmovers are the firms that initially established their role in the industry and set the marketstandards. The current members of the industry all maintain a first mover advantage becausethey are recognized in the market not only as a brand, but also by the mass amounts of assetsthey currently maintain.31

Considering how products and services provided in this industry have been around forsuch an immense time, firms have already created several long-term contracts and relationshipswith suppliers and customers. For example a majority of customers in the industry are verycustomer loyal to products. With the legal age of consuming tobacco being eighteen mostcustomers acquire a brand at a young age. With new legislation "severely restricting the fewremaining channels they have to communicate with adult tobacco consumers," (The BismarckTribune) it makes it very difficult for new entrants to gain consumer popularity. With theproducts and services maintaining low production costs, it would make it more difficult for anew entrant to come and receive lower prices on raw materials. Additionally, the new entrantswould not be able to mass-produce raw materials, making it more difficult to receivecompetitive pricing.New entrants would find it tough to enter this industry because of first moveradvantage. The large firms competing in the industry would already have competitiveadvantage over the new firms, and substantial amount of time and capital in order to cut downthe competitive advantage.Access to Channels of DistributionChannels of distribution can be difficult for new firms who want to enter the competitiveindustry of consumer paper and tobacco. “The limited capacity in the existing distributionchannels and high costs of developing new channels can act as powers barriers to entry”(Palepu & Healy). The firms already competing in the industry, but by the strict tobacco lawsand taxes that are enforced by governments around the world as well do not only bring thisabout. A new firm could find it very expensive to enter into this. As mentioned earlier, nearlyevery firm in the industry operates in a worldwide marketplace, which would require largeamounts of capital.32

RelationshipsThe relationships of the paper and tobacco industry are very important. Most of themain competitors in this industry have been around and operating on average for around 80years. (Schweitzer Mauduit 10-K, Alliance One 10-K, Universal 10-K) The deep relationshipswith their suppliers and customers can be very strong barriers to entry. “With the average ageof a smoker being 13,” (Illinois Dept. of Public Health) and the life expectancy of the worldincreasing everyday with new medical technology, the relationships between companies andtheir customers is imperative. Cigarette customers are both male and female from the ages of13 to 44 worldwide. (Illinois Dept. of Public Health) Additionally the ability to maintainsuppliers in multiple other countries where the cost of goods sold is considerably less is veryimportant. As indicated earlier, many of the firms have outsourced throughout the world.Maintaining the relationships with the suppliers and employees is very important, as well asmaintaining proper relationships with their respective governments.Legal BarriersThe legal barriers affecting the consumer paper and tobacco industry grow every day.The industry is under extreme pressure from national governments worldwide as well as, stateand local governments who are attempting to lower the consumption of these products.Additionally, political turmoil around the world has also been affecting the industry. The desireof the firms to outsource and achieve reduce labor prices have lead them to countries that arenot always politically stable and is frowned upon by many domestic politicians. Taxes ontobacco products have increased greatly throughout the years, and the price of cigarette packshas almost doubled in the past ten years. Additionally, several health insurance companies nowmandate that smokers inform them of their tobacco history and consumption, which could leadthe companies to choose not to cover the tobacco users. The type of advertising has also comeunder plenty of scrutiny, and advertising like “Joe the Camel” that is supposed to appeal tochildren has come under strict supervision by the government. Other countries are alsofollowing in the footsteps of the United States and cracking down on the amount ofconsumption due to the great health risks that come along with it. Right now “one in threeadults today or 1.1 billion people smoke” (Economics of Tobacco Control) and for severalcountries implanting national healthcare companies can become very expensive.33

Not only are they cracking down on the companies, they are also implementing laws onthe amount of crop that is allowed to be grown in other countries. This is greatly affecting theprice of tobacco and paper production levels.Firms must be able to adapt to the new political and economical pressures affectingfirms have greatly increased in the past ten years and are only going to keep increasing. Thecurrent restrictions and future restrictions provide large barriers to entry for new firms.Additionally the large settlements and rising of taxes on the products will greatly affect profitlevels of the industry.ConclusionThe threat of new entrants into the consumer paper and tobacco industry is very low.With the mass amounts of economies of scale already established by current and active firmswould make it very difficult for a new firm to enter and succeed. Additionally with the averageage of the existing firms close to 80 years there is a significant amount of first moveradvantage. Moreover the amount of outsourcing that is done currently in the industry, and theamount of work that is done all over the rest of the world would make it hard for a newcompetitor to enter and achieve the levels of distribution that are already established without alarge amount of investment of capital. As mentioned earlier the addictiveness of the productand the age of the brands have established long-term brand loyalty and relationships withcustomers and suppliers. New entrants would find it hard to get the same competitive pricesthat current firms operating in the industry receive. The legal barriers of the entry make theindustry even more difficult to enter. New legislative and legal restrictions on the companiesare established every day. As well as large amounts of taxes that are being enforced on thelarge firms and greatly reducing profit levels of the industry. Therefore there is little threat ofnew entrants entering the market and stealing market share from current firms.Threat of Substitute ProductsThe possibility of customers using a substitute product is a threat to every company,regardless of the industry. However, in an industry where the government is constantly against34

its product (indirectly), the threat is even higher. Cigarettes have become a huge target ofgovernments because of the health risks imposed by the inhalation of tobacco smoke. “Actionsto restrict or prohibit advertising and promotion of cigarettes or other tobacco products, to limitsmoking in public places and to increase taxes on such products, are intended to discourage theconsumption of cigarettes and other such products” (SWM 10K). Despite competing againstsubstitute products, the tobacco paper industry is indirectly being targeted.Considering how tobacco paper producers have nothing to do with the creation ofcigarettes, it is hard to come up with many substitutes. One substitute tobacco companiescould use is to replace premium tobacco paper products, which are fire safe, with the previouslyused regular paper that does not have a lower propensity for ignition. Another substitute wouldbe smokeless tobacco, which is 98% safer than smoking cigarettes, according to the AmericanCouncil on Science and Health.Buyers Willingness to SwitchThe number of customers in the tobacco paper industry is few, but they each buy asignificant amount of a tobacco paper’s inventory. Therefore, if a firm were willing to switch toa substitute product, it would have a huge affect on any firm. The demand for the tobaccopaper is dependent on the buyer’s ability to sell their product. If there is a decrease in theamount cigarettes demanded then there would be a decrease in the demand for paper productsas (1) their inventory increases and (2) they no longer need tobacco paper. This would alsohave an effect on consumer’s willingness to switch. The benefits may outweigh costs whenconsidering this.Would a consumer be willing to switch back to the previous forms of tobacco paper?Currently, the U.S. is in the process of requiring all cigarette manufacturers to have paper thathas low ignition propensity. Therefore, for any firm planning to operate in the U.S this wouldnot be feasible. Consumers would be unwilling to switch and lose a whole market in thewestern hemisphere.Also, although consumers have the option to switch to smokeless tobacco, most wouldbe unwilling to take away from their cigarette production. According to the Center for DiseaseControl and Prevention, approximately 3% of adults currently use smokeless tobacco. Becausethis market share is so small, it is doubtful that they would even attempt to increase this35

market. Also, there are negative stigmas that go along with smokeless tobacco that affectpurchasing decisions.Relative Price and PerformanceAn important factor when considering substitution is if the quality remains as rivalsbegin to compete on the basis of cost. Often times, there is a correlation between losses ofquality with lowered prices. If a tobacco company were to choose to substitute premiumtobacco paper with the previously used paper, the price difference would only be roughly onecent per cigarette of savings. With the large amount of government regulations, tobacco papercustomers may be willing to pay a little more for the premium paper quality. Firms in thetobacco paper industry have strict restrictions placed on their products (inadvertently, ofcourse). “Certain properties of cigarette paper, such as control of ignition propensity, basisweight, porosity, opacity, tensile strength, texture and burn rate must be controlled to tighttolerances”(SWM 10K).The tobacco industry could also choose to increase their production of smokelesstobacco, and decrease the amount of cigarettes. It is much cheaper to manufacture smokelesstobacco than it is to manufacture cigarettes. However, because the majority of tobacco userssmoke cigarettes, it would be impractical for a tobacco firm to do this.ConclusionIn industries that rely heavily on research and development, the likelihood ofsubstitution is low. It is more likely that they will switch to a company within the industry.Bargaining Power of CustomersWhen considering the bargaining power of buyers, one must ask, “how large of aninfluence do the customers have over prices?” The control over bargaining power dependshighly on the number of customers in the industry. When there are fewer buyers in the market36

it is easy for them to dictate the price over the suppliers. However, if there are few suppliers tothe customers, they will have more power considering there is little competition.The bargaining power of buyers involves many aspects, which includes switching costs,differentiation, and the importance of product for costs and quality, the number of buyers, andthe volume of buyers. In order to understand each of these topics, one must understand whothe customers are and who the consumers are. In the tobacco paper industry, the customer isthe company who buys the raw materials, like cigarette paper, from companies like Schweitzer-Mauduit. For example, when Phillip Morris buys tobacco paper from Schweitzer-Mauduit, theyare the customers. However, when a person goes and buys a pack of Marlboro cigarettes, theyhave just become the consumer. It is important to recognize the difference between these twoin order to understand the difference in their bargaining power.Switching CostsSwitching costs are costs that are incurred due to switching suppliers within the sameindustry. The amount of influence a buyer has depends on how high or low their switchingcosts are. For example, if switching costs are low, the buyer is able to shop around and findwhich company is offering the lowest price. In contrast, when switching costs are high,companies are less likely to change suppliers because the additional costs to find such suppliermay increase the actual costs for the product.When considering the tobacco paper industry, the customers seem to have low and highswitching costs. Even though tobacco companies can easily switch whom they buy theirtobacco paper from for little cost, there would be no reason to. There are very few suppliers oftobacco related paper and it would be unnecessary and a high cost for customers to switchsuppliers. The high cost being the customer finding another supplier with the same motivesand the same cost. According to Schweitzer-Mauduit’s 10K, Phillip Morris International, BAT,JTI, and Imperial account for sixty percent of the previous year’s sales 1 . Losing even one ofthese companies could have a significant impact on their profit and on their operations. Thetobacco paper industry is special in that there are a small number of large companies on thesupply side and the demand side (in regards to customers only). Schweitzer-Mauduit is theexclusive provider of cigarette paper for many of its customers, so in order for one of thesecompanies to switch they would basically have to start from scratch.37

The tobacco paper industry is also indirectly affected by the demand of its consumers.If there is no demand for their product through the customer by consumers, then the customerwill have a decreased demand. Additionally, consumers have almost no influence over the priceof tobacco paper. This is seen by continual sales of cigarettes even as prices are raised 2 .(Western Europe)There is a trend of cigarette demands decreasing, but this is at a very slow rate. This islargely due to increased knowledge of the health risks or the steps that are being taken by thefederal government to decrease the demand for tobacco. Sales could be hugely impacted if thetobacco industry could perform studies that invalidate previous studies on cigarettes. Even withthis possibility, consumers are not able to negotiate prices with the paper industry in order tolower the costs of the overall cigarette.DifferentiationDifferentiation is the use of innovative and unique ideas from firms to separatethemselves from their competitors in the industry. In order for this to be meaningful, the valueadded must be perceivable by the buyers. Otherwise, they may not be willing to pay apremium price for the product.38

As far as the purpose of tobacco paper in a cigarette, those in this industry are not ableto differentiate themselves from the others. Their product is used to wrap tobacco in order forconsumers to “safely” smoke a cigarette. So in order for paper companies to be different theymust conduct a great deal of research and development (R&D). The main reason for R&D is tocome up with ways to be safer in the tobacco market. However, paper is paper, and companieslike Schweitzer-Mauduit spend little money on their R&D team primarily because it is physicallyimpossible to make paper safer. This is one of the reasons bargaining power of the customersis low because their suppliers do not compete on differentiation very much.Costs and Quality ImportanceMost people are willing to pay a little more for a quality product that is pricedreasonably. In the tobacco industry a large amount of money is put into research anddevelopment so that their product is not only of the best quality, but that it is withingovernment regulations. In recent years, there has been a major push for fire safe cigarettes.These cigarettes have a lower chance of burning when left unattended. According towww.firesafecigarettes.org, 99.8% of the U.S. has adopted legislation that requires cigarettescompanies to create these fire safe cigarettes.39

So for the tobacco paper industry, customers are going to buy from companies whomake fire safe paper, which is unattainable. The customers bargaining power is lowconsidering the cost and quality is going to be the same among suppliers.Number of BuyersIn an industry where buyers are highly concentrated, the loss of one buyer could havean adverse affect on that company’s operations. The tobacco paper industry is such anindustry. In Schweitzer-Mauduit, five companies buy over 60% of their supply. What thismeans is that the tobacco paper industry doesn’t need a large number of customers but canprobably thrive on ten or fifteen customers.40

Volume per BuyersThe volume a buyer purchases also can indicate how much influence they will have overtheir supplier. If the volume they are purchasing is a significant amount of the total supplied,then the buyer will be able to somewhat influence the price of the supplier’s product. In thetobacco paper industry, it is normal for one tobacco paper company to be the sole supplier of aspecific buyer. For example, Schweitzer-Mauduit is the sole supplier for Phillip Morris. PhilipMorris has over twenty different cigarette brands internationally.This graph illustrates how the customers of the tobacco paper company are limited to afew major buyers. This increases the bargaining power of the customer to require the papercompanies to give them a good price.41

ConclusionIt is obvious that the tobacco paper industry is heavily influenced by their buyers inregards to price. Because of the low number of buyers in this industry, the customer has highbargaining power. They are able to demand a quality product at a low price. If papercompanies are not able to meet their demands, it is likely that the customer will select anothercompany to supply its tobacco paper. So when choosing a price in this industry, they are muchmore likely to take into consideration their buyer.Bargaining Power of SuppliersA major determinant of an industry’s appeal is the evaluation of their suppliers. Thebargaining power of suppliers is different in every industry and is based primarily on the supplyand demand for a particular product. The higher demand and lower supply for a certainconsumer good can lead to supplier power, where the lower demand and higher supply for thesame good will diminish the supplier’s power. Suppliers gain and lose influence in their marketdepending on a business’s switching costs, differentiation, cost and quality importance, and thenumber of suppliers in the market/volume per supplier.Switching CostsWhen evaluating the suppliers bargaining power in this industry, one must consider theswitching costs. Switching costs are determined by how many suppliers there are in theindustry and how accessible they are. Within the tobacco related paper market, switching costsare going to be inexpensive due to the large number of suppliers there are nationwide. Theraw materials contributed to this industry include wood pulp, tobacco leaf by-products, flaxfiber, cellulose fiber, flax straw, and calcium carbonate. Wood pulp is the major raw materialused in the production of cigarettes and other tobacco products, and is very attainable allaround the world. Companies like Schweitzer-Mauduit or British American Tobacco would nothave problem-switching suppliers, nor would they lose profit or productivity in the conversion ofusing a new supplier. Schweitzer-Mauduit states, “We believe that our purchased raw materialsare readily available from several sources and that the loss of a single supplier would not have amaterial adverse effect on our ability to procure needed raw materials from other suppliers”42

(SWM 10-K). Considering the overall switching costs in this industry, it is expected to be low.Furthermore, suppliers have little bargaining power over companies in this market.DifferentiationAnother key element in determining the bargaining power of suppliers is thedifferentiation in their products. The main strategy of differentiation is to be unique in allaspects of their business. In this industry, the main products suppliers provide are rathersimilar worldwide. Suppliers in this market must position themselves to compete on customerservice, timely execution, and lower costs. Having speedy services and lower cost for bulkorders would be ways for suppliers to get ahead in the distribution of their products. This beingsaid, differentiation in the tobacco related paper industry seems to be low because thematerials being supplied are somewhat identical. There is no room for suppliers to expand theircompetitive advantage when considering differentiation in their products and basic services.Costs and Quality ImportanceOne of the main priorities valued over products is their quality and the cost to eachcompany. Suppliers must compete on their ability to provide superior products at a lower cost.Considering this market, it is less likely that suppliers are going to be innovative with theirproducts. A firm cannot simply change the grade of wood pulp or calcium carbonate sold.Therefore, companies like Schweitzer-Mauduit have the ability to choose which supplier theyuse based on the cost. They once stated, “Selling prices of our paper products are influenced,in part, by the market price for wood pulp, which is determined by worldwide industry supplyand demand” (SWM 10-K). If supply for the raw materials are high, there will be lower costsnationwide. Therefore, making suppliers have a lower bargaining power with their customersbecause there is going to be a similar price for the same quality products.43

Number of Suppliers/Volume per SupplierThere seems to be a vast number of possible suppliers in this particular industry.Businesses all over the world make the products needed to manufacture tobacco related paperand specialty paper, which makes it easy to choose a supplier. It is also easier to have a setsupplier where firms can buy materials in bulk. Schweitzer-Mauduit is a company who hasmade agreements with suppliers in each of their locations where they can buy their rawmaterials on a per ton basis. This is an example of how suppliers once again have a lowbargaining power because firms will usually stick with a supplier if they are satisfied with theirservice and the price of their volume per order.ConclusionConsidering the suppliers in the tobacco and paper industries, it is evident that theyhave little room for bargaining power. Since the companies are looking for consumer goodsthat are relatively similar, it is easy for them to switch suppliers at their own will. When lookingat the switching costs, differentiation, cost and quality importance, and the number ofsuppliers/volume per share, it proves that the suppliers have little authority in these industries.This being said, the industry has most of the negotiating leeway and looks to be more powerfulin the future.Analysis of Key Success Factors for the Value Creation in the IndustryFor a firm to be successful in any industry, it needs to obtain a competitive advantageover its competitors. A corporation can achieve a competitive advantage by using strategieslike differentiation and cost leadership. A firm can focus solely on cost competitive,differentiation, or they can combine the two in their own way. In the past, the tobacco paperindustry has used a mixed strategy with a higher concentration on cost leadership. However,with the latest legislation firms in the industry are being forced to differentiate their products inorder to meet new health regulations.44

Cost LeadershipCost leadership means a firm is able to supply the same product as their competition ata lower cost. An industry in which whose products are very similar to another industry’sproduct use cost leadership as a competitive advantage. Three ways to gain a cost leadershipadvantage are economies of scale, low-cost distribution, and efficient production. Firms achieveeconomies of scale by acquiring enough assets in order to mass-produce their product, reducingtheir marginal cost. Firms achieve a low cost distribution by opening multiple distribution plantsor distribution channels. The most popular way of achieving this is by outsourcing orestablishing plants in foreign territory. The tobacco paper industry uses a cost leadershipapproach with some differentiation as a competitive advantage. Cost leadership is vital forfirms in the paper and tobacco industry to succeed because tobacco products have evolved verylittle over the years. They have only recently been differentiated in the past year.Economies of ScaleEconomies of scale are the advantages firms achieve in costs when expanding theirbusinesses. The tobacco and paper industries can achieve economies of scale by producingmore units of goods while maintaining low costs. In this industry firms have a good amount ofproperty, plant and equipment considering they are multinational firms. Property, plant andequipment accounted for 56% of Schweitzer-Mauduit’s assets. As Schweitzer-Mauduit utilizesthese assets to produce as much as possible their cost of production per unit lowers. Advancedmachinery used to produce tobacco paper and paper products faster and more efficiently drivesthe cost of production down by reducing the marginal cost and increasing marginal revenue.Tobacco products have such low marginal revenue that it is very important for firms in theindustry to reduce costs, allowing them to compete on a cost leadership level.45

Low-Cost DistributionLow-cost distribution is also an important factor in driving down costs to obtain acompetitive advantage. Shipping costs get more expensive when the cost of oil and othertransportation rises. The paper and tobacco industry drives cost down by delivering directly totheir customers, for example, Alliance One ships directly to the distribution center of theirBelgium destination. From there, their Belgium customer can then distribute the product to itsaffiliates. Also, having different means of transportation can have an effect of lower distributioncosts because there may be instances when it’s better to ship by boat than fly the merchandise.Schweitzer-Mauduit has different means of transportation. The tobacco and paper industrieshave selling agreements with their customers so distribution costs are lowered because theyonly ship product when the agreements say. This saves from having orders returned and morecosts added. Being a worldwide corporation is a main factor for how the tobacco paperindustries achieve low-cost distribution. With the large amount of capital invested in plantsabroad, distribution costs are reduced when delivering products to foreign countries.Efficient ProductionThe tobacco and paper industry has been providing the same product for hundreds ofyears and the production process has changed very little. They have become more efficient byusing better machinery, establishing close relationships with customers, and adopting just-intimeinventories.Outsourcing and developing plants abroad also allows the firms to operate moreeconomically. “Unprocessed tobacco is a semi-perishable commodity that generally must beprocessed within a relatively short period of time to prevent fermentation or deterioration inquality” (AOI 10K). So they have their facilities located close to their sources of tobacco. Thisis an example of just-in-time inventory. It is an efficient method to not create waste. Just-intimeinventory is also efficient because there is no excess inventory to crowd the productionsite, which can allow for products to flow in and out of the facilities convenientlyWith cheaper labor overseas firms are able to employ more employees to speed up theproduction process. The large investment in fixed assets in these plants abroad allows the firmsto operate more efficiently, as well. Establishing close relationships with customers allows thepaper and tobacco industry to gain greater perspectives of what customers want and it is less46

likely for the customer to return a product and create waste. Better machinery enhances theproduction process of customer wants and knowing specifications helps the industry provide theright products to the right customers.Research and DevelopmentThe tobacco and paper industry invests a small amount in research and development(R&D) as a percentage of sales. For Schweitzer-Mauduit, they spent approximately 1.08 % ofsales for research and development while the rest of the industry does not spend any amounton research and development. “No material amounts were expended for research anddevelopment during the fiscal years ended March 31, 2009, 2008, or 2007 (UVV 10K).However, firms are being forced to begin investing in R&D to find new ways to make tobaccoproducts healthier due to new legislation and regulations that have been passed on the tobaccoindustry, for example, the requirement for self-extinguishing tobacco paper. Additionally,governments around the world have limited the amount of advertising that could drive minorsto use tobacco products. Leading firms in the industry are trying to find new ways to attract anolder customer base and invest more into research and development.DifferentiationIn the paper and tobacco industry, competition is very high because the products arevery similar. There is little differentiation that can be provided in these industries.Differentiation is a strategy that “involves providing a product or service that is distinct in someimportant respect valued by the customer,” (Palepu and Healy, 2-9). Some factors ofdifferentiation include superior product quality, superior product variety, and investment inresearch and development.Although the paper and tobacco industry creates their competitive advantage throughcost leadership, a small amount of research and development has been utilized to meet theneeds of their customers. Schweitzer-Mauduit is the only firm in the industry to provideresources to research and development. The government has become increasingly involvedwith regulating the tobacco companies over the years. They have placed caps on the amount oftobacco that can be produced and have pressured firms to produce fire-safe cigarettes.47

Schweitzer-Mauduit is “dedicated to developing cigarette papers, reconstituted tobacco andnon-tobacco paper product innovations and improvements to meet the needs of individualcustomers” (SWM 10K).ConclusionDifferentiation and cost leadership are the main strategies for achieving a competitiveadvantage. How well a firm utilizes these strategies can determine their successfulness in anindustry. As previously mentioned, the paper and tobacco industry utilizes more of a costleadership strategy to gain a competitive advantage. Economies of scale, low-cost distribution,efficient production, and research and development are core competencies the industry uses toobtain a cost leadership strategy. In the past, this had lead to a very profitable industry for thefirms but with the new government regulation of the tobacco products, they are being forced tosomehow differentiate their products to make them safer to the consumer. This industry willsoon need to become more differentiated to obtain a competitive advantage.Competitive Advantage AnalysisOverall, the tobacco related paper industry seems to be highly competitive. This industryis competitive because there are a select number of businesses that cater to the production oftobacco paper, as well as specialty paper. Therefore, having fewer suppliers of tobacco paperin the industry drives up the competition considerably. Schweitzer-Mauduit is difficult tocompare since the majority of other tobacco companies in the industry actually manufactureand sell their own cigarettes after production. Schweitzer-Mauduit supplies the specialtycigarette paper, but has no affiliation with the manufacturing of the actual cigarettesthemselves. Because it is such a unique industry, firms compete at the highest level,implementing cost leadership strategies. Firms in the tobacco industry focus on economies ofscale, efficient production, low input costs, and use little yet efficient means for research anddevelopment. Schweitzer-Mauduit implements all of these business strategies and successfactors in order to enable the highest competitive edge. Schweitzer-Mauduit has left asignificant footprint in the paper product and tobacco related paper industry, taking a great deal48

of pride in being the “the world’s largest supplier of fine papers to the tobacco industry”(Schweitzer-Mauduit 10-k).Economies of ScaleWhen more units of a good or service can be produced on a larger scale with less inputcosts, economies of scale exist or are achieved. In other words, when a company grows, moreproduction units can be achieved. Therefore, that company has a greater chance of decreasingits costs. It is similar to buying in bulk, per say. When there are large economies of scaleinvolved, firms trying to enter into the industry will have a harder time competing with theexisting firms. Because there are few companies competing in this uniquely classified industryof specialty papers for tobacco companies, existing firms in the industry have an advantage.Schweitzer-Mauduit and its competitors have been successful in the industry because of theirlasting agreements with their existing customers. Combined, Schweitzer-Mauduit and itscompetitors produced $4.9 billion in revenue for the end of the 2008 fiscal year, $4.7 billion in2007, $4.5 billion in 2006, and $3.6 billion in 2005. The table below shows total assets ownedby each company, in millions, which make up the bulk of the industry.49

After analyzing the table and running the numbers, it is obvious that a new firmwanting to enter this market, it would take a significant amount of capital andmarketing in order to make an indention and compete in the industry. This leaves littleopportunity to gain market share and profits. New entrants clearly will not have theresources to compete with the already established firms.Efficient ProductionHaving a cost-leadership business strategy for the specialty paper productindustry relies greatly on creating low cost production. One of the main components inreducing costs is the efficiency of production. This is achieved when a product iscreated at its lowest cost without wasting any of the company’s resources. Schweitzer-Mauduit continuously evaluates how to “optimize the efficiency and costcompetitiveness of our worldwide production facilities” (Schweitzer-Mauduit 10-k).They do this by conducting regular checks and audits to make sure production isrunning smoothly and numbers are meeting minimum requirements of inventory levels.Also, audits help to recognize and reduce processing and delivery times as well as50

educing product costs. The government has recently proposed new regulations forcigarettes making companies implement a new technology in cigarette paper calledLower Ignition Propensity, LIP. A number of states have already passed these newregulations and it is likely that all fifty states will implement these new LIP regulationsby late 2009 or early 2010. Demand for LIP paper is at a current level of 44 percent,and it is expected to increase to approximately 84 percent by 2010. With the new LIPpaper driving demand in the industry, it will be crucial to have efficient production inorder to lower costs with more paper being produced. Having a firm run its productionprocesses at a high level of efficiency helps lower cost of goods sold, which in turncreates a higher gross profit margin. SWM does a good job of running productionefficiently; they continually improve production times and have decreased product costson a year-to-year basis.Low Input CostsIn order to compete at the highest level in the specialty paper industry, havinglow input costs is crucial. Schweitzer-Mauduit sells its cigarette paper product to all ofthe tobacco industry. Recent activity in the industry shows some consolidation betweenseveral cigarette manufactures. The consolidation of several firms has created asomewhat harmful effect to Schweitzer-Mauduit’s operating results because it hasallowed their customers more negotiating leverage. Losing vital customers orexperiencing decreased sales has a detrimental effect on Schweitzer-Mauduit. To helpalleviate fear of loss or decreased operation results, Schweitzer-Mauduit enters intoagreements with these customers that ensure fixed prices for certain products. SWMuses significant amounts of energy, electricity, natural gas, and fuel oil to run itsmachines that manufacture the pulp and paper. Energy is generally not an issue butprices can and do fluctuate significantly. Due to this, SWM reduces the uncertainty ofenergy costs by entering into agreements with an energy cogeneration supplier toproduce their energy requirements for future periods and keep their energy costs down51

(source – SWM 10k). If critical components of operations, such as energy or wood pulp,increase under these conditions, this would add to their input costs and cause a loss ofrevenue to the company. It is obvious how important this is to Schweitzer-Mauduit’soperations when looking at wood pulp as their main raw material used in production.In 2008, there were 91,000 metric tons of wood pulp consumed in its operations, and in2007, there were 104,000 metric tons of wood pulp consumed in its operations.Schweitzer-Mauduit attempts to keep input costs low and to avoid having material andsubstantial increases defusing low input costs and in turn generating less revenue.Research and DevelopmentFirms that follow cost-leadership strategies allocate little money to research anddevelopment. Schweitzer-Mauduit devotes minimal efforts to research anddevelopment in sales, but claim to allocate enough money to R&D in order to developand produce the top quality paper for their products. In Schweitzer-Mauduit’s mostrecent income statement taken from its 10K, the last three years they have spent only alittle over 1 percent of their revenue on research and development.Schweitzer-MauduitR & D Expenses2006 2007 20088.3 8 7.31.08 % of sales 1.12% of sales 1.11% ofsales(In Millions)52

It is evident when reading the table above that a large sum of money is in factspent on research and development, but relatively this is only a small portion of overallrevenue. Schweitzer-Mauduit acknowledges in their 10-K that there very own “researchand product development capabilities are unsurpassed in the industry and have playedan important role in establishing our reputation for high quality, superior products”(Schweitzer-Mauduit 10-k). According to their 10K’s, neither one of Schweitzer-Mauduit’s competitors, Alliance One or Universal Corporation has spent a substantialamount of money on research and development.ConclusionIn order for Schweitzer-Mauduit to compete against its competitors effectively,an efficient cost leadership strategy must in practice. High concentration on efficientproduction, low input costs, and effective research and development strategies are theessential ingredients to succeeding in the specialty paper and tobacco industry. It hasbeen these characteristics that have allowed Schweitzer-Mauduit to become the world’slargest supplier of specialty cigarette paper to the tobacco industry, while also owningapproximately 35 percent of the global market share. This includes 70-75 percent ofthe North American market, 65-70 percent of the Western European and Asian market,85 percent of the Brazilian market, and 70-75 percent of the South American marketshare.Structure of Formal Accounting AnalysisPerforming an accounting analysis on a firm is crucial for financial analysts to fullyunderstanding the true value of a firm. A complete analysis allows for a firm to be stated at aproper value without any distortions to the numbers. “The purpose of accounting analysis is toevaluate the degree to which a firm’s accounting captures its underlying business reality”(Palepu & Healy 3-1). Accounting can be misconstrued in several ways in which may enhance ordistort the appearance of a company’s financial statements. GAAP (Generally AcceptedAccounting Principles) permits firms to have flexibility in their accounting methods and to reportonly the underlying state of the firm on its balance sheets. Companies like to do this to make its53

usiness more attractive to potential investors or to it looking stable to the naked eye forexisting shareholders.There are six steps in the accounting analysis process. The first step is to identify afirm’s key accounting policies. These policies are related to the firm’s key success factors.Second, assess the accounting flexibility. This varies among the industry because not all firmshave the same amount of accounting flexibility as the others. “When managers have accountingflexibility, they can use it either to communicate their firm’s economic situation or to hide trueperformance” (Palepu & Healy 3-8). Third, evaluate the accounting strategy. This correlateswith the amount of flexibility a firm utilizes. Next, discover the quality of disclosure. Managershave the ability to provide the bare minimum of disclosure set by GAAP, or to have enoughinformation available to investors so that they get a clearer view of the firm’s business activities.The fifth step is to identify potential red flags. Red flags are unusual findings within acompany’s statements and estimates that point to questionable accounting behaviors. When redflags arise the analyst should gather more information and examine the items more closely. Thesixth and last step in the accounting analysis process is to undo any accounting distortions. “Ifthe accounting analysis suggests that the firm’s reported numbers are misleading, analystsshould attempt to restate the reported numbers to reduce the distortion to the extent possible”(Palepu & Healy 3-11). When these six steps are completed, the analyst should have athorough view of the numbers that state the firm at its truest value.Key Accounting Policies The key accounting policies should be directly related to the firm’s key success factors.Key success factors can be directly correlated with the ability of a firm to have a competitiveadvantage over its competitors. The key success factors are always related directly to the keyaccounting policies. The prior factors talked about in our analysis of key success factors forvalue creation in the industry and competitive advantage analysis are a firms type oneaccounting policies. These types one polices allow an analyst to analyze the key success factorsin relation to disclosure. The accounting of day-to-day business operations drives these successfactors. The way management decides to report the financials can create the opportunity forfinancial statements to be distorted to hide potential negative information.54

The second of the two accounting policies deals with distortion. The analyst performingthe accounting analysis identifies and evaluates the key policies the firm uses to measure itsfactors and risks. Distortions occur in the form of goodwill, foreign currency risk, pensions andother post retirement plans, and research and development. It is very important to analyzeeach of these areas where potential distortions have been identified to create a true andaccurate picture of the firm.Type 2 Accounting PoliciesGoodwill Goodwill is used to reflect the portion of the book value of a business entity not directlyattributable to its assets and liabilities. Goodwill occurs when a business acquires anotherbusiness for more than it is worth. Goodwill in turn shows the capability a firm has in providinga higher profit than would come from the sale of such assets. As stated, goodwill appears onthe balance sheet when an asset has been purchased for more than it is worth. In anacquisition, when a company buys another company or makes a substantial purchase of anasset, they may pay more than the fair market value of that asset. This excess cost becomesgoodwill on the financial statements. Goodwill is also an intangible asset; which means it cannotbe touched, seen, or physically measured. In essence, it is nothing more than a numberplugged into the balance sheet and is disguised so that the company does not look to haveoverpaid for an asset. It is recorded as an asset and accountants record goodwill as a write offfor the company in the financial reports.Goodwill is no longer amortized under GAAP; companies are now required to value thereporting units using present values of future cash flows and compare it to their carrying value.If the fair value is less than the carrying value then goodwill needs to be reduced so the fairvalue is equal to carrying value. The impairment loss is reported as a separate line item on theincome statement, and the new adjusted value of goodwill is reported on the balance sheet.The chart below shows how Schweitzer-Mauduit’s goodwill took a spike in 2008 from theprevious four years. In January 2008, two of the company's French subsidiaries purchased28 percent minority interest in LTRI. The purchase price of 35 million Euros, funded byborrowings under the company's Euro Revolver, was allocated to the fair value of the assetsacquired and liabilities assumed, including an allocation of $10 million to identifiable intangible55

assets. The excess of the purchase price over the fair value of the net assets acquired resultedin goodwill of $6.4 million (source – SWM 10k). SWM is expected to purchase more minorityinterest rights in the near future, which make distortions to goodwill highly likely, and goodwillis expected to rise.SWM 2008 2007 2006 2005 2004Goodwill 6.4 2.8 2.8 2.8 2.8PP&E 407.8 456 416.8 414 453.2Goodwill % ofPP&E1.60% 0.60% 0.65% 0.70% 0.62%Foreign Currency RiskFor any company that operates internationally, one of the risks they run is the changein currency and exchange rates. It is one of the main setbacks associated with doing operationsoverseas. Foreign currency exchange rates can be hazardous to Schweitzer-Mauduit’s operatingprofit because it does business in over 90 countries and the transactions may be denominatedin a non-local currency. The result of these changes in exchange rates impact the amount oflocal currency recorded for these transactions. This creates the potential for either unrealizedgains or losses in foreign currency revenue and therefore can impact Schweitzer-Mauduit’soperating profit. Schweitzer-Mauduit alleviates foreign currency transaction risks by enteringinto forward and swap contracts and options contracts to hedge their exposure to foreigncurrency risk when they deem it is beneficial to do so. “The use of these contracts minimizestransactional exposure to exchange rate changes because the gains or losses incurred on thederivative instrument will offset, in whole or in part, the loss or gain on the underlying foreigncurrency exposure” (Schweitzer-Mauduit 10-K). In 2008, changes in the currency exchangerates had a positive impact on sales of $26.4 million for Schweitzer-Mauduit. This was duelargely to the impact of a stronger euro compared with the U.S. dollar. The euro was 6.7%stronger than the U.S. dollar and the Brazilian real was 6.8% stronger against the U.S. dollar.56

SWM for the most part does a sufficient job at hedging. During 2008, when the markets starteda dramatic downturn, it had a little affect on SWM resulting in a slight loss. “As of December 31,2008, a 10 percent unfavorable change in the exchange rate of our functional currencies andthose of our subsidiaries against the prevailing market rates of non-local currencies involvingour transactional exposures would have resulted in a net pre-tax loss of approximately$0.3 million” (SWM 10K).Net Sales bysegment2008 2007 2006 2005 2004U.S 226.7 226 221.8 215.2 196.5French 495.4 435 385 416 427Brazil 70.5 73 67.3 60.2 50.2The chart above shows net sales from each segment the SWM operates in for the pastfiver years. You can see Schweitzer-Mauduit does almost 75% of their business overseas intheir French and Brazil segments, creating a significant amount of foreign currency risk. For themost recent year, 2008, $565.9 million in sales came from the combined French and Brazilsegments out of the total $767.9 million generated in sales for the overall company. Comparedto SWM’s main competitors, Alliance One and Universal Corp, it has slightly less foreigncurrency risk. These companies both get approximately 85% of their sales from overseas.Pension and other Post Retirement Plans Pension and post retirement plans are benefits paid to former employees of the companyduring their retirement years. A pension is a steady flow of income, similar to an annuity. Postretirement benefits most commonly include life insurance and medical plans but could alsoinclude vision and dental packages as well depending on how the contract is set up.Pension plans come in two types; defined benefit plans and defined contribution plans.Most companies will have numerous defined benefit plans and defined contribution planscovering the majority of their employees. With a defined benefit plan, the retiree receives afixed monthly income and knows the terms of the benefit they will receive upon retirement. The57

company is responsible for investing in a fund in order to meet its obligations to the employee.With this plan, the company takes on the investment risk. Among defined benefit plans, themost popular type states a promise to pay retirees based on two factors, the length of theirservice and their salary history at the time of retirement. More and more companies areswitching to a defined contribution plan, such as a 401k. With this plan, the company makescontributions or matching contributions but does not promise the future benefit to theemployee. A defined contribution plan has the employee take on the investment risk, which inturn reduces the company’s costs and expenses. “The Company recognizes the estimated compensation cost of employees' pension andother postretirement benefits over their approximate period of service in accordance with SFASNo. 87, “Employers’ Accounting for Pensions” and SFAS No. 106, “Employers’ Accounting forPostretirement Benefits Other than Pensions”. The Company's earnings are impacted byamounts of expense recorded related to these benefits, which primarily consist of U.S. andFrench pension benefits and U.S. other postretirement benefits, or OPEBs. Each year's recordedexpenses are estimates based on actuarial calculations of the Company's accumulated andprojected benefit obligations, or PBOs, for the Company's various plans” (Schweitzer-Mauduit10-K). Pensions and other post retirement benefits are recorded as liabilities on the balancesheet. The discount rate is a major determinant of the planned assets and the future value ofthe cash flows the plans should create. The discount rate is indirectly correlated with firm’sliabilities, which will skew the financial statements if it is under or overestimated.Pension and Other Post Retirement BenefitsCompany 2008 2007 2006 2005 2004Schweitzer-Mauduit67.3 38.9 54.2 38.1 47.8Alliance One 11.3 1.9 8.9 3.3 4.1Universal Corp 88.3 100 70.4 50.9 46.5(In millions)58

Schweitzer-Mauduit and its competitors group pensions and other post retirementbenefits together in their balance sheets. The table above compares Schweitzer-Mauduit to itscompetitors in expensing the liability of pensions and post retirement benefits. It shows howSchweitzer-Mauduit expenses more than Alliance One but less than Universal Corp, puttingthem in the middle of the pack. Based on each of the company’s balance sheets and incomestatements, Schweitzer-Mauduit expenses a greater percentage to pensions and other postretirement benefits relative to its competitors because they are a smaller company with lessrevenues and assets.Research and DevelopmentResearch and development is crucial to a company’s operations in the tobacco relatedpaper and specialty paper product industry. “The specialized nature of these tobacco-relatedpapers requires unique research and development capability and special papermakingequipment and skills to meet exacting customer specifications” (Schweitzer-Mauduit 10K –competition). Companies in the tobacco industry expense high amounts of cash into researchand development in order to have the highest quality of paper for their cigarettes. Out of itscompetitors, Schweitzer-Mauduit is the only company that denotes any cash to research anddevelopment. Alliance One and Universal Corp do not expense any cash into research anddevelopment. In both of their 10-k’s, it says no material amounts were expensed towardsresearch and development for any of the past five years.Research and development is treated as an expense on the income statement, it isexpensed out of gross profit and is expensed when incurred. “Some companies do not record aseparate line item for research and development expenses. To the extent that they do incursuch expenses they are probably lumped into selling, general, and administrative expenses butwould be disclosed in a footnote. Companies that are more reliant on research will generallyreport it separately” (www.financial-education.com – research and development expense). SWMis reliant on research and development because R&D is such a crucial part in having the mostefficient top of the line paper product to supply. For this reason, R&D is crucial and SWM doesreport research expense on a separate line item.59

SWM 2008 2007 2006 2005 2004R & D 8.3 8 7.3 9 9.3OperatingIncome16.9 17.9 5.3 39.3 57.7R & D % relative toOperating Income49% 45% 138% 23% 16%(In millions)The chart above shows how much money was expensed by Schweitzer-Mauduit over thelast five years into research and development. It shows research and development expensesrelative to operating income for restatement purposes for Schweitzer-Mauduit. The chart alsoshows how research and development exceeds 20 percent of operating income, which means itmust be restated in the financial statements. As you can see SWM expenses a significantamount into research and development relative to its operating income. SWM commitment toresearch and development has enabled them to produce high-performance papers, producepapers to exacting specifications with very high consistency, produce cigarette paper withextremely low basis weights, and develop cigarette paper for LIP cigarettes. Due to R&D, SWMis at the forefront of the industry and has immense competitive lead way over its competitors.Accounting FlexibilityManagement of a firms accounting flexibility is determined by their accounting policiesand the accounting standards set by GAAP. The amount of flexibility differs between firms andindustries due to the accounting policies for the certain key success factors. Some managers donot have the ability to choose their policies because there are rules that GAAP must enforce oncritical valuations for firms financial statements. Firms have no accounting discretion on howthey report their research and development costs. However, how a firm estimates futurebenefits is very flexible because different companies have different rates they use depending on60

their economic activity. If firms have little flexibility, managers face information lack in theirfinancial statements, which leaves insufficient room for “dressing up” their statements. Incontrast, managers of firms having high flexibility obtain the power to use specific numbers andrates that will make there accounting estimates informative for future economics. Highflexibility will also allow managers to formulate their consolidated financial statements in a morepositive standing. The following paragraphs discuss the flexibility of Schweitzer-Mauduit’saccounting policies in regard to their key success factors.GoodwillGoodwill is defined as the difference between the acquisition price of a company and thefair value of it. Meaning that a company has goodwill when they by another company or firm. Itis an intangible asset that is reported on the balance sheet. Under No. 142 SFAS goodwill hasan indefinite life and must be tested for impairment annually. Reporting impairment for goodwillis very flexible because managers can use their own discretion when recording the amount.This is due to how firms estimate the fair value after discovering impairment. These numbersdiffer when managers are biased over recording the impairment.In the case of SWM, recording goodwill is based on the implied fair value of the assetcompared to the book value. The implied fair value is determined in the second step in theimpairment test, which measures the difference of the fair value of the goodwill and the fairvalue of all other assets and liabilities other than goodwill. SWM tests for goodwill annually inthe fourth quarter. In the years ended 2008, 2007 and 2006 they had no impairment chargesfrom their required impairment tests, making their financial statements appearances beneficial.This shows how companies can have more flexibility when reporting goodwill impairmentsbecause managers can use their own discretion.61

The graph above depicts the amount of goodwill that was recorded for the years 2004through 2008. In these particular years, Schweitzer-Mauduit has significantly lower goodwillwhen compared to Universal Corporation. This shows how they have not acquired near as manyassets as Universal. When comparing these two companies, investors may conclude thatUniversal’s balance sheet looks more appealing due to higher assets.Foreign CurrencyCurrency risks result when companies do part of their operations in foreign markets.Firms must be up to date with exchange rates in their particular overseas area. These exchangerates vary depending on the current ratio to the US dollar. Considering how public the exchangerates are it leaves little flexibility for management manipulation. They have strict standards setby the GAAP that they must follow. A company like SWM operates nationwide and must recordexpenses due to the exchange rates in France and Brazil. SWM transacts business in severalcountries, which are not all in local currency, which can affect their operating profitsubstantially. According to their 10-K, SWM’S managements, “utilize a forward and swap62

contracts and, to a lesser extent, option contracts to selectively hedge our exposure to foreigncurrency transaction risk when it is practical and economical to do so”. These contracts help tolessen transactional exposure to exchange rate changes that will eventually offset the foreigncurrency exposure. They follow SFAS No. 52 “Foreign currency transaction” when SWMtranslates their foreign operations income statements into local US dollars.Foreign currency risks occur when firms conduct business in non-local currencies. SWMendured “losses resulting from re-measurement and settlement of such transactions andbalances, included in other expenses, net, were $4 million, $1.1 million and $1.3 million in2008, 2007 and 2006 respectively”. They reported these losses from exchange rates inunrealized for current charges on their consolidated statement. This is an example of how firmshave no room for flexibility in reporting the gains or losses of currency risk.Pensions and Other Postretirement Benefit PlansPension and Post-Retirement plans are made up of companies’ annualcontributions, which provide employees benefits when they retire. Management has asubstantial amount of flexibility because the planned assets are all based on estimatesdetermined by there certain accumulated and future benefit plan obligations.Companies have an option of the amount and what type of plan they intend to use. AtSchweitzer-Mauduit, they are in accordance with No. 87, “Employers’ Accounting forPensions”, and No. 106, “Employers’ Accounting for Postretirement Benefits Other thanPensions”, of the SFAS. In their 10-K, SWM states that “the company recognizes theestimated compensation cost of employees’ Pension and other Post-Retirement Benefitover their approximate period of service” in regards to the SFAS. In their United Statesfacilities, Schweitzer-Mauduit offers a defined benefit plan or a defined contributionplan. However, in France, which includes the Indonesian and Philippines branches,they are covered under a government-administered program.63

The amount of flexibility is high when evaluating the discount and growth rate acompany uses for their planned assets. Firms must be careful when determining these ratesbecause over or underestimating either can distort the firm’s liabilities and earnings on thebalance sheet. In the case of Schweitzer-Mauduit, this rate is determined annually by how muchpensions they wish to distribute, which is based on management judgment. Furthermore, thediscount rate may tend to fluctuate year to year due to Schweitzer-Mauduit’s current marketrates.Discount Rates for Last Five years 2004 2005 2006 2007 20086.00% 5.75% 6.00% 6.40% 6.40%6.00% 5.75% 5.75% 5.50% 5.75%6.00% 5.75% 6.00% 5.90% 5.90%In the chart listed above, Schweitzer-Mauduit’s discount rates are larger in 2006, 2007and 2008 compared to its competitors. Having these rates larger makes their liabilities andexpenses less than that of Universal and Alliance One. Using a lower discount rate orunderestimating it can skew the liabilities and expenses on the balance sheet. In conclusion,managers value the discount rates for pension retirement plans allowing for high flexibility andfuture problems.Research and DevelopmentThe flexibility related to research and development recording are pretty clear in relationto GAAP standards. GAAP requires that management expense all R&D costs associated in thefinancial statements. This gives firms leeway in the end when they need to restate theseexpenses. Companies have the flexibility to expense the associated costs, or to capitalize them.64

The ability to do this gives firms the option to enhance or distort their financial statements.Firms that need to improve the appearance of their net income can capitalize the expensesrelated to the realized asset, which would also increase their assets on the balance sheet.Evaluation of Accounting StrategyBecause of the discretion given to managers through accounting flexibility, theaccounting strategy differs across companies in the industry. The evaluation of each company’saccounting strategy is necessary to determine whether or not a manager’s accounting flexibilityis used to “either communicate their firm’s economic situation or to hide true performance”(Palepu and Healy). This can be determined by establishing whether or not they are highlydisclosed, meaning they provide sufficient information on how they apply their accountingstrategies in regard to their key accounting policies; or if they have low disclosure, meaningthey only disclose the minimum set by GAAP. This will help when assessing if they areconservative or aggressive in its choice of accounting policies. Having a conservative policy canlead to lower reported earnings, while an aggressive approach would lead to higher reportedearnings.GoodwillTo evaluate the accounting strategy of goodwill, analysts must first determine whetherthe company contains high disclosure or low disclosure. Goodwill is the excess of the purchaseprice of an acquired business over the fair value of net assets. It must be tested forimpairment annually and should be impaired if the book value of the goodwill exceeds its fairvalue. Firms in the industry test for goodwill impairment in the fourth quarter. Schweitzer-Mauduit International, Inc (SWM) evaluates goodwill by performing a two-step test. The firsttest is to compare the book value of the reporting unit to its fair value. If the book valueexceeds the fair value then “we determine an implied fair value of the reporting unit’s goodwillby allocating the fair value of the reporting unit to all of the assets and liabilities other thangoodwill. The difference between the total fair value of the reporting unit and the fair value of65

all the assets and liabilities other than goodwill is the implied fair value of that goodwill” (SWM10-k).SWM did no impairments of goodwill during 2004-2008. In fact, their goodwill was 2.8million from 2004 to 2007. Universal Corp. (UVV) and Alliance One International, Inc (AOI) hasonly impaired goodwill once in the last 5 years which was $1.7 million and $256.9 million,respectively. It is reasonable for Schweitzer-Mauduit to not impair goodwill because manycompanies do not impair unless it is more than 20% of their property, plant and equipment.There is also little segmentation in regard to goodwill, giving that these firms are allmultinational.After reviewing the balance sheet of not only SWM’s competitors, but also otherindustries, most firms do not have a consistent goodwill rate. This could be a major concern ifgoodwill was more than 20% of PP&E and staying at a consistent rate because it could meanthat Schweitzer-Mauduit is playing with the numbers too aggressively and trying to boostearnings. Although this is not the case for Schweitzer-Mauduit, the industry still applies anaggressive accounting policy because there has been little to no impairment of goodwill, whichagain, could lead to higher earnings. Ultimately, this could be considered a potential red flag.Foreign CurrencySchweitzer-Mauduit is a company that operates globally, meaning they deal with foreigncurrencies and are at risk of losses from fluctuations in foreign currency exchange rates. Lately,currency risk has increased substantially as economic stability globally has decreased. Becauseof this uncertainty, the transaction risk increases (risk on future contracts already entered in) onlong-term contracts. To alleviate some of this risk, Schweitzer-Mauduit denominates their salesin U.S. dollars; however, in some countries they must use the non-local currency. Theyalso use what is called hedging tactics, which is discussed later. This allows them tolower their foreign currency transaction risk, however, there will still be currencytranslation risk. “A weakening of the U.S. dollar versus the local currency of the foreignsubsidiary will have favorable currency translation impact when positive financial resultsof that foreign subsidiary are translated to U.S dollars” (SWM 10-k). They denominate66

their sales in U.S. dollars to minimize their interest rates and foreign currency risk.From the information given, it illustrates how SWM has moderate disclosure. The nextstep is to analyze whether the company is aggressive or conservative.Most companies that operate globally use hedging tactics. Hedging is a positionestablished in one market in an attempt to offset exposure to unwanted risk(Wikipedia.com). To allow hedging, the industry utilizes forward and swaps contractsand derivative instruments to have less foreign currency transaction risk. Forwardcontracts are contracts that allow a firm to negotiate prices for the future today andenter into a binding contract to lock in these prices. Swap contracts are contractsbetween two parties in which the parties: (a) promise to make payments to oneanother on scheduled dates in the future, and (b) use different criteria or formulas todetermine their respective payments (www.richard-­‐wilson.blogspot.com). Neither SWMnor its competitors provide information on what these derivative instruments are. Theydo however provide sufficient information on the dollar amount of benefit from thesetactics. For example, SWM had forward contracts used to purchase $42 million and $16million in 2008 and 2007, respectively. The contracts “were designated as cash flowhedges of foreign currency transactions to fix the Company's local currency cash flow”(SWM 10-k). UVV and AOI recognized $15.1 million and $4.1 million, respectively, ingains in 2008. SWM has a conservative accounting policy. They provide sufficientinformation on how they protect themselves from foreign currency risk and their gainsor losses in comprehensive income.Pension/Post Retirement BenefitsSchweitzer Mauduit offers two forms of pension plans: a defined benefits plan and anemployee contribution plan. A defined benefit plan promises a specified amount of monthlyincome after retirement. It is common for this amount to be based on salary and/or years ofservice. Conversely, in an employee contribution plan, the amount available at retirement is at67

the employee’s sole discretion. This makes future estimates even more uncertain becauseemployees’ contribution to their plan may fluctuate severely month-to-month. The best way toanalyze a company’s pension benefits is to examine three things: the discount rate, return onplan assets, and projected increase in salaries and compensation expense. A big enoughdistortion in any of these three can suggest that they are trying to increase earnings.One of the easiest ways for a company to increase earnings is to adjust their estimatedpension expense. An unusually high discount rate could suggest that the company may betrying to lower their liabilities expense. Schweitzer Mauduit’s discount rate fluctuates around6%. By looking at the table below we can see that this is pretty much the average in thisindustry.Discount Rates for Last Five years 2004 2005 2006 2007 20086.00% 5.75% 6.00% 6.40% 6.40%6.00% 5.75% 5.75% 5.50% 5.75%6.00% 5.75% 6.00% 5.90% 5.90%The second thing we want to consider is where they are investing their money to pay forthese future benefits. In the long run, a pension plan that invests a large portion of its assetsin equities is more than likely going to earn a higher profit than if they were to invest in fixeddebt securities. As shown in the table below, firms in this industry invest a significant amountin equity securities. They also invest a significant amount in hedge funds and real estate, whichthe firms have labeled alternative investments.68

Schweitzer Mauduit 2004 2005 2006 2007 2008Equity Securities 65% 66% 65% 60% 58%Fixed Income Securities 25% 21% 25% 18% 14%Alternative Investments 10% 10% 10% 20% 26%Universal Corporation 2004 2005 2006 2007 2008Equity Securities 53% 54% 53.3% 55%Fixed Income Securities 18.9% 17.6% 60.5% 30%Alternative Investments 28.1% 28.4% 30.2% 15%Alliance One International 2004 2005 2006 2007 2008Equity Securities 78% 68% 80% 73% 43%Fixed Income Securities 17% 28% 15% 18% 41%Alternative Investments 5% 4% 5% 9% 16%This may be the cause in the exceptionally high-expected rate of return. Usually areasonable rate of return is between 6 and 7%. All three firms have a higher rate or return.However, since all three companies have about the same rate of return it does not raise any redflags.Lastly, we need to look at projected increase in salaries and compensation expenses.Since most companies base pension benefits on the employee’s salary at retirement, anexceptionally low projected increase in salary can have a dramatic effect on their ability to payfuture pension liabilities. The higher the salary, the greater the pension obligation will be.69

2004 2005 2006 2007 2008Schweitzer 3.5 3.5 3.5 3.5 3.5Universal 2.5 3 5 5 5Alliance Unknown Unknown 3.75 3.75 3.75(Unknown because Alliance only has last two reports on website.)As you can see, Schweitzer Mauduit’s projected increase in salaries is lower than itscompetition. We are uncertain if this is due to the fact that they just have a lower expectedsalary increase or if they are trying to use this to excuse their discount rate. This could be apotential red flag, just because they are lower than the industry average as a whole.Research and DevelopmentThe SEC requires all final reporting to be done following the rules of GAAP. GAAPstrictly prohibits the capitalization of research and development, cutting off a significantpotential asset in the long run. They do this to offset potential problems that come up if aproduct in research and development becomes obsolete. For Schweitzer Mauduit, this unlikelybecause the amount of time it takes to create a new product is significantly less than say apharmaceutical company. Nonetheless, Schweitzer has to still recognize these as expenseswithout the ability to capitalize them once they begin creating profits. The level of disclosure ispretty much the same across the industry, in that they must follow strict guidelines from GAAPrecognizing it as an expense (so moderate). Because of this, each firm follows a conservativeaccounting policy.70

ConclusionThe accounting strategy a firm decides to use, whether aggressive or conservative, isimportant when valuing a firm. This is due to the fact that manager’s performance is usuallytied to their ability to create or maintain profits. When analyzing Schweitzer Mauduit, it seemsas if they typically follow more of an aggressive accounting policy.Asset Level of DisclosureGoodwillForeignCurrencyPensionLiabilitiesResearch andDevelopmentLowModerateHighModerateAsset Accounting Policy: Conservative or AggressiveGoodwillForeignCurrencyPensionLiabilitiesAggressiveAggressiveAggressive71

Qualitative DisclosureOne of the most important steps when valuing a firm’s performance is to assess theirlevel of disclosure. The amount of disclosure a firm contains depends on what they wantanalysts and investors to see. Considering how GAAP requires a minimum level of disclosure,management has large leeway when deciding on what to reveal. A firm having low disclosureraises questions on how clear their financial statements are and makes it difficult for investorsto value their company performance. Investors will feel more at ease when comparingcompanies if there is adequate and relevant information available. The level of disclosure alsodepends on management’s utilization of their accounting flexibility. Firms that exercise moreflexibility tend to have low disclosure because of the freedom they possess regarding theirestimations. The following paragraphs evaluate Schweitzer-Mauduit’s level of disclosure, whichwill give a broader view of the truthfulness to their financials, as well as how transparent thecompany is.GoodwillAfter observing Schweitzer-Mauduit’s 10-k’s for the past five years, it shows that theyhave a very good level of disclosure. They describe how they must test for impairment ingoodwill, which is done in the fourth quarter annually. An impairment loss is determined as theexcess of book value of goodwill over the implied fair value of goodwill. For the years 2004-2008, no impairment loss was recorded for the goodwill. In SWM’s case, in all of their 10-k’sthey discuss their acquisitions and what part of it is property, plant and equipment, inventory,and then states the goodwill. They also include goodwill as Other Assets for each acquisition ontheir consolidated balance sheets.Another element to observe is the percentage of goodwill to property, plant andequipment. If goodwill is greater than 20% of PP&E, it is impaired and must be restated. Thehigher the percentage of goodwill to PP&E leads to the conclusion that the firm may have toomany assets on their balance sheet that are not very useful.72

Schweitzer-Mauduit2004 2007 2006 2007 2008PP & E 453.2 414 416.8 456 407.8Goodwill %of PP & E0.62% 0.7% 0.65% 0.6% 1.6%(In millions)For SWM, they have a very low percentage compared to their PP&E, which shows theydo not have unnecessary assets that are destructive to their business activities. This also showswhy they have not had any impairment losses in the past 5 years. Overall, Schweitzer-Mauduithas a good level of disclosure because it provides information in all the relative areas forrecording goodwill and goodwill impairments. And if it necessary to state, if an impairment losswas recorded, it is likely that they would adequately describe how their tested for it and why itoccurred.Foreign Currency RiskSchweitzer-Mauduit’s annual reports for the past five years give a considerable amountof disclosure over their foreign currency risk. Considering how firms have minimal flexibilitywhen disclosing hedging activities, they do not have a choice. There is substantial informationabout the high risk of foreign currency exposure because they transact business in 90 differentcountries. They state how they hedge their exposure to these risks by using derivativeinstruments, such as forward and swap contracts. SWM shows the fair and market risk for eachposition in their future contracts, and discusses the numbers calculated. In 2008, they had a“10 percent unfavorable change in the exchange rate of [their] functional currencies and thoseof [their] subsidiaries against the prevailing market rates of non-local currencies involving[their] transactional exposures [which] would have resulted in a net pre-tax loss ofapproximately $0.3 million”. They explain how they use this information to presume ahypothetical loss resulting from the foreign exchange rate changes. In this example, they clarifyhow they would reduce the risk and hypothetical loss by selectively hedging their exposure by73

using the derivative instruments. Furthermore, Schweitzer-Mauduit discloses sufficientinformation when calculating the gains and losses from unrealized foreign currency changes,which are present in the consolidated financial statements. Overall, Schweitzer-Mauduit has ahigh level of disclosure which helps investors and analysts when valuing the risk of foreigncurrency changes.Pensions and Postretirement Benefit PlansWhen comparing Schweitzer-Mauduit’s 10-k’s with its competitors, it seems to discloserelatively the same level of disclosure or a little less. SWM has all of their numbers anddescribes where they derived them from and where they go in the company, however not ingreat detail. Alliance One’s 10-k has a lot more written explanations about their plan assetnumbers and describes how and where they are being invested. A company’s managersdetermine the discount rate, which establishes the future cash flows to cover pension andretirement plan payments, and these rates can only tell so much. Schweitzer-Mauduit does notgo into that much detail about their rates, but they do offer information on how they determinethe fair value of the plan assets. This being said, SWM and most of its competitors haveadopted the FSP No. FAS 132(R)-1, “Employers’ Disclosures about Postretirement Benefit PlanAssets”, which will be effective after December 15, 2009. This “enhances the requireddisclosures about plan assets in an employer’s defined benefit pension or other postretirementplan, including investment allocation decisions, inputs and valuation techniques used tomeasure the fair value of plan assets and significant concentrations of risks within plan assets”(SWM 10-k). Taking this into account, as of right now SWM has an adequate level of disclosure,but after this adoption there should be a significant increase of disclosure.Research and DevelopmentWhen evaluating the tobacco paper industry, it has a low level of disclosure; however,SWM seems to be the only one with adequate disclosure. Schweitzer-Mauduit’s competitors,Alliance One and Universal Corp did not expense any research and development during the pastfive years, while SWM expensed R&D for the past three years. In SWM’s case, they value theirproducts to be the most superior quality due to how they utilize R&D. They accurately portraythese expenses in their financial statements, and explain why the R&D was expensed rather74

than capitalized. The only reason they would capitalize research costs would be to eitheraccelerate taxable income or to delay deductions in order to sustain positive domestic taxableincome or to minimize a domestic taxable loss (SWM 10-k). Considering how much cash, timeand effort they put into their product, one can only assume that SWM has a good level ofdisclosure, which is true in this case. Not only do they discuss why they expense or capitalizeR&D costs, which are in their financial statements, but they also go into great detail about theiroverall R&D and how they go about conducting it in their branches nationwide.Quantitative AnalysisQuantitative analysis allows investors, management, and equity analysis’s the ability tounderstand the true status of the firm. GAAP allows companies ample amounts of flexibility;therefore there is sufficient manipulation in financial reports. “Big Bath’s” allow firms toseverely understate their current assets and overstate expenses in order to make an alreadybad year look worse and look ahead to the future. This can result in agency problems ordilemmas where management is not looking out for the best interest of the shareholder andmaximizing shareholder wealth. This makes it very important when analyzing firms to identifypotential red flags and other manipulations.There are two types of manipulation diagnostics that can be exercised; revenuemanipulation and expense manipulation. Revenue manipulation strictly concentrates on sales,but additionally highlights cash from sales, accounts receivables, inventory, and warrantyexpense. Expense manipulation pinpoints cash from operations, operating income, netoperating assets, asset turnover, and total accruals.Sales Manipulation DiagnosticsSales Manipulation Diagnostics are used to determine the relationship between a firmsnet sales and specific items on a firm’s balance sheet. These ratios can be compared in order tovalidate the truthfulness of a firm’s accounting methods. These also help a firm determine redflags. Ratios that seem abnormal could raise concern for the validity of a firm.75

Net sales/ Cash from salesDue to the time value of money theory this ratio is incredibly important for firms. Tocompute the ratio a firm would take total sales collected from the year and subtract the changein accounts receivable in order to calculate cash from sales. Followed by net sales divided bythe cash from sales. The ratio describes the relationship between the amount of total sales andthe amount of sales collected in cash. An ideal ratio would be 1:1, however if the ratio issignificantly high it may indicate an overstatement of sales. In comparison if the ratio issignificantly low the firm may be understating accounts receivables in an attempt to understatetotal assets for the period and a potential red flag.12 Sales/Cash from Sales 10 8 6 4 2 SWM AOI UVV Industry Average 0 2004 2005 2006 2007 2008 76

5 Δ Sales/Cash from Sales 4 3 2 1 0 -1 -2 -3 -4 -5 2004 2005 2006 2007 2008 SWM AOI UVV Industry Average From the graph pictured above, it shows that the industry in the past hasexperienced a very stable ratio over the past five years. Schweitzer-Mauduit andUniversal have continued to maintain ratios that were near the industry average.Alliance One, however, experienced rapid growth in the ratio from 2007-2008 that couldpotentially raise a red flag. However, the large growth in sales and a decrease inaccount receivables explain the large growth in the ratio.Net Sales / Accounts ReceivableIn order to calculate the ratio and ensure accuracy the allowance for doubtfulaccounts should be deducted from accounts receivables. Following net sales of the firmwould be divided by the new computed accounts receivables account. The calculationof a high ratio would indicate a firm’s ability to collect receivables quickly. On the otherhand a low ratio would represent a firm that is unable to collect accounts receivables.Ratios should grow proportionally with the growth in sales from year to year. However if77

a ratio is growing unusually, it may suggest that a firm is understating accountsreceivables in order to present a more favorable income to investors.20 Net Sales/Accounts Receivable 15 10 5 SWM AOI UVV Industry Average 0 2004 2005 2006 2007 2008 78

Δ Net Sales/Accounts Receivable 100 80 60 40 20 0 -20 2004 2005 2006 2007 2008 SWM AOI UVV Industry Average -40 The graph depicts that industry as a whole has maintained a stead ratio throughout thepast years of close to 8.0, indicating that for every eight dollars of sales, one dollar is collectedon account. In the previous two years all the firms were able to maintain a ratio close to theindustry average. However from 2006 to 2007 Universal experienced a significant decline intheir ratio. This could possibly raise a red flag, indicating that Universal is attempting tounderstate assets or sales to understate net income. However in further examination of the 10-K a large decrease in sales is the cause of the decrease in the ratio.79

Net Sales/ InventoryThe ratio is the measure of how quickly a firm is turning its inventory into sales. Inorder to calculate the ratio a firm would take the net sales for the period and divide it by theinventory level for the period. Low ratios are ideal due to the fact that maintaining high levelsof inventory are detrimental to firms. This is due to the fact that storing inventory is expensiveand could potentially represent a zero investment. Inflation additionally causes inventory tolose value. High ratios and positively correlated ratios are ideal for firms. Low ratios couldimply large levels of inventory that could be very detrimental to the liquidity of the firm.7 6 5 Net Sales/Inventory 4 3 2 SWM AOI UVV Industry Average 1 0 2004 2005 2006 2007 2008 80

Δ Net Sales/Inventory 30 25 20 15 10 5 0 -5 -10 2004 2005 2006 2007 2008 SWM AOI UVV Industry Average The charts displayed above show the sales inventory raw levels, and thepercentage change for the industry. From the raw information investors are able to seethe stability of the industry. No firm in the industry had a ratio fall or rise by more thanone point throughout the past five years. Most of the stability is brought on by theaddictive nature of the product. During good and bad economic times the necessity forthe product remains the same for the consumer, leaving the firms with a veryestablished and constant customer base. Additionally, this industry encounters noseasonality problems. The products produced from the industry are used continuouslythroughout the year.81

Expense DiagnosticsThe expense manipulation diagnostic ratios help draw conclusions on whether afirm has distorted the income statement or the statement of cash flows. By analyzingthe CFFO/OI, CFFO/NOA, asset turnover, and pension expense/ SGA expense ratios,investors may determine if firms distorted either of these statements to perceive thefirms as more profitable or less profitable. Any significant abnormalities located in theratios allow firms to raise potential red flags. Once the red flags are realized, investorscan investigate why the firm distorted their financial statements and what they arehiding.CFFO/ OIThe cash flows from operations divided by operating income is a highly effectivemethod to distinguish any differences between the firm’s statement of cash flow and theincome statement. The ratio describes a firm’s ability to turn operating income intoeither positive or negative cash flows for the firm. With a steady ratio near one, a firm isable to create most of its income from habitual operations. Any number over one orsignificantly changing from year to year may be a sign of manipulation and a red flagpotentially should be raised.82

0.3 CFFO/OI 0.25 0.2 0.15 0.1 0.05 SWM AOI UVV Industry Average 0 -0.05 2004 2005 2006 2007 2008 Based on the graph, Schweitzer-Mauduit and Universal were able to maintain the moststable and closest ratios to the industry average. Alliance One experiences a fluctuation ofratios. Universal followed the industry trend however the ratio was slightly below the industryaverage. From 2005 to 2006 the ratio jumped from roughly 0.0 to .25. Then from 2007 to2008 the ratio declined to a rate of .02. This could raise a potential red flag.83

7 6 5 4 3 2 1 0 -1 -2 -3 Δ CFFO/OI 2004 2005 2006 2007 2008 SWM AOI UVV Industry Average CFFO/ NOACash flows from operations provide a very valuable and analytical approach toefficiently examine firms depreciating procedures. The ratio is discovered by dividingthe cash flows from operations by net operating assets. Net operating assets are firmsfixed long term assets or most of the time, the plant, property and equipment. Themore elevated the ratio, the more efficient a firms is utilizing its long term assets;creating more cash flow from operations. Firms can possibly manipulate the ratio byover or understating the depreciation on assets to make the firm appear moreprofitable.84

12 CFFO/NOA 10 8 6 4 2 SWM AOI UVV Industry Average 0 2004 2005 2006 2007 2008 6 4 2 0 -2 -4 -6 -8 -10 -12 Δ CFFO/NOA 2004 2005 2006 2007 2008 SWM AOI UVV Industry Average The chart pictured above displays that Schweitzer-Mauduit was able to maintain thesteadiest ratio over the past five years. Although they were below the industry average, theywere able to stay between the zero and 0.2 range. Universal was able to stay the closet to theindustry average, where as Alliance One International experienced very static movement on thegraph. When referring back to Alliance One’s 10-K, it is documented that between the years2006-2007 the firm’s cash flow from operating activities doubled and then fell drastically in2008. Also, the firms net operating assets doubled from 2005-2006 and then drastically fell85

from 2007-2008. Potential red flags may be raised during these time periods due to the largeamount of growth in comparison to the industry as a whole.Asset TurnoverThe ratio allows investors and analysts to see if a firm is depreciating assets properly.The ratio is computed by dividing total sales by total assets. The ratio can be manipulated byhow aggressively or conservatively the firm records its assets. As well as with intangible assetswhere there is considerable room for manipulation to either make assets look more or lessprofitable. Normal ratios are normally around 1, and low turnovers could indicate manipulationand red flags.3.5 Asset Turnover 3 2.5 2 1.5 1 0.5 SWM AOI UVV Industry Average 0 2004 2005 2006 2007 2008 86

200 Δ Asset Turnover 150 100 50 SWM AOI UVV 0 -50 2004 2005 2006 2007 2008 Schweitzer Mauduit has the largest asset turnover depicted in the graph above. It isslightly above the industry average and the other competitors which could potentially rise a redflag indicating that Schweitzer that they are conservatively accounting their assets. Howeverthe large ratio is explained by the fact that Schweitzer is not fully involved in the tobaccoindustry in comparison to Alliance One and Universal. From the change graph the large spike ofAlliance one in the ratio could raise a potential red flag. In 2005 the amount of assetsrecognized fell radically and then grew radically in 2007. This could mean that Alliance Onemanipulated its assets aggressively in 2007 to recover from the poor performance in 2005 andpresent higher earnings and higher asset levels.Total Accruals/ SalesThe total accruals/ sales ratio is attained by subtracting CFFO from net income andthen dividing the number by total sales. The ratio will describe how the firm’s sales wererecorded in the books. The ideal ratio for firms is 1:1 due to the fact that every dollar inaccrual would be matched by one dollar in sales. When firms ratios are below one it indicatedto analysis that most of the sales are in cash, in comparison to a ratio above one implying thatmost of the firms sales are on account.87

0.1 Total Accruals/Sales 0.05 0 -0.05 -0.1 -0.15 -0.2 -0.25 -0.3 2004 2005 2006 2007 2008 SWM AOI UVV Industry Average The graphs above indicate that the industry as a whole receives a majority of its sales incash or in other methods as opposed to on account. From the graph Alliance One experiencesa large deviation in its ratios in comparison from the rest of the industry that could raise apotential red flag. Schweitzer Mauduit and Universal maintained steady ratios and performed inthe same way as the industry. When the industry experienced an increase or decrease in theratio as did the two firms. Signifying that all the firms would most likely not experience troubleswhen attempting to meet short-term liabilities.88

4 Δ Total Accurals/ Sales 2 0 -2 -4 -6 -8 -10 2004 2005 2006 2007 2008 SWM AOI UVV Industry Average From the graph and change total accruals/ sales graph above Schweitzer Mauduit wasable to maintain the closet ratio to the industry average however maintain a ratio slightly lower.Alliance one and Universal on both the raw and change graphs had very unusual movement inthe ratio possibly indicating manipulation in net sales or cash flows from operations.Pension Expenses/ SGA ExpensesPension expenses divided by the Selling, General and Administration expenses providesinvestors and analysts with information on how much a firm is expensing every year on pensionplans. Ideally, firms would prefer to have this ratio less than one. If a firm’s ratio were higherthan one, it would indicate that the firm is paying out more in pension expenses than it is onselling expenses and not efficiently running the firm. Due to how both areas of the ratio couldexperience some amount of manipulation, it is very important to analyze the ratio.89

0.6 Pension Expenses/SGA Expenses 0.5 0.4 0.3 0.2 0.1 SWM AOI UVV Industry Average 0 2004 2005 2006 2007 2008 5 Δ Pension Expense/SGA Expenses 0 -5 -10 -15 -20 -25 -30 -35 2004 2005 2006 2007 2008 SWM AOI UVV Industry Average When examining the graph above the visual describes that ideally Schweitzer Mauduitmaintains the ideal ratio in the industry. On average between .1 and .2 indicating that only tento twenty percent of expenses are being expensed as pension expenses. The small ratioimplies that Schweitzer Mauduit is conservative when managing their pension expense andsuggests no manipulation has occurred to understate or overstate revenue. However Universalsunusual movement on the raw and change graphs could represent manipulation on behalf ofUniversal to understate revenues.90

ConclusionThe ratios examined above allow investors and analysts the ability to look at themeasure of expense manipulation. Often time’s firms will manipulate their expenses to eithermake the firm look more profitable or even look worse during hard times. By examining theprevious ratios and charts no red flags could be raised on any on the firms in the industry.Alliance one experienced times of irregular volatility on the graphs however is explained by asmall depression the firm experienced. Schweitzer-Mauduit and Universal both indicatedstability, throughout the ratio diagnostics.RatioSchweitzer-MauduitTrendCFFO/ OI Above Average StableCFFO/ NOA Below Average VolatileAsset Turnover Above Average StableTotal Accruals/ Sales Above Average StablePension Expenses/SG&ABelow AverageStable91

Potential Red FlagsDue to the flexibility given to firms through GAAP, managers are able to distort theinformation that will be provided in their annual financial statements, which can raise potentialred flags. Red flags identify questionable accounting methods and suggest that the analystshould examine certain items more closely or gather more information on them (Palepu &Healy). For the most part, Schweitzer-Mauduit operations are either above average or relativelyclose to the industry average. There are, however, two questionable red flags.One potential red flag was caught in their cash flows statement. This was noticed afterperforming expense manipulation diagnostics. In comparison to competing firms, Schweitzer-Mauduit’s Cash Flow from Operation/Operating Income is below average. This requires furtheranalyzing on why this would occur; either cash flow from operations has lowered or operatingincome has increased. From the Cash Flow Statement it is shown that net cash provided by(used in) has significantly dropped in 2008. Upon further research, a reason this may haveoccurred could be due to the acquisition of a minority share in LTRI. Although thesetransactions began in 2006, they were not completed until January of 2008. This ratio shouldbecome closer to industry average in 2009, as the Schweitzer believes that this acquisitionshould improve earnings and a more competitive production base.Another red flag that was found is that projected increases in salaries are lower thanthat of the industry. Schweitzer-Mauduit expects the companies’ salaries to increase by 3.5%,as evidenced from the past five years and 2009’s projection. However, when examining theirgeneral and administrative expenses from 2006 to 2008 alone, there has been 593%. Inconclusion, their low projected increase in salaries is unrealistic, and that they should possiblyre-evaluate actual spending in relation to projected spending.Undo Accounting DistortionsSpecific standards have been put in place for the sole reason to protect investors frommanipulation. The Federal Accounting and Standards Board have implemented explicitprinciples and conditions in order to give analysts and investors a more comprehensible outlook92

of a firm’s financials. The firm’s management ultimately decides how much information theywould desire to disclose. In order for firms to appear more credible to investors and analysts, ahigh level of disclosure and low levels of manipulation is necessary. When firm’s numbers andfinancial analysis appear irregular, potential red flags could possibly be raised. When theirregularities are spotted, red flags denote that there may be distortions in a firm’s financials oraccounting policies. Firms must then undo these distortions by going through their financialstatements and find where they must make adjustments and restate anything necessary.After reviewing Schweitzer-Mauduit’s annual reports for the past five years, it seems asif the research and development expense is the only asset needed to be restated. This isbecause this particular expense is more than 20 percent of its operating income for the past 3years; the first 2 years (2004 and 2005) had no R&D expense. It is not necessary to restategoodwill, which will be discussed later.93

Original Balance Sheet For years ended December 31 (dollars in millions) Assets 2003 2004 2005 2006 2007 2008 Current Assets Cash and cash equivalents 3.7 4.5 5.1 13.7 4 11.9 Accounts Receivable 91.9 97.7 99.8 88.9 100.6 87 Inventories 97.5 119.6 123 119.2 131.2 118.4 Other Current Assets 9.2 9.9 14.8 13.8 11.4 11.1 Total Current Assets 202.3 231.7 242.7 235.6 247.2 228.4 PP & E 413.8 453.2 414 416.8 456 407.8 Deferred Income Tax Benefits 2.3 -­‐ -­‐ -­‐ 15.2 26.4 Goodwill and Intangible Assets -­‐ -­‐ -­‐ 2.8 15.6 Investment in Equity Affiliates -­‐ -­‐ -­‐ 15.4 15.4 Other Assets 19.8 32.2 34.1 44.2 38.4 35.1 Total Assets 635.9 717.1 690.8 696.6 775 728.7 Liabilities and Stockholders' Equity Current Liabilities Current Debt 30.7 50.9 30 17.1 13.6 34.9 Accounts Payable 68.8 71.3 64.3 62.5 84.3 64.5 Accrued Expenses 74.1 76.7 71.7 80.9 111.3 91.7 Current deferred revenue 6 7.5 6 6 6 6 Total Current Liabilities 179.6 206.4 172 166.5 215.2 197.1 Long-­‐term Debt 66.2 63 83.7 80.2 87.3 144.9 Pension and Post retirement Benefits 47.9 47.8 38.1 54.2 38.9 67.3 Deferred income tax liabilities 26.3 39.3 40.2 29 25 11 Deferred Revenue 41.6 35.9 30 24.1 18.1 12.3 Other Liabilities 14.6 18.7 20.1 23 22.7 18.7 Minority Interest 9.5 13.4 13.8 15.6 26 -­‐ Total Liabilities 385.7 424.5 397.9 392.6 407.2 451.3 Common Stock 1.6 1.6 1.6 1.6 1.6 1.6 Additional Paid-­‐in-­‐Capital 61.5 63.3 63.8 63.6 68 64.6 Treasury Stock -­‐21.9 -­‐22.3 -­‐15.6 -­‐11.4 -­‐12.3 -­‐14.1 Retained Earnings 244 271.5 281.8 271.6 264.6 255.9 Unearned compensation on stock -­‐0.7 -­‐0.5 -­‐0.3 -­‐ -­‐ -­‐ Accumulated OCI -­‐21 -­‐38.4 -­‐21.1 19.9 -­‐30.6 Total Stockholders' Equity 250.2 292.6 292.9 304 341.8 277.4 Total Liabilities & Stockholders’' Equity 635.9 717.1 690.8 696.6 775 728.7 95

Restated Income Statement For years ended December 31 (dollars in millions) 2003 2004 2005 2006 2007 2008 Net Sales 566.90 657.50 669.80 655.20 714.80 767.90 Cost of Goods Sold 458.00 535.40 572.50 571.10 606.70 664.70 Gross Profit 108.90 122.10 97.30 84.10 108.10 103.20 Selling expense 23.10 27.10 24.40 22.70 22.80 23.10 Research expense 0.83 1.86 1.80 1.46 1.60 0.83 General expense 23.60 28.00 24.60 27.70 35.40 32.80 Total nonmanufacturing expenses 47.53 56.96 50.80 51.86 59.80 56.76 Restructuring and Impairment expense -­‐ -­‐ 21.10 24.00 22.10 Operating Profit 61.37 65.14 46.50 11.14 24.30 24.37 Interest expense -­‐2.30 3.70 6.20 5.50 5.90 10.50 Other expenses -­‐0.20 1.50 2.50 -­‐0.50 0.10 3.40 Income before Income Taxes 59.05 62.94 42.80 5.14 18.30 10.47 Provision for income taxes at 27% 12.00 12.10 10.40 -­‐4.20 0.50 -­‐1.90 Minority interest in earnings of subsidiaries 4.90 7.00 5.80 4.10 8.00 0.20 Loss from equity affiliates -­‐ -­‐ 0.20 -­‐ 4.00 Net Income 42.15 43.84 26.60 5.04 9.80 8.17 96

Restated Balance Sheet For years ended December 31 (dollars in millions) Assets 2003 2004 2005 2006 2007 2008 Current Assets Cash and cash equivalents 3.7 4.5 5.1 13.7 4 11.9 Accounts Receivable 91.9 97.7 99.8 88.9 100.6 87 Inventories 97.5 119.6 123 119.2 131.2 118.4 Other Current Assets 9.2 9.9 14.8 13.8 11.4 11.1 Total Current Assets 202.3 231.7 242.7 235.6 247.2 228.4 Research and Development 7.47 7.44 7.2 5.84 6.4 7.47 PP & E 413.8 453.2 414 416.8 456 407.8 Deferred Income Tax Benefits 2.3 -­‐ -­‐ -­‐ 15.2 26.4 Goodwill and Intangible Assets -­‐ -­‐ -­‐ 2.8 15.6 Investment in Equity Affiliates -­‐ -­‐ -­‐ 15.4 15.4 Other Assets 19.8 32.2 34.1 44.2 38.4 35.1 Total Assets 645.67 724.54 698 702.44 781.4 736.17 Liabilities and Stockholders' Equity Current Liabilities Current Debt 30.7 50.9 30 17.1 13.6 34.9 Accounts Payable 68.8 71.3 64.3 62.5 84.3 64.5 Accrued Expenses 74.1 76.7 71.7 80.9 111.3 91.7 Current deferred revenue 6 7.5 6 6 6 6 Total Current Liabilities 179.6 206.4 172 166.5 215.2 197.1 Long-­‐term Debt 66.2 63 83.7 80.2 87.3 144.9 Pension and Post retirement Benefits 47.9 47.8 38.1 54.2 38.9 67.3 Deferred income tax liabilities 26.3 39.3 40.2 29 25 11 Deferred Revenue 41.6 35.9 30 24.1 18.1 12.3 Other Liabilities 14.6 18.7 20.1 23 22.7 18.7 Minority Interest 9.5 13.4 13.8 15.6 26 Total Liabilities 385.7 424.5 397.9 392.6 433.2 451.3 Common Stock 1.6 1.6 1.6 1.6 1.6 1.6 Additional Paid-­‐in-­‐Capital 61.5 63.3 63.8 63.6 68 64.6 Treasury Stock -­‐21.9 -­‐22.3 -­‐15.6 -­‐11.4 -­‐12.3 -­‐14.1 Retained Earnings 251.47 278.94 289 277.44 271 263.37 Unearned compensation on stock -­‐0.7 -­‐0.5 -­‐0.3 Accumulated OCI -­‐21 -­‐38.4 -­‐21.1 19.9 -­‐30.6 Total Stockholders' Equity 259.97 300.04 300.1 309.84 348.2 284.87 Total Liabilities & Stockholders' Equity 645.67 724.54 698 702.44 781.4 736.17 97

Research and Development Schweitzer Mauduit invests sizeable amounts of possible cash flows back intoresearch and development. Normally research and development is listed as an expenseon the income statement however, rather than an expense we opted to capitalize it asan asset on the balance sheet. It was determined that the capitalization rate of 80percent would be preferable. However 20 percent of the research and developmentexpenses will continue on the income statement as an expense. The table listed belowfurther details the capitalization of research and development as an asset.Research and Development ExpenseIn millions 2004 2005 2006 2007 2008Research andDevelopmentExpense9.3 9.0 7.3 8.0 8.3Research andDevelopment1.86 1.8 1.46 1.6 1.66DepreciationTotalResearch andDevelopmentCapitalization(80%)7.44 7.2 5.84 6.4 6.6498

Due to the fact that research and development is normally considered and expense onthe income statement, the new capitalization affects the total assets of the company. The chartdisplayed below will display the new amount of total assets for the Schweitzer Mauduit, byincluding the new capitalization of research and development.Schweitzer Mauduit Long Term Asset ValueIn millions 2004 2005 2006 2007 2008 Total Assets Before Capitalization Total Assets After Capitalization 231.7 242.7 235.6 247.2 228.4 239.14 249.9 241.44 253.6 235.04 After the capitalization of Research and Development to total assets, the additionaltwenty percent of research and development left in the income statement will affect thepreviously discovered net income. With research and development expenses lowered netincome will rise. However with the additional net income, a new tax level will be reached forthe firm. Upon averaging the previous five years tax rate, a rate of 27 percent was concluded.The table listed below will show the new effects of taxes on net income.99

New taxes on Net IncomeIn millions 2004 2005 2006 2007 2008TaxableIncome48.06 28.04 (6.54) 5.5 (3.64)Taxes 12.98 7.57 1.77 1.49 .98Tax Rate 27% 27% 27% 27% 27%Once the new taxes and net incomes have been computed a new net income may bestated. The table below will show the different between the original net income and therestated net income.Schweitzer-Mauduit’s Net IncomeIn millions 2004 2005 2006 2007 2008Previous 36.4 19.4 (.8) 3.4 .7New 40 24.4 3.6 8.8 6.4The final stage of restating the financials is to calculate the new retained earnings afterthe capitalization of research and development. In order to calculate the new retainedearnings, the amount capitalized will be added to the previous retained earnings figure.100

Schweitzer-Mauduit’s Retained EarningsIn millions 2004 2005 2006 2007 2008PreviousRetainedEarningsResearchandDevelopmentNewRetainedEarningsBalance271.5 271.6 281.8 264.6 255.99.3 9.0 7.3 8.0 8.3280.8 280.6 289.1 272.6 264.2GoodwillThere are two ways in determining whether goodwill must be restated on a firm’sfinancial statements. The first method compares goodwill as a percentage of a firm’s property,plant and equipment. If the goodwill is higher than 20 percent of the PP&E in any of the past 5years, it must be restated. The second approach amortizes the carrying value of goodwill overthe 5 years. If this amount exceeds 20 percent of the firms operating income, goodwill must berestated.101

Amortized Goodwill

Financial Ratio AnalysisIn order to successfully evaluate a firm a three-step process is completed. The first stepof the process is a ratio analysis of the firm, followed by using the ratios to forecast the firm’sfinancial statements, and completed by determining a cost of capital. Creditors, investors, andfinancial analysts commonly use the analysis. In order to draw conclusions on liquidity,profitability, and capital structure of the firm, it’s competitors and the industry as a whole.Liquidity RatiosLiquidity ratios allow investors and management to understand the firm’s ability to meetits short-term obligations; many of which measure sales to several other items to determine itsliquidity. The ratios additionally inform firms on management control and several other policiesregarding their capability of paying off their short-term debt. The firm should be focused onreaching high liquidity ratios to make their operations look more appealing to investors andcompetitors. Firms need to ensure stability within these ratios, as well as the industry as awhole. The ratios used in analyzing the liquidity of Schweitzer-Mauduit include the currentratio, quick asset ratio (the acid test). Other ratio’s will evaluate the operating efficiency andare working capital turnover, accounts receivable turnover, days’ sales outstanding, inventoryturnover, and days’ supply in inventory.Current RatioThe current ratio describes a firm’s ability to meet its short-term obligations. Thecurrent ratio is computed by dividing current assets by current liabilities. A ratio that is higherthan 1 indicates that the firm is able to meet its short-term debt if it needed to liquefy its shorttermassets. A ratio that is lower than 1 would imply a firms inability to meet its short termobligations and would be forced to sell off long term assets, such as property, plant andequipment, at a discount due to the fact that they are far less liquid. The ratio for theconsumer paper industry has remained at a steady and stable 1.804. This indicates that allfirms competing in the consumer paper industry have been able to meet all short-term103

obligations in the past five years, as well as indicating the consistency of the industry. Thechart does show a slight decline in ratio in recent years, most likely attributable to newlegislation on the industry and tobacco manufactures; limiting firms to the amount of inventorythey may produce and have on hand at one period of time.4 3.5 3 2.5 2 1.5 1 0.5 0 Current Ratio 2004 2005 2006 2007 2008 SWM AOI UVV Current Ratio2004 2005 2006 2007 2008SWM 1.12 1.41 1.41 1.14 1.15AOI 1.94 2.16 1.64 1.88 1.58UVV 2.04 1.844 1.92 2.23 3.52Schweitzer-Mauduit’s current ratio is significantly lower than the others depicted in thechart. On average, Schweitzer-Mauduit’s current ratio is 45 percent less than the rest of the104

industry. This is accredited to the fact that Schweitzer-Mauduit does not fully compete in thetobacco industry. Most of their business is selling tobacco rolling paper and filters to the majortobacco firms. However, with new and much safer burning papers and filters, Schweitzer-Mauduit should expect growth of the current ratio in years to come.Quick Asset RatioThe quick asset ratio is very similar to the current ratio, however, inventories issubtracted from the current assets and then divided by current liabilities. By subtractinginventories, firms can focus more on their higher liquid current assets. Inventories are notconsidered a very liquid asset due to the fact they would have to be sold at a discount in orderto cover short-term liabilities. From the chart you can infer that by comparing the quick assetratio to the current ratio, the same patterns and trends occur across the industry. However,the chart also denotes that these firms would find it hard to meet its short-term liabilitieswithout selling inventories at a discount. Most of the companies operating in the industry haveover 50 percent of their current assets in inventory as tobacco. Since tobacco is a seasonalgrowing product, firms will have large amount of inventories when the growing season iscompleted, and must be able to store it for the remainder of the year. With the industriesoperating in several different atmospheres there is almost a constant inventory of tobacco forthe firms, making the level of inventory very constant, but necessary. Additionally, there is nota defined smoking season within the industry, which could create the inventory to slowlydeplete and be replenished throughout the year.105

1.200 Quick Asset Ratio 1.000 0.800 0.600 0.400 0.200 SWM AOI UVV Industry Average 0.000 2004 2005 2006 2007 2008 2004 2005 2006 2007 2008SWM 0.97 0.71 0.67 0.71 0.54AOI 0.88 0.93 0.71 0.93 0.88UVV 0.92 0.82 0.79 0.82 0.92Industry Average 0.93 0.82 0.73 0.82 0.78The chart pictured above conveys that the industries ratio as a whole has fallen since2004. This may be attributed to the lower amount of assets and inventories tobacco firms areable to maintain by law. The chart also can infer that Schweitzer-Mauduit could find problemsin the future meeting its short-term liabilities if the ratio does not increase. However theindustry as a whole has experienced decreasing ratio’s making the firms less able to withstanddisasters.106

Working Capital TurnoverWorking capital turnover compares the firm’s sales to its net working capital. The networking capital is a firm’s current liability subtracted from its current assets. Dividing the networking capital by sales will derive the working capital turnover ratio. This ratio will allow firmsand investors to see “how many dollars of sales a firm is able to generate for each dollarinvested in operating working capital” (Paledu and Healy). When examining the ratio, a highworking capital turnover would be most preferable. The charts portray that the firmscompeting in the consumer tobacco and paper industry all maintain a decent working capitalturnover. The industry maintains an average of over 5, describing that in this industry; forevery dollar invested in working capital, five dollars of sales is generated for the firm.Schweitzer-Mauduit did extremely well in 2004, 2007, and 2008, maintaining a ratio of over 20.In comparison to the rest of the industry, the ratio is most likely explained by the smallamounts of tobacco inventory maintained in comparison to the other firms. Most of the firmsactively involved in the complete tobacco industry had inventories roughly 20 percent higherthan Schweitzer-Mauduit.The steady rise of the ratio throughout the industry is not contributed to more salesbeing produced, but by a steadily dropping net working capital. Emphasizing that utilizing afirm’s resources can be extremely profitable in the long run.25.00 Working Capital Turnover 20.00 15.00 10.00 5.00 SWM AOI UVV Industry Average 0.00 2004 2005 2006 2007 2008 107

2004 2005 2006 2007 2008SWM 25.98814 9.299859 9.48191 22.3375 24.53355AOI 1.911242 2.776458 3.920271 3.72019 4.569386UVV 2.876587 3.99984 4.06032 2.354872 2.114665IndustryAverage10.25866 5.358719 5.820834 9.470854 10.40587Accounts Receivable TurnoverThe accounts receivables turnover depicts how efficient a firm is collecting its salesoutstanding. It is calculated by dividing total sales by accounts receivables. Firms with a highaccount receivable ratio are very efficient at collecting outstanding sales; implying a steadyrelationship with customers and superior management tactics. Low ratios indicate that a firm isunable to collect outstanding sales and could result in a firm’s failure to meet its short-termobligations. Schweitzer-Mauduit and Alliance have preserved a steady growing ratio for thepast five years. However, Universal started out strong and then began to fall in 2007, only torecover in 2008. This is a similar trend for the industry, which also experienced a decline in2007 and was picked back up in 2008. This can most likely be contributed to new legislationand regulations on the industry. The industry as a whole has done a worthy job of collectingand regulating policies, but Universal has by far set the standard for the industry.108

25 Accounts Receivable Turnover 20 15 10 5 SWM AOI UVV Industry Average 0 2004 2005 2006 2007 2008 2004 2005 2006 2007 2008SWM 6.729785 6.711423 7.370079 7.373757 8.826437AOI 4.16139 5.928734 6.584342 9.088303 11.11346UVV 14.0983 19.05726 16.51311 7.687575 10.06922IndustryAverage8.329826 10.5658 10.15584 8.049879 10.00304Days Sales OutstandingDays Sales Outstanding gives a more in-depth look at how adequately firms are able tocollect its receivables and enforce its credit policy. The only difference between day’s salesoutstanding and accounts receivable turnover is that the days sales outstanding ratio providesthe firm or investor with an amount in days it takes to collect its receivables. The ratio can befound by taking the number of days in a year, 365, and dividing it by the firm’s previous year’saccounts receivables turnover. In comparison to the previous ratio, accounts receivablesturnover, where a high ratio is preferred, a small number of days are favored in this109

comparison. A small ratio shows investors that the firm has a solid management core, as wellas a more liquid company.100.00 90.00 80.00 70.00 60.00 50.00 40.00 30.00 20.00 10.00 0.00 Days Sales Outstanding SWM AOI UVV Industry Average 2004 2005 2006 2007 2008 2004 2005 2006 2007 2008SWM 54.2365 54.38489 49.52457 49.49987 41.35304AOI 87.71107 61.56458 55.43454 40.16151 32.84306UVV 25.88964 19.15281 22.10364 47.47921 36.24907IndustryAverage55.94574 45.03409 42.35425 45.71353 36.81506The chart above indicates that Universal has done the best job of collecting andenforcing its policies, averaging a days sales outstanding ratio of 30 days over the past 5 years,which is significantly lower than the industry average of 45 days. The industry as a whole hasimproved with time going from 55 days in 2004 to 36 days in 2008. The recent decrease indays may be related to the current credit crisis affecting industries worldwide, forcing firms toenact strict collecting policies.110

Inventory TurnoverInventory turnover depicts how successful a firm is at maintaining a steady level ofinventory as sales are made. The ratio is computed by dividing the cost of goods sold byinventory. Inventory is considered a short-term asset; however maintaining too much inventorycan be very detrimental to the firm, especially in an industry where the freshness of the productis highly scrutinized. Additionally, in the case of meeting short-term liabilities, inventory beingsold off at a discount instead of full market price can be very unfavorable to the firm.A high inventory turnover can imply one of two things. One being the firm has highsales for that period that were not well forecasted or planned for, and the second that the firmis inadequately purchasing inventory. A low inventory turnover can imply the firm is eitherhaving very low sales for the period or that they are maintaining too high of an inventory level.The ratio however can differ between industries. For instance, the tobacco industry and thesemi conductor industry will have a different ratio. The most efficient method to compare theratio is to an industry average.111

6 Inventory Turnover 5 4 3 2 1 SWM AOI UVV Industry Average 0 2004 2005 2006 2007 2008 2004 2005 2006 2007 2008SWM 4.476589 4.786789 4.643089 4.624238 5.61402AOI 1.46675 2.229867 2.180096 2.704862 2.754529UVV 2.170832 2.687889 2.78523 2.456522 2.657948Industry Average 2.704723 3.234848 3.202805 3.261874 3.675499The industry average for the inventory turnover ratio has remained balanced around 3.2for the past five years. Alliance One and Universal have been able to maintain a steady ratioaround 2, while Schweitzer-Mauduit has continued to have a ratio higher than 4. Part of thereason for Schweitzer-Mauduit’s high ratio reflects upon the fact that they do not fully operatein the tobacco industry. They operate mainly in the paper and filter part of the tobaccoindustry, which allows their products to have a longer shelf life than tobacco.112

Days’ Supply of InventoryThe days’ supply of inventory ratio presents how effectively a firm is able to sell itsinventory. This number is inversely related to the inventory turnover. Most firms would like toattain a low day’s supply of inventory in order to get rid of inventory faster and keep revenuesup. The ratio is calculated by taking 365 days and diving by a firm’s inventory turnover.The current industry average of day’s supply of inventory is approximately 114 days.This could be considered extremely high for some industries. However in the consumer paperand tobacco industry, the large amount and the constant replenishment of inventory is thebyproduct of this large turnover. As mentioned earlier, there is no seasonality to the purchaseof the products, but there is seasonality to raw materials of the finished goods. This obligatesfirms in the industry to maintain a large inventory of tobacco, therefore leading to higher ratiosthan other industries.300 Days Supply of Inventory 250 200 150 100 50 SWM AOI UVV Industry Average 0 2004 2005 2006 2007 2008 113

2004 2005 2006 2007 2008SWM 79.52484 76.25153 78.61145 78.93193 65.0158AOI 242.7135 163.6869 167.4239 134.9422 132.5091UVV 163.9924 135.7943 131.0484 148.5841 137.324Industry Average 131.6216 112.8337 113.9626 111.8989 99.30624ConclusionUpon the calculation these ratios, an investor or management is able to effectivelyappraise a firm’s position in the industry regarding liquidity. Schweitzer-Mauduit’s current ratioposition in the industry is very promising. They were able to maintain the highest ratio,improving the liquidity of the company and the impression on investors. However, Schweitzer-Mauduit was unable to produce an efficient quick ratio. This may be due to how their inventoryis not as easy disposable or liquefiable as the rest in the industry. Schweitzer-Mauduit’sinventory mainly consists of tobacco paper and filters, whereas the rest of the industrymaintains a large portion of tobacco in their inventory. As far as the working capital turnover,Schweitzer-Mauduit strives above the rest in the industry. Over the past five year the firmaveraged a ratio of 18.28, insinuating that for every dollar put into working capital it hasreturned 18.28 dollars of sales. The turnover ratios had some of the same results. Schweitzer-Mauduit’s account receivable’s turnover, days’ receivables outstanding, and inventory turnoverratios were all inferior to its competitors. The poor performance however is not contributed tothe company, but the industry instead. Schweitzer-Mauduit competes predominantly in theconsumer paper market for tobacco products, not necessarily in the full tobacco and cigarettemaking industry; making the ratios become more important to look at, especially ones includinginventory. This being said, Schweitzer-Mauduit was able to establish the best day’s inventoryratio.114

Overall, Schweitzer-Mauduit’s liquidity efficiency may be considered average. Thefollowing table displays Schweitzer-Mauduit’s performance in comparison to its competitors andindustry trends.Liquidity Ratio Performance Industry TrendCurrent Ratio Above Average Stable UpwardQuick Asset Ratio Above Average Stable StableWorking CapitalTurnoverAccountsReceivableTurnoverDays’ SalesOutstandingInventoryTurnoverAbove Average Stable UpwardPoor Stable UpwardAverage Stable DownwardPoor Stable UpwardDays’ Supply ofInventoryAbove Average Unstable DownwardOverall Average Stable Stable115

Profitability Ratio AnalysisProfitability ratios allow us to analyze a firm’s ability to adequately cover their expenseswith their revenues. Investors can use this information to determine whether or not a firm’shigh profit comes at a high cost. Profit means nothing if a large portion of it goes towardspaying expenses. These ratios are also used to determine if a firm’s profits are consistent,which is why we use five years instead of two or three. If a firm shows a consistent trend,whether positive or negative, we can then use this information to predict future profitability.The most commonly used ratios include gross profit margin, operating expense ratio, operatingprofit margin, net profit margin, asset turnover, return on assets, return on equity, internalgrowth rate, and sustainable growth rate. Because all of these ratios are used to testprofitability, investors prefer to see higher results (i.e. 25% is more preferable than 1%).However, if results are exceptionally high and are not consistent throughout the years, investorsand analysts would need to look further into what might have caused such a dramatic increase.Gross Profit MarginThe gross profit margin relates the gross profit to total sales. It is calculated bysubtracting cost of goods sold from net sales and then dividing the resulting number by netsales. This ratio is important because it shows the coverage of sales revenue to inventoryexpenses and other expenses required to produce and manage inventory. The graphs belowshow how effective Schweitzer-Mauduit is at utilizing its revenues for the past five years.116

25 Gross Pro`it Margin 20 15 10 5 Schweitzer Universal Alliance Industry Avg. 0 2004 2005 2006 2007 2008 Gross Profit Margin 2004 2005 2006 2007 2008Schweitzer 18.57% 14.53% 12.84% 15.12% 13.44%Universal 19.46% 18.66% 16.49% 22.11% 20.04%Alliance 13.15% 14.33% 10.64% 14.94% 12.45%Industry Average 17.06% 15.84% 13.32% 17.39% 15.31%The graph above shows that Schweitzer-Mauduit is performing pretty close to theindustry average, falling in-between Universal and Alliance One. With a gross profit marginaveraging about $0.15, SWM only profits about fifteen cents out of every dollar that theyreceive from sales. This is due to the high cost of goods sold which lowers gross profit. Theindustry trend fluctuates between 13-18%, so SWM falls between this median 80% of the time.In order to increase their gross profit margin SWM will need to minimize its costs or raiseprices.117

Operating Expense RatioThe operating expense ratio is a profitability ratio that allows investors to see how higha firm’s selling and administrative expenses are relative to its sales. A high operating expenseratio indicates that a firm is not adequately controlling costs and may have inflated prices inorder to cover what may be unnecessary costs. To calculate the operating expense ratio,simply divide selling and administrative expenses by sales. The following graph shows theresults from calculating the operating expense ratio.Axis Title 20 18 16 14 12 10 8 6 4 2 0 Operating Expense Ratio 2004 2005 2006 2007 2008 Schweitzer Universal Alliance Industry Avg. SWM (Restated) 118

Operating ExpenseRatio2004 2005 2006 2007 2008Schweitzer 9.79% 8.66% 8.81% 9.26% 8.36%SWM (Restated) 8.66% 7.58% 7.92% 8.37% 7.50%Universal 18.38% 11.84% 7.13% 12.42% 10.52%Alliance 10.99% 9.49% 7.77% 8.00% 7.83%Industry Average 13.05% 10.00% 7.90% 9.89% 8.90%Schweitzer-Mauduit for the most part, except for in 2005, remains below industryaverage, even when it has been restated to include research and development. This is a goodsign because this shows that they are keeping general and administrative costs low. We canalso see that within this five-year span, Schweitzer has lowered this ratio by almost 1.5%,which can be significant when expenses are in the millions. Additionally, this decrease mayprovide additional value to the shareholders.Operating Profit MarginOperating profit margin is another measure of a firm’s business profitability. This isbecause it calculates what proportion of a company’s revenue is left over after pay variablecosts. It is calculated by taking the firm’s operating income (gross profit minus selling andadministrative expenses) and dividing it by total sales. Unlike the operating expense ratio, it ismore favorable for this number to be high because it indicates that that a firm’s operations arecontributing to a higher amount of sales.119

15 Operating Pro`it Margin 10 5 0 -5 2004 2005 2006 2007 2008 Schweitzer Universal Alliance Industry Avg. SWM (Restated) -10 -15 Operating Profit Margin 2004 2005 2006 2007 2008Schweitzer 8.78% 5.87% 0.81% 2.50% 5.08%SWM (Restated) 9.91% 6.94% 4.91% 6.76% 5.94%Universal 4.39% 2.93% 1.69% 8.15% 8.91%Alliance -0.65% 4.80% -13.22% 5.75% 4.65%Industry Average 4.17% 4.53% -3.57% 5.47% 6.21%By looking at the above graph and table, we can see that for the industry as a whole,the year 2006 experienced a huge decline in operating income. The cause of this can be foundby doing extensive research into each company’s 10-K. By doing this, we found that during theyear 2006, each company recognized a restructuring expense or impairment that significantlyreduced operating income, causing a very low or negative operating income. For Schweitzer-Mauduit, this was caused by the reduction of paper machine operations, causing layoffs and theunexpected expense of severance pay. For Universal, this expense was recognized because of120

the closing of a leaf factory. For Alliance, this was due to a very large amount of goodwillimpairment ($256,916,000), which is the first time they have impaired goodwill in the past fiveyears. This new information can explain the abnormal decreases in 2006 not only in this ratio,but also in most of the other ratios. If we look at the five-year span, we can see that thisindustry trends downward from 2004 to 2006, and after that begins to increase again.Schweitzer did have the leading operating profit margin until after 2006, when Universal wasable to increase at a faster rate.Net Profit MarginThe net profit margin is a measure of profitability for the firm, as it compares netincome to sales. It is calculated by dividing net income by net sales. This ratio is used toanalyze how much of sales are retained as part of net income. Investors would prefer a highernet profit margin because it demonstrates how well they are controlling costs. This also allowsinvestors to analyze whether higher sales translate into higher profits. However, sometimeshighersales also come with higher costs.10 Net Pro`it Margin 5 0 -5 -10 -15 2004 2005 2006 2007 2008 Schweitzer Universal Alliance Industry Avg. SWM (Restated) -20 -25 121

Net Profit Margin 2004 2005 2006 2007 2008Schweitzer 5.54% 2.90% -0.12% 0.48% 0.09%SWM (Restated) 6.08% 3.64% 0.55% 1.23% 0.83%Universal 4.39% 2.93% 0.23% 2.21% 5.55%Alliance -4.10% 1.01% -21.18% -1.09% 0.84%Industry Average 1.94% 2.28% -7.02% 0.53% 2.16%The graph and table above conclude that none of the companies have exceptionallyhigh net profit margins. Schweitzer-Mauduit again seems to gravitate between the Universaland industry average. It is also shown that they are having a harder time recovering from thelow net income in 2006 than Universal which bounced back to 5.55% in 2008. The industry asa whole was again increasing from 2004 until 2006, when there was a steep drop and then slowincrease thereafter. Schweitzer-Mauduit needs to improve this because this indicates that theyare not able to use their profits to re-investment purposes or pass on to its shareholders, whichis unfavorable to potential investors.Asset TurnoverAsset turnover is another tool used to assess how well a company is using their assetsto generate sales. To calculate asset turnover, divide net sales by the previous year’s totalassets. As most investors would like to see firms performing as efficiently as possible, a higheris number is preferred. A higher number signifies that a larger amount of sales are beingproduced using few assets. Asset turnover is also significant because it allows us to link theincome statement to the balance sheet and compare the relationship between the two.122

1.6 Asset Turnover 1.4 1.2 1 0.8 0.6 0.4 Schweitzer Universal Alliance Industry Avg. SWM (Restated) 0.2 0 2004 2005 2006 2007 2008 Asset Turnover 2004 2005 2006 2007 2008Schweitzer 1.03 0.93 0.95 1.03 0.99SWM (Restated) 1.01 0.92 0.94 1.02 0.98Universal 1.01 1.31 1.22 0.69 0.92Alliance 0.59 0.97 1.50 1.04 1.22Industry Average 0.88 0.77 1.22 0.92 1.04By looking at above graphs we can that Schweitzer is performing below the industryaverage and has decreased by .04 over the five-year span, and by .03 when restated. Thisproves that they are not properly utilizing their assets to generate sales. In contrast, theindustry as a whole increased by .16. In the future, Schweitzer-Mauduit will need to use theirassets more efficiently so that they can have better asset turnovers.123

Return on AssetsThe return on asset figure (ROA) is used to measure the firm’s profitability and evaluatehow efficiently they are turning their assets into profits. This is calculated by dividing netincome by the previous year’s total assets. We use the previous year’s assets because theseare the assets that are used to produce the current year’s income. In finance, this is termed as“lag” because it uses the previous years’ financial term to calculate current information. Returnon assets is an important estimate because all of those who invest their money into a specificfirm are doing so with the expectancy of having a higher return than they originally invested.10 Return on Assets 5 0 -5 -10 -15 -20 -25 -30 -35 2004 2005 2006 2007 2008 Schweitzer Universal Alliance Industry Av.g SWM (Restated) 124

Return on Assets 2004 2005 2006 2007 2008Schweitzer 5.72% 2.71% -0.12% 0.49% 0.09%SWM (Restated) 6.20% 3.36% 0.51% 1.25% 0.82%Universal 4.44% 3.84% 0.28% 1.53% 5.12%Alliance -2.43% 0.98% -31.87% -1.13% 1.02%Industry Average 2.58% 2.51% -10.57% 0.29% 2.08%As shown in the graphs, Schweitzer is able to maintain higher than industry averageevery year except for 2008 for the as stated and restated. However, this average is skewed bythe unusually low ROA from Alliance. The industry’s average trend followed the trends frommost of the other ratios, with a low spike in 2006 with slow increases afterwards. Schweitzerneeds to increase their return on assets in the future by allocating their resources to methodsthat have proven to be more productive and efficient.Return on EquityThe Return on Equity ratio (ROE) is used to determine how well a firm is usingshareholder capital to generate return for the firm. This may be one of the most important andrelevant ratios to investors. This is calculated by taking the current year’s net income anddividing it by the previous year’s total equity. This ratio is also “lagged” because it uses theprevious year’s equity as a basis for the current year. Interestingly enough, the return on equityhas a direct relationship with a firm’s capital structure. Return on equity is negatively orpositively affected by shifts in the debt to equity ratio (this is with the assumption that netincome is held constant).125

40 Return on Equity 20 0 -20 -40 -60 -80 -100 -120 2004 2005 2006 2007 2008 Schweitzer Universal Alliance Industry Avg. SWM (Restated) Return on Equity 2004 2005 2006 2007 2008Schweitzer 14.55% 6.63% -0.27% 1.12% 0.20%SWM (Restated) 15.99% 8.34% 1.23% 2.89% 1.87%Universal 16.06% 12.64% 0.97% 4.60% 11.56%Alliance -7.23% 3.20% -108% -10.08% 7.48%Industry Average 7.79% 7.49% -35.77% -1.46% 6.41%Schweitzer has consistently decreased its ROE over the past five years, taking intoaccount that 2006 had an abnormal expense. There does seem to be a correlation betweenROE and ROA because as ROA decreases, ROE also decreases. Conversely, as ROA increases,ROE also increases. So it is possible that if Schweitzer-Mauduit is able to increase its ROA bymore efficiently using assets, than ROE may also increase.126

Internal Growth RateThe internal growth rate is one of the two ratios that are used to estimate potentialfuture growth. This ratio is used to determine the maximum potential growth of a firmassuming that they receive no outside funding. Therefore, the firm will be using only funds fromtheir cash flows. This ratio would be very important to potential investors because they aremore likely to invest in a company that is predicted to grow as opposed to remaining the same.To calculate the internal growth rate (IGR) we use the following formula:IGR = ROA x (1- dividends/net income)ROA is the same return on assets number that we calculated earlier. The second portion of theformula is the plowback ratio (1 – dividends/net income), also known as the retention rate.This ratio shows how much net income is retained after paying out dividends. If a firm doesnot pay dividends, IGR is simply the return on assets calculated previously.10 IGR 5 0 -5 -10 -15 -20 -25 -30 -35 2004 2005 2006 2007 2008 Schweitzer Universal Alliance Industry Avg. SWM (Restated) 127

Internal Growth Rate 2004 2005 2006 2007 2008Schweitzer 4.32% 1.44% -1.48% -0.86% -1.12%SWM (Restated) 4.82% 2.11% -0.83% -0.09% -0.38%Universal 3.16% 2.18% -1.24% 1.53% 5.12%Alliance -3.18% -0.02% -32.52% -1.13% 1.02%Industry Average 1.44% 1.20% -11.74% -0.16% 1.67%The graph depicts an overall decrease in the IGR from 2004-2006 for each firm, andthen picks back up from 2006-2008. The industry average, once again, is distorted due toAlliance One’s drastic decline in 2006. However, Schweitzer-Mauduit has stayed relatively closeto Universal for the main part, and then falls below each firm and the industry average from2007-2008. A negative return could be explained by an increase in the dividend payback ratio.If the dividend payout ratio were to increase to a number larger than one, then the plowbackratio would be negative, causing a negative internal growth rate. The low growth rate indicatesthat SWM is not able to generate much growth from its resources within its company.Schweitzer-Mauduit will need to increase their internal growth rate. This can be done by usingsome of the same tactics mentioned in raising ROA.Sustainable Growth RateAnother preferred growth measure is the sustainable growth rate (SGR). Thesustainable growth rate goes one step further than the internal growth rate to integrate thefirm’s capital structure. It is the maximum rate at which a firm can grow without changing itsfinancial leverage. This rate is easily calculated by taking the internal growth rate we justcalculated and multiplying it by (1 + total liabilities / shareholders equity). In essence, this iswhat the formula would look like:SGR = IGR x (1 + total liabilities / shareholder equity)128

Using this formula makes it easier to analyze a firm’s ability to grow while investing,while still adequately managing their debt. Obviously, SGR is dramatically affected by changesto capital structure.40.00 Sustainable Growth Rate 20.00 0.00 -20.00 -40.00 -60.00 -80.00 -100.00 -120.00 2004 2005 2006 2007 2008 Schweitzer Universal Alliance Industry Avg. SWM (Restated) Sustainable GrowthRate2004 2005 2006 2007 2008Schweitzer 10.99% 3.52% -3.48% -1.97% -2.55SWM (Restated) 15.79% 8.23% 1.21% 2.86% 1.85%Universal 11.44% 7.81% -4.35% 4.59% 11.56%Alliance -9.46% -0.07% -110.2% -10.08% 7.47%Industry Average .99% 3.87% -57.3% -15.2% 9.52%The graph above shows how that Schweitzer Mauduit has been consistently loweredover the past five years. In this calculation, Alliance One’s decrease in 2006 did not affect the129

industry average as much as it did the IGR. Schweitzer-Mauduit is above the industry average,but still lower than Universal, which has been seen repeatedly in the previous graphs.Considering how SWM and Universal had similar trends with their IGR’s, it is not surprising thattheir SGR’s are steady as well. This means that Schweitzer-Mauduit will be able to grow withoutdisrupting its financial leverage, and that they will not have a hard time keeping a stable SGR inthe future.ConclusionSchweitzer-Mauduit’s profitability performance is relatively average, but a little low, incomparison to the industry. They fall just below the industry average for the gross profitmargin, operating expense ratio and asset turnover; both of which picked back up aboveindustry average after 2006. However, they perform above average for the operating profitmargin, net profit margin, return on assets (ROA), return on equity (ROE), internal growth rate,and the sustainable growth rate. Profitability is the driving factor for most businesses because itis what allows them to reinvest and to transfer this on to their shareholders. Taking all theseratios into consideration, we can see that for the most part Schweitzer is performing below adesirable level and could use much improvement.Profitability Ratio Performance Trend 130

Ratio Performance Trend Gross Profit Margin Average Decreasing Operating Expense Ratio Average Decreasing Operating Profit Margin Slightly Underperforming Increasing Net Profit Margin Average Increasing Asset Turnover Underperforming Increasing Return on Assets Slightly Outperforming Stable Return on Equity Underperforming Volatile Internal Growth Rate Average Increasing Sustainable Growth Rate Underperforming Volatile Overall Underperforming Increasing Capital Structure AnalysisWhen evaluating a firm’s financial leverage, capital structure analysis becomes a criticalelement. Capital structure ratios are used in obtaining how well a company is using their debtand equity to finance their operations and manage their credit risk. There are three main ratiosto help utilize this analysis for Schweitzer-Mauduit; debt-to-equity ratio, times interest earned,and the debt-to-service margin. The debt-to-equity ratio will be used to assess Schweitzer-Mauduit’s credit risk, the times interest calculation to evaluate its ability to pay off its interestwith income from operations, and the debt-to-service margin to see how it’s paying off itscurrent portions of long-term debt. After these ratios are examined, the final step in evaluationis determining the Altman’s z-score, which is used to analyze the risk the firm has to becomingbankrupt. These in turn will be the key factors in Schweitzer-Mauduit’s capital structureanalysis.131

Debt/Equity RatioThe debt-to-equity ratio represents the amount of credit risk a company is incurring. It“provides an indication of how many dollars of debt financing the firm is using for each dollarinvested by its shareholders” (Palepu and Healey 5-20). Since this is a capital structure analysis,the stockholders equity will be a major element in this ratio. A high debt-to-equity ratioindicates that there is more short term and long term debt than their total equity, showing it issusceptible to credit risk. A ratio above 1.5 is considered to be too high of a risk. Therefore, afirm must attempt to lower the ratio by decreasing their liabilities. This will lower their capitalstructure risk and improve relations with investors. If the debt-to-equity ratio is less than one,the assets are financed through equity. If it’s greater than one, the assets are financed throughdebt.132

As you can see above, all except one year’s debt-to-equity ratio is greater than one,showing the companies assets are primarily financed through debt. Schweitzer-Mauduit andUniversal Corporations average debt-to-equity ratios, 1.38 and 1.78 respectively, are muchsmaller than Alliance Ones who averaged 5.02. In this case Alliance One finances more on itsoperating assets then Schweitzer-Mauduit and Universal Corporation. As you can see above, thetrend in the tobacco industry is capital intensive with debt to equity ratios being between .91and 7.89. In this industry, many of the firm’s debt to equity ratios over one makes the firmsmore risky, especially in times of higher interest rates. Between the years 2007 and 2008Schweitzer-Mauduit saw an increase in the debt-to-equity ratio due to purchases of machineryand restructuring related activities that reduced the cash generated from operations and ahigher capital spending. Schweitzer-Mauduit’s debt to equity ratios increasing over the yearsleads to the company’s higher risk. Even though they will have a much higher debt-to-equityratio they will still be in good standing with the credit agreement financial covenants, as long asthe net debt to equity ratios don’t exceed 1.0. In 2008, Schweitzer-Mauduit’s net debt to equityratio was .61 under the requirements of the covenant agreement. At this time Schweitzer-Mauduit shouldn’t be concerned of the debt-to-equity ratio but need to be aware that if theratio increases in the coming years they could lose their ability to continue the loans with thefinancial covenants.Times Interest EarnedThe second ratio in the capital structure analysis is the times interest earned. This ratiois very important because it determines how well a company can pay its own interest with itsincome from operations. Firms then discover the amount of income from operations that will beprovided to the stockholders for their investments in the company. Times interest earned iscomputed by diving the firm’s income from operations by the amount of interest expenseincurred. This ratio shows potential investors the amount of the company’s income that isgoing towards the interest expense and how much they will have left over to pay thestockholders. Investors look at this ratio to determine if it is likely they will be paid back afterthe interest is all paid.133

Schweitzer-Mauduit is at a low 1.61 for they’re times interest earned, meaning they areable to pay off its interest 1.61 times with their income from operations. Even they are still ableto pay off their interest in 2008, it looks to decline in this ability in the future. In 2004,Schweitzer-Mauduit was at a hig15.6, and then quickly declined throughout the 5 years.Universal Corp has also declined from 2005-2006, but has picked up after that. Alliance One isin no competition from 2004-2008 because of their negative ratios, meaning they had to findother means of payment for their interest expense. Overall, the industry has been very volatileand Schweitzer-Mauduit must look to increase their ratio so investors will not be discouragedfrom its company.134

Debt/Service MarginThe third ratio in evaluating a firm’s financial leverage is the debt-to-service margin. Thedebt-to-service margin shows the ability a firm has to pay off its current portion of its long-termdebt with cash supplied from their operating activities. This ratio is “lagged”, meaning it usesnumbers from the previous year. It is calculated by dividing the cash provided from operatingactivities by the previous year’s current portion of long-term debt. The previous year’s currentlong-term debt is the “lagged” element and is used because the ratio assumes that that endingamount is the new beginning amount due the following year (the year that the ratio iscalculating). The larger the margin indicates that a firm is well off in paying its current portionof long-term debt with cash provided from its operations.Schweitzer-Mauduit 2004 2005 2006 2007 2008 1.85 0.75 1.72 4.17 2.35 Schweitzer-Mauduit Restated 2.09 0.74 0.13 0.3 0.27 Universal Corporation Alliance One Debt Service Margin 40 30 20 10 0 -10 -20 -30 -40 -50 -0.26 -1.9 0.51 28.65 0.55 -44.73 2.16 26.34 6.67 7.23 Schweitzer-Mauduit Schweitzer-Mauduit Restated Universal Corporation Alliance One The chart above shows that Schweitzer-Mauduit looks to have a steady debt-to-servicemargin. Both Universal and Alliance had negative margins in 2004 due to negative amounts intheir cash flows from operation. Alliance flew back up to a positive margin, showing that theyhad a lot more cash to repay their debt without looking for another means of payment like theydid in the previous year. For Schweitzer-Mauduit’s competitors, their debt-to-service marginshave been increasing for a year, and then decreasing the next. Furthermore, Schweitzer-135

Mauduit has stayed pretty stable throughout the five years, indicating that they havemaintained balanced cash flows from operating activities to repay their current portion of longtermdebt.Altman’s Z-ScoreThe final stage in the capital structure analysis is finding the Altman’s z-score. The z-score is a measure used when determining how vulnerable a firm is to becoming financialdistressed; bankrupt. The “Altman’s z-score weights five variables to compute a bankruptcyscore” which in turn predicts the firm’s financial concern. The equation ends up being the sumof a firm’s measure of liquidity, measure of cumulative profitability, measure of return on assets(ROA), measure of market leverage, and the measure of sales generating potential of assets.Taken from Palepu and Healy, these measures are broken down into:Z = 1.2(X1) + 1.4(X2)) + 3.3(X3)) + 0.6(X4)) + 1.0(X5)Where,X1) = net working capital/total assetsX2) = retained earnings/total assetsX3) = earnings before interest and taxes/total assetsX4) = market value of equity/book value of total liabilitiesX5 = sales/total assetsAccording to this model, a z-score that is less than 1.81 suggests bankruptcy; from 1.81-2.67 isthe “gray area”; and above 2.67 indicates little to no financial distress for a firm. This z-score isvery important to investors because it predicts the risk they will endure if the firm is susceptibleto financial distress.136

Z-Score 4 3.5 3 2.5 2 1.5 1 0.5 0 2004 2005 2006 2007 2008 Schweitzer-Mauduit 2.8 2.35 2.17 2.06 2.01 Universal Corporation 2.38 2.42 2.32 2.71 3.39 Alliance One 1.36 1.79 0.72 1.75 1.6 Schweitzer-Mauduit Universal Corporation Alliance One Universal Corporation the last two years has had a z-score above the 2.67 allowing themto borrow money at the lowest interest rates in the industry. Schweitzer-Mauduit’s z-score overthe last four years has fallen into the “gray area” giving them higher interest rates compared toits competitor Universal Corp and a possible chance of bankruptcy in the future. Unfortunatelyfor Alliance One, they fall way below the “grey area” for the past several years putting thecompany into a serious chance of bankrupt in future years. Overall, Schweitzer-Mauduit’s z-score has been slowly declining over the past five years. Even though it has not fallen below1.8, the score of bankruptcy, it is inching its way there. This should enable Schweitzer-Mauduit’s management to reassess their ability to pay off their debt.ConclusionThe capital structure analysis is considered one of the most crucial elements inevaluation a firm’s financial leverage and stability. Overall, they measure a firm’s capability offinancing their assets and liabilities. When looking at the debt-to-equity ratio, it shows thatSchweitzer-Mauduit is underperforming, being far below their competitors, showing a highcapital risk. The firm had a major decline in their times interest earn starting in year 2004, and137

it looks to keep declining, meaning SWM will need to increase their operating income. However,they were pretty stable in their debt-to-service margin and their z-score, even though its z-score seemed to be underperforming.Financial Statements ForecastingForecasting a firm’s financial statements is a means to see how they will progress in thefuture. The most efficient way to forecast financials is to use historical data and trends; also byutilizing ratios, averages and growth rates. This data will be crucial when evaluating a firm’sfuture performance. There are three main financial statements that are the most important toforecast; income statement, balance sheet, and the cash flow statement, in that order as well.Beginning with Schweitzer-Mauduit’s income statement is important because it deals the mostwith the profitability of a firm. The balance sheet will be forecasted next to guarantee that thefirm’s future assets equal its combined future liabilities and stockholder’s equity. Lastly, thestatement of cash flows will show the future cash flows from operating, investing, and financingactivities.Income StatementAs mentioned, we want to start our forecast with the income statement. The reason tostart with the income statement is not only the fact that it’s the easiest of the three to forecast,but the basis of all forecasting stems around your sales growth rate. Since sales growthrevenue is found on the income statement, it is very important that the income statement isforecasted as accurately as possible because the income statement directly affects the balancesheet and cash flow statement.The first step in forecasting the income statement is to compute the future sales growthof the firm. This is the most crucial part of all forecasting because many steps that follow thisprocess deal with the sales forecast. When making a sales forecast, it is also very importantthat all current and past trends are evaluated. This includes looking into the current economyand current recession, as well as past recessions to help formulate the future from this point intime. We have gathered information from the last recession in the early 2000’s and seen howSchweitzer-Mauduit performed through that, as well as the cigarette industry. Looking back at138

the early 2000’s recession, Schweitzer-Mauduit sales growth averaged -0.20%. In 2000, SWM’ssales growth was -1.51%, in 2001 growth came in at 0.54%, and 2002 at 0.38%. This gives usa good indicator of how SWM will fair during the current recession; however, there are stillother factors to consider.Schweitzer-Mauduit had an average sales growth of 7.54% from 2003-2008. In 2003sales growth was 13.06%, 2004 was 15.98%, 2005 was 1.87%, 2006 was -2.18%, 2007 was9.10%, 2008 was 7.43 %. The main reason why SWM came out of the early 2000’s recessionwith such a bang in 2003 and 2004 was due to backlog orders in their French segment. TheFrench segment is the primary segment of the three that SWM operates; French, U.S andBrazil. The French operation had cigarette paper orders backlogged in 2003 worth $54 million inrevenue and $39 million in 2004, with reconstituted tobacco leaf (RTL) backlogged in 2003worth $106 million in revenue and $62 million in 2004. This caused sales growth to spike above13% for both years. Furthermore looking at SWM’s 10-Q, we see through 6 months into 2009SWM has $367.4 million in sales. Comparing this with total 2008 sales of $767.9 million, theyhave reached about 47.8% through 6 months in 2009. All things considered, it is logical toforecast sales in 2009 to have a slight decline. We believe sales will decline 2% in 2009 andhike back up to 6% in 2010. The cause of the 8% turnaround from 2009 to 2010 is due to theU.S. government implementing lower ignition propensity paper (LIP) in all cigarettes. The U.S.government is requiring all states to use LIP papers in all cigarettes for safety precautions byJanuary 2010. From 2011-2018 we expect sales growth to be 5% through 2012 and level downto 3.5% by 2018.After giving careful thought and consideration to the sales growth and getting afoundation, a forecast for the firm’s cost of goods sold (COGS) is conducted. First, we need tofind the COGS as a percentage of sales. This is called common sizing the financial statement.For the income statement, we common size every line item in the statement as a percentage ofsales. Once the income statement has been common sized, we see that COGS over the last 6years averaged 84.38%. The COGS has had a steady relationship to sales of about 86%.Through 2005-2008, the COGS average was 86.02%. We feel confident and comfortablemaking the assumption to forecast COGS at 86%. By multiplying each year’s respected salesforecast by 86% we can estimate Schweitzer-Mauduit’s COGS forecasts from 2009-2018.139

Gross profit is the next step in forecasting the income statement. To find gross profit,you take sales and subtract out COGS. Since COGS was forecast to be 86%, gross profit will beforecast to be 14% to equal 100% of sales. From 2005-2008 gross profit averaged 13.98%ofsales, with the prior six-year average from 2003-2008 coming in at 15.62%of sales. Like COGS,gross profit has not fluctuated much and we do not foresee it fluctuating much in the future.This gives us a reasonable and confident assumption to forecast gross profit at steady 14%ofsales from 2009-2018.Operating profit is our next major line item on the income statement to forecast.Operating income is found by subtracting selling, general, and administrative expenses fromgross profit. SWM’s average operating income from 2003-2008 was 4.94% of sales. Looking atSWM’s income statement, you will notice that operating income from 2006-2008 wassubstantially lower than the average and also lower than operating income from 2003-2005.This was due to restructuring and impairment expenses that were incurred in 2006, 2007 and2008. A couple of plants’ operations were shut down during the last 3 years; one plant in theU.S. segment and one plant in the Brazil segment. This caused the restructuring andimpairment expenses during these years. Severances were paid to employees of the closingplants and asset impairment charges were assessed from accelerated depreciation onequipment. We do know that 2009 is the last year of the closing plant process and thereforehave to recognize the restructuring and impairment expense for 2009. For 6 months endedthrough 2009, SWM has recognized $13.3 million in restructuring and impairment expenses. Wewill make the assumption that this will double and end at $26.6 million for the year ended 2009.This causes our 2009-forecasted operating profit to be at the same levels from 2006-2008. Wealso believe that operating profit levels will hike back up to 2003-2005 levels starting in 2010since the plants will be closed down and no restructuring and impairment expenses areexpected.The last line item to forecast in the income statement is net income. Net income for thepast six years has averaged 2.49%of sales for SWM. Net income has fluctuated and has beenvery low since 2006. This is directly related with operating income being low due torestructuring and impairment expenses previously discussed. After 2009 when operating incomehikes back up due to sales increasing, net income is forecasted to increase as well. In 2010, weforecast net income to be slightly higher than 2% and increasing to 2.7% in 2018.140

Restated Income StatementAfter restating Schweitzer-Mauduit’s income statement, there is not much variationbetween the actual and the restated income statement. SWM’s income statement was restateddue to research and development expense exceeding 20% of operating income. The restatedincome statement shows the effect of operating profit when research and development expenseis amortized at 20% per year for the last five years. When research and development isamortized out, operating profit increases. The difference from actual operating profit to restatedoperating profit in 2004 was a 1.13% increase, 1.18% increase in 2005, 2.09% increase in2006, 1.36% increase in 2007, and a 1.39% increase in 2008. Tracking the new amortized R&Dfrom 2004-2008, we come out with an average of 0.24% with 2006-2008 having the samepercentage at 0.22%. We feel confident assuming R&D to be forecasted at 0.22% for 2009-2018. Net income on the restated financials also benefit from having research and developmentamortized. It is higher due to the higher operating profit. We forecast net income to be 0.50%in 2009. This is low because of the restructuring and impairment expenses we talked aboutearlier. In 2010 we forecast net income to be 2.65% growing to 3.20% in 2018.After evaluating the restated income statement, we were able to gage how this affectedSWM and our analysis. The bottom line basis was net income being slightly higher on therestatements. With net income coming in at a slightly higher number, we still have the sameopinions about SWM as we did before the restatements. A slight change did not create a drasticalteration of where we still believe the company stands financially.142

Balance Sheet143

The balance sheet is the next financial statement to be forecasted after the incomestatement. It is slightly more difficult to forecast but still not as complicated as the cash flowstatement. Like the income statement, a common size balance sheet is also needed. Wedecided to common size the asset portion of the balance sheet to total assets, and the liabilityand equity side of the balance sheet is common sized to total liabilities and shareholder equity.The income statement and the balance sheet are directly linked together by the asset turnoverratio. You find the asset turnover ratio by dividing net sales by total assets. Over the last 5years, Schweitzer-Mauduit’s asset turnover ratio has been consistent staying around 1.0. Wetherefore assume an asset turnover ratio of 1.0. By dividing the one year ahead forecasted netsales on the income statement we get total assets for the year.Current assets for the last five years have hovered around 32%, while non-currentassets have stayed around 63% and other remaining assets on the balance sheet averagingabout 5% for the last five years. Therefore, we forecast current assets to be 32% for the nextten years, non current assets to be 63% and other assets to be 5% to get a total of 100% fortotal assets.By evaluating Schweitzer-Mauduit’s asset portion of the balance sheet, we were able toconfidently forecast its current assets, account receivables, and inventories due to noticeabletrends. The account receivables are linked together with the income statement with the accountreceivables turnover ratio, which are net sales/account receivables. We are going to assume anA/R turnover of 8.9 times. The other forecasted current asset was inventories, which are linkedtogether with the income statement with the inventory turnover ratio. COGS/inventorycalculates the inventory turnover ratio. In the forecasting of inventories we assumed aninventory turnover ratio of 5.8. We also forecasted out the non-current asset property, plant,and equipment (PP&E). PP&E is linked with the income statement with the PP&E turnover ratio,sometimes called the fix asset turnover ratio since PP&E is known as a fixed asset. Netsales/PP&E calculate the PP&E turnover ratio. For forecasting purposes, we assume a PP&Eturnover of 1.9.After forecasting the assets, we move on to forecasting the short-term liability side ofthe balance sheet. The asset side is directly related to the liability side with the current ratio.This ratio is calculated by taking the current assets/current liabilities. We assume a current ratioof 1.15 to link Schweitzer-Mauduit’s current assets with its current liabilities. To get the current144

liabilities, we take the already forecasted current assets and divide by 1.15. Now that currentliabilities have been forecasted, the next step is to move directly to forecasting shareholder’sequity.Retained earnings will be the first step in forecasting Schweitzer-Mauduit’s shareholder’sequity. In order to compute retained earnings, the retained earnings formula will be used whichis taking SWM’s beginning balance of RE and adding into net income and subtracting outdividends. Net income can be found from the forecasted income statement and dividends canbe found from the statement of cash flows. We were then able to forecast the next ten years ofretained earnings. The final step taken in the shareholder’s equity portion of the balance sheetwas to make the necessary changes to total shareholder’s equity as a result of the changes inretained earnings.Once total shareholder’s equity and total assets are forecasted, the last remaining lineitems, total liabilities and non-current liabilities, can be forecasted. Total liabilities can bedetermined by subtracting shareholder’s equity from total assets. Finding SWM’s total liabilitiesenabled us to compute its non-current liabilities. By subtracting its current liabilities from totalliabilities, its non-current liabilities are left to forecast.145

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Statement of Cash FlowsThe statement of cash flows is the last financial statement to forecast. The reason it islast is because it is the most difficult to forecast of the three financial statements and is theleast reliable. The first step in forecasting it is to common size all the line items just like theincome statement and balance sheet. We took all of Schweitzer-Mauduit’s operating activities asa percentage of cash flows from operations (CFFO), all investing activities as a percentage ofcash flows from investing (CFFI), and all financing activities as a percentage of cash flows fromfinancing (CFFF). After all the data has been common sized, it is easier for us to look at andanalyze Schweitzer-Mauduit’s operations and to draw our assumptions.The first section to focus on in forecasting is the CFFO section. This forecast is importantto compute first because it is the link between the statements of cash flows to the incomestatement with the CFFO/OI ratio. With confidence in forecasted operating income and theCFFO/OI ratio from the past five years, we could easily forecast SWM’s cash flows fromoperating activities with the same ratio. Analyzing the past five years of the CFFO/OI ratio, weassume 0.085 to use for SWM’s forecasts. We placed our emphasis in computing the ratio onthe years 2004, 2006, and 2007.The next section to forecast is the cash flows from investing activities (CFFI). CFFI wastough to get a grasp on. SWM expenses capital into long term assets so we decided to forecastCFFI by the change in property, plant and equipment. The last step in forecasting the statementof cash flows is to forecast dividends under the cash flow from financing activities (CFFF).Looking at recent trends over the last five years, we found an average increase of two cents pershare that SWM paid to its investors. We decided to then assume this would be the case for thefuture and we continued this trend for the ten-year forecast.147

148

Estimating Cost of CapitalCost of EquityThe Cost of Equity (Ke), as explained by investopedia.com, is the compensation themarket demands in exchange for owning an asset and bearing the risk of ownership. Indetermining the cost of equity we use the capital asset pricing model (CAPM). The CAPMmeasures the amount of return an investor can expect when risk increases. The formula forthe CAPM is:Ke = Risk Free Rate + Beta(Market Risk Premium)Factors used in determining the CAPM are the risk free rate, beta, and market riskpremium. The risk free rate is determined by using the most recent Treasury bill rates, foundfrom the St. Louis Federal Reserve website, and the market risk premium is determined bysubtracting the risk free rate from the market return. Market risk premium is the additionalreturn for bearing beta, and beta measures how sensitive a firm’s performance is with themarket. Firms that are highly sensitive have a beta that exceeds one, which means the firm’sprice will be more volatile than the market. Those that are less sensitive have a beta less thanone, and their price will be less volatile than the market.A regression analysis must be performed to find the most appropriate Beta for the CAPM.The factors used for regression analysis are the firm’s returns, market returns, and risk freerate. To begin the analysis we gathered the stock prices of the past 80 months for Schweitzer-Mauduit and found the 3 month, 1 year, 2 year, 5 year, and 10 year risk free rates to locate thefive points of the yield curve. We then found the average return from the S & P 500.Regressions were run for five investment horizons, 24, 36, 48, 60, and 72 months, for eachpoint on the yield curve. This is done to test the stability of Beta over time. After running all ofthe regressions, we looked for the highest Adjusted R-squared because it is the highest149

explanatory power of the estimated Beta. The highest Adjusted R-squared was found in the 24month of the one-year regression. This would tell investors that Schweitzer-Mauduit is more ofa short-term investment. The results of the best Adjusted R-squared for each horizon arebelow.Horizon Months MRP RF BetaBetaUpperBetaLower Adj. R2 KeKeUpperKeLower3 month 24 0.08 0.34 1.4863 2.3613 0.6112 0.3315 0.1529 0.2229 0.08281 year 24 0.08 0.34 1.4984 2.3646 0.6322 0.3404 0.1538 0.2231 0.08452 year 24 0.08 0.34 1.4986 2.3662 0.631 0.3396 0.1538 0.2233 0.08445 year 24 0.08 0.34 1.4969 2.3664 0.6275 0.3381 0.1537 0.2233 0.084210 year 24 0.08 0.34 1.4964 2.3664 0.6264 0.3376 0.1537 0.2233 0.0841The highest adjusted R-squared is 34.04% and has a beta of 1.49, which is not muchdifferent from the published beta from YAHOO! Finance of 1.46. A beta of 1.49 explains 34.04%of the overall risk of Schweitzer-Mauduit. The beta is put into the CAPM equation to determinethe cost of equity. The following equations show the cost of equity to be 12.32%. The upperand lower bounds are the 95% confidence intervals that show the cost of equity to be between5.44% and 19.28%Ke: 0.1232 = 0.004 + 1.49 (0.08)Ke lower: 0.0544 = 0.004 + 0.63 (0.08)Ke upper: 0.1928 = 0.004 + 2.36 (0.08)150

Size-Adjusted Cost of EquityThe CAPM is the most commonly used method in determining cost of equity, but someanalysts believe it may not be a complete method. The size-adjusted cost of equity is anothermethod that can be used to find the Ke. Size-adjusted cost of equity suggests that factorsother than systematic risk play a part in determining return, like size. Smaller firms are knownto give larger returns as larger firms give smaller returns. Size-adjusted Ke is used to take intoaccount the varying sizes of firms. The size-adjusted cost of equity can be found with thefollowing formula:Ke = Risk Free Rate + Beta(Market Risk Premium)Size Adjusted Ke: 0.1462 = 0.004 + 1.49 (0.08) + 0.023Size-adjusted cost of equity is essentially the same as the CAPM plus size premium. Sizepremium is determined by size deciles ranging from 1 to 10. 1 represents the smallest firmsand progresses to 10, which represents the largest firms. Market capitalization is used todetermine which decline a firm is located in. We calculated Schweitzer-Mauduit’s market cap tobe $780.55 million. This gives the firm a market size of 2.3%. The cost of equity is estimatedto be 14.62%, which is a reasonable estimate because it falls within the 95% confidenceinterval found earlier.Alternative Cost of Equity Estimation MethodThe alternative cost of equity estimation method, also known as the backdoor cost ofequity, is another method used to solve for Ke. This method takes into consideration thecurrently observed stock price. It is computed very differently from CAPM because it uses theprice to book ratio, ROE, and a growth rate. The price to book ratio considers the currentmarket price of the firm. We calculated the P/B ratio to be 2.53. ROE was computed byaveraging the forecasted lagged ROE’s for the next ten years, 2009-2018, which was 7.12%.151

The growth rate (g) of 2.58% is the average growth rate of the forecasted stockholder’s equityfor the next ten years. The formula for the backdoor cost of equity is:(Price/Book)-1 = ROE – (Ke)/(Ke-g)Backdoor KeROE P/B Ratio GrowthRateCost ofEquitySWM 7.12% 2.53 2.58% 4.37%The backdoor cost of equity comes to equal 4.37%, which is significantly smaller thanthe Ke found from the capital asset pricing model, 12.32%, and the size-adjusted cost ofequity, 14.62%. It is also below the lower bound of the 95% confidence interval of 5.44%. Forthis reasons the backdoor method would not be a reasonable estimate of Ke for Schweitzer-Mauduit.Cost of DebtTo find your firm’s total cost of capital, the firm needs to break down both its cost ofequity and cost of debt. The cost of debt is your measure of the interest rate on the debt. Interms of risk, the cost of debt is almost always less risky and therefore lower than the cost ofequity. There is less risk on the cost of debt because debt is paid off before equity in the eventthat the firm defaults and goes through a liquidation process. The cost of debt is calculated bytaking the weights of each line item on the liability portion of the balance sheet, both currentliabilities and long term liabilities, and multiplying them by the interest rate designated to eachliability.152

The table below shows the liability portion of Schweitzer-Mauduit’s balance sheet. Lineitems are designated with the proper interest rates next to them to get the weighted averagecost of debt. Interest rates were derived from a few credible sources such as Schweitzer-Mauduit’s 2008 10K, the St. Louis Federal Reserve, and yahoo! Finance for bond rates. Forcurrent debt, long-term debt, and other liabilities we use the weighted average cost of longtermdebt found on SWM’s 10-K. Accounts payable and accrued expenses interest rates werederived from the St. Louis Federal Reserve non-financial three month commercial paper rate.Current deferred revenue and long-term deferred revenue rates came from the yahoo! Financetwo-year bond rate. This rate has opportunity costs associated with it which makes for acredible rate to use for these line times. We used the defined pension plan rate for pension andpost retirement benefits. Lastly, the St. Louis Federal Reserve 10-year risk-free Treasury billrate was used for deferred income tax liabilities.Now that interest rates are delegated to their respected liabilities we can calculate theweighted average cost of debt. The first step in the calculation is to divide individual liabilitiesby total liabilities to get your weights. Next, multiply your weights by the designated interestrates. Lastly, add up all the weighted averages to get your total weighted average cost of debt.After calculating the WACD for Schweitzer-Mauduit, we found its weighted average cost of debtto be 3.57%.153

Schweitzer MauduitBalance SheetFor years ended December 31(Dollars in millions) 2008Liabilities and Stockholders'EquityInterestRateWeightWACDCurrent LiabilitiesCurrent Debt 34.9 5.40% 0.0773 0.00417594Accounts Payable and AccruedExpenses156.2 0.18% 0.3461 0.00062300Current deferred revenue 6.0 1.99% 0.0133 0.00026457Total Current Liabilities 197.1Long-term Debt 144.9 5.40% 0.3211 0.01733791Pension and Post retirement Benefits 67.3 6.50% 0.1491 0.00969311Deferred income tax liabilities 11.0 3.40% 0.0244 0.00082872Deferred Revenue 12.3 1.99% 0.0273 0.00054237Other Liabilities 18.7 5.40% 0.0414 0.00223754Total Liabilities 451.3 Kd 0.03570315Ve= 1.74Vd= 1.69Vf= 3.43Ke = 11.43%Kd= 3.64%Tax rate = 23.6%WACCBT = 7.59%WACCAT = 7.17%Weighted Average Cost of CapitalBefore-Tax WACD = 3.57%154

The cost of capital is the interest rate used for financing debt and equity. The weightedaverage cost of capital (WACC) is used to determine the interest rate, as well as the estimatedcost of equity and debt to determine the cost of capital. The following equation is used tocalculate WACC before taxes:(BVL/MVF)*(Kd) + (MVE/MVF)(ke)WACC is calculated by dividing the book value of liabilities by the value of the firm andmultiplying it by the cost of debt. Next, divide the value of equity by the value of the firm andmultiple by the cost of equity. These two sums add up to the interest rate, which will be used.WACC can also be computed on an after-tax basis with the following formula, where t is the taxrate.(BVL/MVF)(kd)(1-t) + (MVE/MVF)*(ke)Weighted Average Cost of CapitalBVL/MVF Kd TaxRateMVE/MVF Ke WACCWACCbt 61.93% 3.57% 38.06% 12.32% 6.9%WACCat 61.93% 3.57% 35% 38.06% 12.32% 6.13%WACCbt(upper) 61.93% 3.57% 38.06% 19.28% 9.55%WACCbt(lower)61.93% 3.57% 38.06% 5.44% 4.28%The estimated WACC before-tax is 6.9% and the WACC after-tax is 6.13%. These areacceptable rates because they only differ slightly. The WACC shows the average rate of returnthe company must have to meet investors’ demands. The upper and lower bounds of WACCbtwere computed to show the 95% confidence interval in which the rate must be kept.155

Restated Weighted Average Cost of Capital Restated Weighted Average Cost of CapitalBVL/MVF Kd TaxRateMVE/MVF Ke WACCWACCbt 61.30% 3.57% 37.68% 12.32% 6.83%WACCat 61.30% 3.57% 35% 37.68% 12.32% 6.o6%WACCbt61.30% 3.57% 37.68% 19.28% 9.45%(Upper)WACCbt (61.30% 3.57% 37.68% 5.44% 4.24%Lower)Method of ComparablesThe method of comparables involves using a price multiple to evaluate whether a firm isrelatively fairly valued, undervalued, or overvalued in relation to the benchmark value. Thereare eight ratios used in the comparables: Price/Earnings (trailing), Price/Earnings (forecast),Price/Book, Dividends/Price, P.E.G., P/EBITDA, P/FCF (per share), and the EV/EBITDA. To makeour recommendation we will use a 15% margin of safety. On November 2, 2009 Schweitzer-Mauduit’s stock price closed at $50.95. Therefore, any computed price that falls below $43.31 is156

declared overvalued. Prices falling between $43.31 and $58.59 are declared fairly valued.Lastly, any price over $58.59 is declared undervalued. The method of comparables is widelyused by investors but we consider them not conclusive because they are not back by theory.Firms in the industry are not identical and are all run differently. The method of comparablesdoes not take this into account in any of the ratios. All ratios are computed using prices as ofNovember 2, 2009 and numbers and ratios from competitors were taken from yahoo finance(yahoofinance.com).P/E TrailingThe P/E trailing ratio is computed by taking the price per share and dividing it by the netearnings per share. Net earning per share can be calculated by net income from the previousyear divided by the total number of shares outstanding. We took the P/E ratios of SWM and itstwo main competitors and got and industry average of 59.20. We took the average andmultiplied it by the earnings per share and got the computed price of $2.96, which infers thatour stock is severely overvalued compared to our stated price of $50.95 and margin of safety of$43.31. On a restated basis, Schweitzer- Mauduit’s earnings per share was 0.42. The restatedcomputed price came out to be $24.86, which is much higher than the as stated price.However, $24.86 still falls below our 15% margin of safety price of $43.31 and still suggeststhat Schweitzer-Mauduit is overvalued.157

P/E TrailingCompany PPS EPS P/E Trailing ComputedPriceSWM 50.95 0.05 2.96SWM Restated 50.95 0.42 24.86Alliance One 4.37 0.189 23.03Universal 41.84 0.439 95.37Average 59.20P/E ForecastedThe forecasted ratio looks at both the earnings and prices for future years and does notlook back into the past. This is why the trailing ratio can be overlooked by the forecasted ratiobecause analysts would rather know what is going to happen to a company and not necessarilywhat has already happened. We computed the forecasted earnings per share by taking theforecasted net income and dividing it by the current total number of shares outstanding. Due tothe fact that we were not able to find the industry average for the price to earnings forecastedratio from our source at yahoo finance, we were not able to calculate a price to earningsforecasted price. It is a strong possibility that the earnings per share for these companies werenegative numbers, and therefore could not be derived. This goes to show one of several flawsof the method of comparables.158

P/E ForecastedCompany PPS EPS P/E Forecast ComputedPriceSWM 50.95 0.12 N/ASWM Restated 50.95 0.25 N/AAlliance One 4.37 N/AUniversal 41.84 N/AAverageN/APrice to BookThe price to book ratio is important because it enables analysts to determine whetherthe firm’s stock market value is justified by its book value of equity. The P/B ratio is calculatedby dividing the current price per share by the current book value of equity per share. Bookvalue per share is derived by dividing the book value by the number of shares outstanding.Once you compute the P/B ratios for each firm you must compute the industry average. Wemultiply the industry average by SWM’s book value of equity per share.159

Price/Book RatioCompany PPS BPS P/B ComputedPriceSWM 50.95 18.11 25.90Alliance One 4.37 2.38 1.84Universal 41.84 41.07 1.02Average 1.43After computing this ratio, we were able to calculate a price of $25.90. This again falls belowour margin of safety of $43.31, telling us that SWM is overvalued.Dividends/PriceThe dividends to price ratio is a useful tool because unlike the price to earnings ratio, itis not susceptible to creative accounting. Dividends are either declared or paid in cash or theyaren’t paid at all. To calculate this ratio, simply take the dividends per share divided by the priceper share. To compute dividends per share you take the total amount of dividends paid anddivide it by total number of shares outstanding. Once you compute the D/P, you take anindustry average and divide the average by your firm’s dividends per share.160

Dividends/Price RatioCompany PPS DPS D/P ComputedPriceSWM 50.95 0.61 N/AAlliance One 4.37 N/A N/AUniversal 41.84 1.80 0.04AverageN/AAs you can see from the table, we were not able to compute an industry average.Alliance One did not pay dividends in the current period. We felt pricing our company to onecompetitor would not be an efficient way to conduct our D/P ratio, so we did not price ourcompany to an industry average and therefore do not truly know if we are overvalued,undervalued, or fairly valued for this ratio’s computed price.Price Earnings Growth (P.E.G)The Price Earnings Growth ratio is used to determine a stock’s value while taking intoconsideration the earnings growth. The P.E.G. ratio is calculated by dividing the P/E ratio by theforecasted growth rate in earnings. Investors favor this method over the P/E ratio because ittakes into account the growth rate. You want to have a P.E.G. industry average of around 1.00for it to be a logical value. Higher P.E.G ratios signify being overvalued and lower P.E.G ratiosindicate being undervalued. P.E.G ratios for both Universal Corp. and Alliance One wasunavailable in yahoo finance and growth rates were not available as well so an industry averagecannot be determined. Therefore no comparable price can be computed for Schweitzer-Mauduit.161

P.E.G. RatioCompany P/E Growth Rate P.E.G. ComputedPriceSWM 1019.0 2.49% N/ASWM Restated 121.3 2.49%Alliance One 23.03 N/A N/AUniversal 95.37 N/A N/AAverageN/APrice to EBITDA (P/EBITDA)The price to EBITDA ratio is a similar concept to the price to earnings ratio. It measuresthe amount you are paying for a given amount of earnings, but P/EBITDA is a better method touse when the companies have different amounts of debt because EBITDA is unlevered. Theratio is calculated by taking the current market cap and dividing by EBITDA. EBITDA isrepresented for earnings before interest, taxes, depreciation, and amortization. Compute theP/EBITDA ratios for your company and your competing firms, once you get the industryaverage, multiply it by EBITDA and then divide by the number of shares outstanding to convertit back to a final price per share number.162

Price/EBITDACompany Market Cap EBITDA P/EBITDA ComputedPriceSWM 780.554 13.50 2.43SWM Restated 780.554 20.10 3.62Alliance One 409.244 239.17 1.71Universal 1,080.414 283.17 3.82Average 2.76Market Cap and EBITDA in millionsAs shown above, the P/EBITDA for Schweitzer-Mauduit is $2.43 on a stated basis and$3.62 on a restated basis. This is considerably lower than our 15% confidence margin of $43.31thus the firm is overvalued.Enterprise Value to EBITDA (EV/EBITDA)Enterprise value to EBITDA measures the price an investor pays for the benefit of thecompany’s cash flow. The important thing EV/EBITDA does is that it looks at firms with a debtfree analysis, so if an investor wants to value a company and not take debt into consideration,this ratio is one they would choose to look at when evaluating. The enterprise value of acompany is the sum of market capitalization and book value of debt minus cash andinvestments. It is then divided by EBITDA because it is easier to compare to other companieswhen capital structure and accounting policies are not considered.163

Enterprise Value/EBITDACompany EV EBITDA EV/EBITDA ComputedPriceSWM 1,204.554 13.50 -22.05SWM Restated 1,204.554 20.10 -19.70Alliance One 1,435.737 239.17 6.15Universal 1,741.495 283.17 6.00Average 6.075Market Cap and EBITDA in millionsThe industry average equals 6.075. To compute Schweitzer-Mauduit’s comparable pricewe multiple EBITDA by the industry average and then subtract out book value of debt and addback cash and investments. We then divide by number of shares outstanding to get a price of$-22.05. The computed price is negative because book value of debt exceeds cash andinvestments by $ 424 million. However, stock prices cannot be negative so this price is notapplicable. The computed restated price was $-19.70 and once again stock prices cannot benegative so the restated stock price is not applicable as well.Price to Free Cash Flow (P/FCF)The price to free cash flow ratio compares the firm’s market price to its amount of freecash flow, which is cash flows from operations minus capital expenditures. This ratio is ameasure of how well a company’s free cash flows can support its equity value. It is calculatedby multiplying price per share by shares outstanding and dividing by free cash flow. Free cashflow is computed by CFFO + CFFI +/- the change in CFFF. After computing the firm’s free cashflows find the industry average. Once you have the industry average, multiply by your firm’smarket cap and then divide that number by total number of shares outstanding.164

Price/Free Cash FlowCompany Market Cap FCF P/FCF ComputedPriceSWM 780.554 -61.8 N/AAlliance One 409.244 -19.8 -20.66Universal 1,080.414 111.17 9.72AverageN/AMarket Cap and EBITDA in millionsWe cannot compute a price for P/FCF because of a negative industry average.ConclusionAs you can see from the results the method of comparables it is hard to get an accuratepicture from this form of valuation. From the ratios that we were able to compute, we wereable to determine that Schweitzer-Mauduit is severely overvalued to our stated price onNovember 2, 2009 of $50.95 as well as our15% margin of safety of $43.31. Our closest ratio toreaching the $43.31 mark was the P/B ratio of $25.90. Also no prices fell in between the 15%margin of safety of $43.31 and $58.59. Again, these ratios are not based on financial theory.This should be taken into consideration when valuing a firm.165

Intrinsic Valuation ModelsThe intrinsic valuations models differ from the method of comparables in the sense thatthey are more precise and are back by financial theories. The models analyzed include thediscounted dividends model, discounted free cash flow model, residual income model, long-runresidual income model, and the abnormal earnings growth model. Each of these models usesthe forecasted figures that have been calculated for SWM for the years 2009 through 2018.With these models, analysts have the opportunity to observe the stock prices by manipulatingthe cost of equity (Ke), the growth rate, and the weighted average cost of capital (WACC). Thisis shown in each sensitivity analysis for the models, where a 15% analyst position is performed.In these analysis’s, model share prices are calculated from a range of different Ke’s and growthrates to help us determine SWM’s overall value.Discounted Dividends ModelThe discounted dividends model is the most straightforward intrinsic valuation model;however it is the most unreliable. This model has the lowest explanatory power than the othervaluation models. In the end, this model shows the present value of future forecasteddividends. This is calculated by finding the present value of the year-by-year dividends pershare (DPS) and the present value of the perpetuity in year 2019. The problem with this modelis that it holds growth rates constant, basically saying that the firm would be paying dividendsforever, which is unrealistic.To value Schweitzer-Mauduit’s stock using the discounted dividends model, the first stepwas to find the total dividends paid using our forecasted financial statements. Next, we dividedthe total dividends paid by the number of shares outstanding, which gave us the total dividendsper share. We then discounted each year’s dividend back to time zero by multiplying each yearby its corresponding present value factor, which gave us the present value for each year. Thesum of the ten years present values gives us the total PV of year-by-year dividends. The nextstep was to determine the present value of the perpetuity in year 2019. The first step is todivide 2019’s forecasted DPS by the cost of equity minus the growth rate, then take thatnumber and multiply it by its present value factor. This discounts the perpetuity to time zero,giving us the present value of the terminal value perpetuity.The sum of the PV of year-by-year dividends and the PV of the terminal value perpetuitygive us a model share price as of 12/31/09. Since we are valuing SWM stock price as of166

November 2, 2009 we had to calculate the time consistency price. This is computed bymultiplying the model share price by 1 plus Ke raised to the (10/12) power, giving us a timeconsistency price on November 2, 2009. The time consistency price gives analysts an estimateof value for SWM.Schweitzer-­‐Mauduit's Discounted Dividends Sensitivity Analysis Growth Rate Cost of Equity 0.00% 1.04% 2.70% 4.05% 5.40% 6.75% 8.10% 8.39% 9.92 10.5 11.86 13.73 17.28 26.69 123.729.70% 8.75 9.14 9.99 11.04 12.77 16.06 24.9311.01% 7.84 8.11 8.67 9.33 10.3 11.89 14.9512.32% 7.12 7.31 7.69 8.39 8.74 9.63 11.113.63% 6.52 6.6 6.94 7.24 7.64 8.19 9.0214.94% 6.02 6.13 6.33 6.55 6.82 7.19 7.716.25% 5.6 5.77 5.83 5.99 6.19 6.44 6.7815% Analyst Position Undervalued > $58.6 $43.31 < Fairly Valued < $58.60 Overvalued < $43.31 In the sensitivity analysis for the discounted dividends model, the cost of equity andgrowth rates are manipulated to change the time consistent price. SWM’s observed share priceis $50.95, which is significantly higher than each of the time consistent prices. We used a 15%analyst position, meaning that any price above $43.31 and below $58.60 will make the firmfairly valued. Using SWM’s 12.32% cost of equity and 4.05% growth rate, the stock price cameout to b $8.13. This price is drastically lower than the observed price of $50.95, showing thatSWM is a highly overvalued firm. The only time it is undervalued is by using a very high growthrate and a very low cost of equity, which made the price $123.72. This number proves howunrealistic the discounted dividends model is because of how sensitive it is to growth rates. Byincreasing the growth rate from 6.75% to 8.10%, it gave us a stock price of almost 4 ½ timesmore than the previous years. Nonetheless, it suggests SWM to be a very overvalued company.167

Discounted Free Cash Flows ModelThe discounted free cash flows model has a little more explanatory power than thediscounted dividends model, however not by much. This intrinsic valuation model takes intoaccount the firms net cash flows. It is somewhat unreliable because the cash flows come fromthe forecasted cash flow statement, which is the hardest to forecast. This being said, this modeldetermines the firms value of equity by summing present value of forecasted free cash flowsand the present value of the free cash flows perpetuity in year 2019.The firm’s net cash flows are computed by subtracting cash flow from investing activities(CFFI) from the cash flow from operating activities (CFFO). Once these cash flows are derivedfor each year, we must discount them back to time zero. This is done by multiplying each year’snet cash flows by their corresponding present value factors, giving us each year’s present value.The present value factors are determined by diving each year’s cash flows by 1 plus WACCbt.The sum each year’s present value gives us the total PV of year-by-year free cash flows. Thenext step is to calculate the present value of the continuing perpetuity in year 2019 andbeyond. This is done by dividing the estimated cash flow in year 2019 by WACCbt minus thegrowth rate, then discounting that number back to zero by multiplying it by its present valuefactor. This gives us the present value of the free cash flows perpetuity. Finally, by adding thePV of free cash flows and the present value of the perpetuity, we obtain the market value ofassets.The estimated market value of assets is very important because it is used to give us themarket value of equity. By subtracting the book value of liabilities from the market value ofassets, it gives us the market value of equity. A model share price must be calculated bydividing the market value of equity by the number of shares outstanding. Since this share priceis of 12/31/09, we must multiply it by 1 plus the WACCbt raised to the (10/12) power, whichgives us a time consistency price as of November 2, 2009.168

Schweitzer-­‐Mauduit's Free Cash Flow Sensitivity Analysis Growth Rate Cost of Equity 0.00% 1.04% 2.70% 4.05% 5.40% 6.75% 8.10% 8.39% 1.59 1.72 2.03 2.46 3.27 5.41 27.529.70% 1.33 1.42 1.61 1.85 2.23 2.98 4.9711.01% 1.13 1.19 1.32 1.46 1.68 2.03 2.7112.32% 0.98 1.02 1.1 1.2 1.33 1.53 1.8513.63% 0.85 0.88 0.94 1.01 1.09 1.21 1.3914.94% 0.75 0.77 0.81 0.86 0.92 1 1.1116.25% 0.66 0.68 0.71 0.74 0.78 0.84 0.9115% Analyst Position Undervalued > $58.6 $43.31 < Fairly Valued < $58.60 Overvalued < $43.31 In the sensitivity analysis of the discounted free cash flow model, it shows SWM to behighly overvalued no matter what WACCbt or growth rate. The lower the WACCbt, and thehigher the growth rate derive a number that is closest to the observed share price of $50.95.This is unreliable because it increases the market value of assets and the market value of equityto be substantially high, almost $35,000 larger than the rest of the market values using thegiven inputs. This being said, the free cash flows model is less likely to be used to value thefirm, but it does show SWM as being overvalued which is true.Residual Income ModelThe residual income model is one of the most precise valuation models due to its highlevel of explanatory compared to the other models. On average, the residual income model hasan 80 – 90% explanatory power in respect to the industry and up to 70% explanatory powerfor individual firms. This shows how the model is extremely reliable in comparison to thediscounted dividends and discounted free cash flows, which have explanatory levels of less than20%. The difference in explanatory power among these models is due to how the residual169

income model is not sensitive to changes in the growing perpetuity, which is a majorcomponent if the model. This being said, the high level of explanatory power allows uscomplete confidence in determining the value of the firm.The residual income model is important because it determines whether or not the firmhas created or destroyed value. If annual residual income is positive, the firm has createdvalue; if annual residual income is negative, the firm has destroyed value. Annual residualincome is computed by subtracting annual normal income (the benchmark) from the sameyear’s net income. The annual normal income is determined for each year by multiplying thebook value of equity of the previous year by the cost of equity, Ke. This can only be calculatedafter each year’s book value of equity is found. To compute each year’s book value of equity,the total dividends paid for the current year is subtracted from the sum of the previous year’sbook value of equity and the forecasted net income in the current year. This is computed overthe entire forecasted ten years. After using these equations to find each year’s annual residualincome, the results have shown negative numbers for all ten years. This means that SWM isforecasted to destroy value in the years 2009-2018. Now that the annual residual income hasbeen computed for each year, we must discount them back to time zero to get the presentvalue. This is computed by multiplying each year’s residual income by its corresponding presentvalue factor. The present value factor is calculated by dividing 1 by 1 plus the cost of equityraised to its time value, 1/(1 + Ke)^t . By multiplying the PV factor by each year’s residualincome, we derive the present value of the year-by-year residual incomes. The sum of eachyear’s present value is the total present value of year-by-year residual income. After calculatingSWM’s present value of the year-by-year residual income, it resulted in negative numbers for allten years. The same principle applies that if the firm is consistently producing negative presentvalues then the firm is expected to destroy value for the firm.The next step in the model is to calculate the present value of the perpetuity in year2019. First, we need to find the terminal value perpetuity. For both the as-stated and restatedresidual income models, we calculated the percent growth rate after 2018 to decline by 4%.This negative percent change was then added to 1 and multiplied by the residual income in2018 in order to calculate the residual income in year 2019. This number was then divided bythe initial cost of equity minus the perpetuity growth rate. To get the present value of theperpetuity, we discounted it back to time zero by multiplying it by its corresponding PV factor.170

Now that we have calculated the total present value of the year-by-year dividends andthe present value of terminal value perpetuity, we must find the market value of equity forSWM. The market value of equity is computed by adding the PV of year-by-year residualincomes plus the PV of the terminal value perpetuity plus the book value of equity at time zero,year 2008. The market value of equity is then divided by the number of shares outstanding toget a model price. To bring this model price up to November 2, 2009 at a time consistent price,we multiplied the value by 1 plus the cost of equity raised to the (10/12) power. Below is thesensitivity analysis’s for the as-stated and restated residual income models.Schweitzer-­‐Mauduit's As-­‐Stated Residual Income Sensitivity Analysis Growth Rate Cost of Equity 0.0% -­‐10.0% -­‐20.0% -­‐30.0% -­‐40.00% -­‐50.00% -­‐60.00% 8.39% 18.01 17.58 17.45 17.38 17.35 17.32 17.319.70% 12.01 13.9 14.52 14.82 15.01 15.13 15.2211.01% 7.42 10.75 11.93 12.54 12.91 13.15 13.3312.32% 3.78 8.02 9.63 10.49 11.01 11.37 11.6313.63% 0.82 5.63 7.58 8.64 9.3 9.75 10.0814.94% N/A 3.53 5.73 6.96 7.74 8.28 8.6716.25% N/A 1.66 4.07 5.43 6.31 6.93 7.3815% Analyst Position Undervalued > $58.6 $43.31< Fairly Valued < $58.60 Overvalued < $43.31 Schweitzer-­‐Mauduit's Restated Residual Income Sensitivity Analysis Growth Rate Cost of Equity 0.0% -­‐10.0% -­‐20.0% -­‐30.0% -­‐40.00% -­‐50.00% -­‐60.00% 8.39% 21.45 20.03 19.61 19.41 19.29 19.21 19.169.70% 14.40 15.82 16.28 16.51 16.65 16.74 16.8011.01% 9.01 12.21 13.34 13.92 14.28 14.51 14.6812.32% 4.76 9.08 10.73 11.60 12.14 12.50 12.7713.63% 1.31 6.36 8.40 9.51 10.21 10.68 11.0314.94% N/A 3.95 6.31 7.62 8.45 9.03 9.4516.25% N/A 1.82 4.42 5.89 6.85 7.51 8.0015% Analyst Position Undervalued > $58.6 $43.31 < Fairly Valued < $58.60 Overvalued < $43.31 171

The sensitivity analysis for both as-stated and restated models gives relatively the samemodel prices. Negative growth rates are used to bring the terminal value of the perpetuity backto equilibrium. Growth rates ranged from 0% to 60%, where lower growth rates returned toequilibrium faster and high growth rates returned to equilibrium slower. The different cost ofequity and growth rates were inputted in order to manipulate the time consistent price. In bothcases, the highest cost of equity of 16.25% resulted in the lowest model price in every differentgrowth rate, while the lowest cost of equity of 8.39% gave us the highest model prices. Eachmodel price has shown to be significantly less than the observed share price of $50.95.Considering the high explanatory power of the residual income model, we are confident insaying that SWM in overvalued.Abnormal Earnings Growth (AEG) ModelThe abnormal earnings growth (AEG) is a model based on financial theory. Incomparison with the other models, the AEG model utilizes the information obtained from thefirm’s financial statements. The AEG model uses the dividends reinvested (DRIP), normalearnings, and cumulative dividend earnings. By examining these components, analysts candetermine a firm’s ability to meet liabilities to investors. In comparing normal earnings withcumulative earnings growth per fiscal year, firms can determine the difference between actualand expected earnings for investors. In addition, the AEG model contains a very high validationlevel in comparison to the dividend and discounted free cash flow models.The first step in the AEG model is to calculate the DRIP. DRIP is computed bymultiplying the previous year’s dividend payment by the cost of equity in the previouslyforecasted 10 years. The DRIP is the amount of money investors can reinvest in the firm withtheir previously years dividend payment. Once the DRIP is calculated, the next step is tocompute the cumulative dividend earnings, which is calculated by adding the dividendreinvestment to the forecasted net income for the year. Then we compute benchmark earningsfor the next nine years. Multiplying 1 plus the estimated cost of equity by the previous year’snet income derives the benchmark or normal earnings. Now AEG can be calculated by172

subtracting the normal earnings for each year by the cumulative dividend earnings. However,these now need to be discounted back to time zero to get the present value. The present valueis calculated by multiplying each year’s AEG with its corresponding present value factor. Thepresent value factor is one divided by one plus the cost of equity, raised to the time period,t(1/((1+Ke)^t)). By summing up each of the years present values it gives us the total PV ofyear-by-year AEG’s.Once the present value of the abnormal earnings growth is found, the terminal value ofthe perpetuity needs to be calculated. However, first we need to estimate the AEG for year2019. In order to calculate its AEG, the trend over the previous ten years should be considered.By calculating the percent change in AEG over the forecasted ten years, it gave us an estimateof what the AEG will be in 2019. For both as-state and restated AEG models, we calculated apercent change of 18%, which was added to 1 and multiplied by the previous year’s AEG to getthe AEG in 2019. Once the 2019 AEG is found, it must be converted into the present value. Inorder to do this we divide the forecasted AEG by the cost of equity minus the growth rate,followed by multiplying the perpetuity by the present value factor of 2018, resulting in theterminal value perpetuity.With the present value of the forecasted years AEG and the present value of theperpetuity, the intrinsic value per share can be found. The first step in the calculation of theintrinsic value, or the model price, is to find the total average net income. The figure iscomposed of the net income from 2009, the year-by-year present value of AEG and the value ofthe terminal perpetuity. Next the total average net income is divided by the number of sharesoutstanding to develop earnings per share. The intrinsic value per share must be computednext by dividing the cost of equity by the intrinsic value per share. In order to get the timeconsistent price in 11/2/2009 dollars, the previous share price must be multiplied by 1 plus theestimated cost of equity raised to the (10/12) power.173

Schweitzer-­‐Mauduit's As-­‐Stated AEG Sensitivity Analysis Growth Rate Cost of Equity 0.0% -­‐10.0% -­‐20.0% -­‐30.0% -­‐40.00% -­‐50.00% -­‐60.00% 8.39% 1.7 1.76 1.78 1.79 34.73 1.79 1.89.70% 0.9 1.25 1.36 1.41 1.45 1.47 1.4911.01% 0.5 0.93 1.08 1.16 1.21 1.24 1.2712.32% 0.3 0.74 0.9 0.99 1.04 1.08 1.113.63% 0.21 0.61 0.77 0.86 0.92 0.96 0.9814.94% 0.17 0.53 0.69 0.77 0.82 0.86 0.8916.25% 0.17 0.48 0.62 0.7 0.75 0.79 0.8215% Analyst Position Undervalued > $58.6 $43.31 < Fairly Valued < $58.60 Overvalued < $43.31 Schweitzer-­‐Mauduit's Re-­‐Stated AEG Sensitivity Analysis Growth Rate Cost of Equity 0.0% -­‐10.0% -­‐20.0% -­‐30.0% -­‐40.00% -­‐50.00% -­‐60.00% 8.39% 1.87 2.72 2.97 3.09 3.16 3.21 3.249.70% 1.06 2.04 2.37 2.53 2.62 2.69 2.7311.01% 0.68 1.63 1.97 2.14 2.24 2.32 2.3712.32% 0.51 1.37 1.69 1.86 1.97 2.04 2.0913.63% 0.46 1.2 1.5 1.66 1.76 1.83 1.8814.94% 0.45 1.09 1.36 1.51 1.61 1.67 1.7216.25% 0.47 1.01 1.26 1.39 1.48 1.54 1.5915% Analyst Position Undervalued > $58.6 $43.31 < Fairly Valued < $58.60 Overvalued < $43.31 We used a 15% margin of acceptance, which means any number in between 43.31 and58.60 is fairly valued. The AEG sensitivity analysis shows that for both as stated and restatedthe change in the cost of equity and growth rates results in very small changes to price. It alsoshows that no matter how high or low each variable is, SWM is a highly overvalued firm. Wetake great consideration in the AEG model to determine the value of SWM because of its highexplanatory power. Therefore, we can safely say that Schweitzer-Mauduit is overvalued.174

Long-Run Residual Income Valuation ModelThe long-run residual income valuation model is much like the residual income model.With the long run residual income model we will use earnings instead of dividends. Aspreviously mentioned, dividends tend to be inconsistent and therefore forecasted earnings willbe more reasonable. The model relies heavily on book value of equity, return on equity, Ke, andgrowth rates to generate a market value of equity on which to derive a share price. The formulathat will be used for this model is:MVE = BVE * [1+ (ROE-Ke) / (Ke-G)]First, return on equity (ROE) must be calculated. We calculate ROE on a lagged basis bytaking the forecasted net income for the year and dividing it by the previous year’s forecastedbook value of equity.2010 2011 2012 2013 2014 2015 2016 2017 2018ROE0.0068 0.06065 0.06628 0.06834 0.06873 0.07567 0.08032 0.0802 0.0801ROERestated0.01299 0.07019 0.07499 0.07405 0.07583 0.08129 0.08466 0.08369 0.08285175

As stated in the formula, there are no longer only two variables in this particular model.The variables included are return on equity, cost of equity, and a growth rate. On the statedbasis, book value of equity is $277.4, cost of equity is 12.32% and we have a 0% growth rate.Once all yearly ROE’s were computed, we took the average of eight years of 2011-2018 in orderto get the ROE to plug into the formula. We took an eight-year average because we determined2010 was an outlier and did not need to be included in the average. Once all variables had beendetermined, the time consistent price was computed by entering a Ke of 12.32%, a growth rateof 0%, and an average ROE of 7.0% into the time consistent formula. The time consistent pricecomputed was $11.33. This figure is well below the reported stock price on November 2, 2009and suggests the Schweitzer-Mauduit is overvalued.On a restated basis, book value of equity is $285.7, cost equity remains at 12.32% andwe still assumer a 0% growth rate. We took another eight year average of years 2011-2018leaving 2010 as an outlier to get our ROE. ROE was computed to be 8.0%. After all variableswere determined, we plugged them into our time consistent formula and calculated $13.34.Once again this number is well below the reported stock price on November 2, 2009 of $50.95and says that Schweitzer-Mauduit is overvalued.As mentioned above, the time consistent price when all variables have been introducedis $11.33 on a stated basis and $13.34 on a restated basis. Considering the upper and lowerboundaries, a price of $11.33 and $13.34 indicates that Schweitzer-Mauduit is severelyovervalued. Judging by the sensitivity analysis, the results also show that SWM is overvalued.The sensitivity analysis shows how sensitive the price can be to changes in Ke, ROE, andgrowth. The long-run residual income valuation model shows that the price is very sensitive,especially in the ROE/Ke valuation. Even though the sensitivity is strong, the results for allthree analyses show that SWM has been overvalued.176

Cost of EquityReturn on Equity-0.14 -0.07 0 0.07 0.14 0.21 0.28-30% 7.54 10.84 14.14 17.44 20.74 24.04 27.34-20% 3.7 8.02 12.34 16.66 20.98 25.31 29.63Growth -10% -3.57 2.68 8.94 15.19 21.45 27.71 33.96Rate 0% -22.67 -11.33 - 11.33 22.67 34 45.3410% -206.36 -146.17 -85.98 -25.79 34.39 94.58 154.7720% 88.31 70.13 51.95 33.77 15.58 -2.6 -20.7830% 49.64 41.75 33.85 25.95 18.05 10.15 2.2540% 38.92 33.87 28.83 23.78 18.74 13.69 8.6550% 33.88 30.18 26.47 22.76 19.06 15.35 11.6515% Analyst Position Undervalued > $58.6 $58.60 < Fairly Valued < $43.31 Overvalued < $43.31 177

Return on EquityGrowth RateKe -30% -20% -10% 0% 10% 20% 30% 40% 50%8.39% 18.66 18.42 17.9 16.16 36.08 21.68 20.61 20.22 20.019.70% 18.23 17.78 16.88 14.11 195.59 24.69 22.16 21.3 20.87Cost of 11.01% 17.82 17.2 15.98 12.56 -25.79 28.56 23.93 22.45 21.79Equity 12.32% 17.44 16.66 15.19 11.33 -17.2 33.77 25.95 23.78 22.7613.63% 17.08 16.17 14.49 10.34 -16.65 41.11 28.3 25.21 23.8114.94% 16.74 15.71 13.86 9.53 -12.35 52.24 31.06 26.78 24.9416.25% 16.42 15.29 13.29 8.84 -9.85 71.16 34.34 28.52 26.1515% Analyst Position Undervalued > $58.6 $58.60 < Fairly Valued < $43.31 Overvalued < $43.31 178

Growth RateReturn on Equity-0.14 -0.07 0 0.07 0.14 0.21 0.288.39% -­‐32.31 -16.16 - 16.16 32.31 48.47 64.639.70% -­‐28.23 -14.12 - 14.11 28.23 42.34 56.4611.01% -­‐25.12 -12.56 - 12.56 25.12 37.68 50.24Cost of 12.32% -­‐22.67 -11.33 - 11.33 22.67 34 45.34Equity 13.63% -­‐20.69 -10.34 - 10.34 20.69 31.03 41.3814.94% -­‐19.06 -9.53 - 9.53 19.06 28.58 38.1116.25% -­‐17.69 -8.84 - 8.84 17.69 26.53 35.3715% Analyst Position Undervalued > $58.6 $58.60 < Fairly Valued < $43.31 Overvalued < $43.31 179

Cost of Equity RestatedReturn on Equity-0.16 -0.08 0 0.08 0.16 0.24 0.32-30% 6.8 10.68 14.56 18.44 22.33 26.21 30.1-20% 2.54 7.63 12.71 17.8 22.88 27.97 33.05-10% -5.52 1.84 9.2 16.57 23.93 31.3 38.66Growth 0% -26.68 -13.34 - 13.34 26.68 40.02 53.36Rate 10% -230.24 -159.4 -88.55 -17.71 53.13 123.98 194.8220% 96.3 74.9 53.5 32.1 10.7 -10.7 -32.130% 53.45 44.16 34.86 25.56 16.23 6.97 -2.3240% 41.56 35.63 29.69 23.75 17.81 11.88 5.9450% 35.99 31.62 27.26 22.9 18.54 14.18 9.8115% Analyst Position Undervalued > $58.6 $58.60 < Fairly Valued < $43.31 Overvalued < $43.31 180

Return on Equity RestatedGrowth RateKe -30% -20% -10% 0% 10% 20% 30% 40% 50%8.39% 19.74 19.67 19.52 19.02 24.77 20.61 20.3 20.19 20.139.70% 19.28 18.99 18.41 16.61 134.3 23.47 21.83 21.27 20.99Cost of 11.01% 18.85 18.37 17.43 14.78 -40.29 27.16 23.57 22.46 21.92Equity 12.32% 18.45 17.8 16.57 13.34 -17.71 32.1 25.56 23.75 22.913.63% 18.07 17.27 15.8 12.18 -11.43 39.08 27.88 25.17 23.9614.94% 17.71 16.78 15.12 11.21 -8.48 49.67 30.59 26.74 25.0916.25% 17.37 16.33 14.5 10.41 -6.77 67.65 33.83 28.49 26.3115% Analyst Position Undervalued > $58.6 $58.60 < Fairly Valued < $43.31 Overvalued < $43.31 181

Growth Rate RestatedReturn on Equity-0.16 -0.08 0 0.08 0.16 0.24 0.328.39% -­‐38.03 -19.02 - 19.02 38.03 57.05 76.079.70% -­‐33.23 -16.61 - 16.61 33.23 49.84 66.46Cost of 11.01% -­‐29.57 -14.78 - 14.78 29.57 44.35 59.13Equity 12.32% -­‐26.68 -13.34 - 13.34 26.68 40.02 53.3613.63% -­‐24.35 -12.18 - 12.18 24.35 36.53 48.714.94% -­‐22.43 -11.21 - 11.21 22.43 33.64 44.8616.25% -­‐20.82 -10.41 - 10.41 20.82 31.23 41.6315% Analyst Position Undervalued > $58.6 $58.60 < Fairly Valued < $43.31 Overvalued < $43.31 Analysis RecommendationUpon completion of our extensive research and analysis on Schweitzer-Mauduit we havedetermined that the firm is significantly overvalued. Our conclusion was based on the resultsfrom an in depth industry analysis, accounting analysis, forecasted financials, and an intrinsicand sensitivity analysis. The main portion that led us to this determination was from theforecasted financials and the intrinsic valuation models.By first analyzing the paper and tobacco industry we were able to identify and evaluateSchweitzer-Mauduit’s compared to its competitors. Additionally, we were able to determinemanagerial policies for the firms and competitive advantages firms held over one another.182

Once the industry analysis had been observed, an accounting analysis took place allowing anoverview of the firm’s truthfulness in its financial statements. From the analysis it wasunderstood that the impairment of research and development would need to be capitalized andrestated. By capitalizing research and development, more accurate expense and revenue levelscan be documented, as well as restated net income levels. After conducting the tests forimpairment of goodwill, it was concluded that it would not need to be restated.From the financial analysis we were able to establish levels of liquidity, profitability, andcapital structure for Schweitzer-Mauduit, its competitors, and the industry. By establishing salesand expense manipulation ratios, as well as liquidity and profitability ratios, we were able todetermine that Schweitzer-Mauduit does not exceed nor fall behind its competitors in theindustry. From the analysis it is shown that Schweitzer-Mauduit did not manipulate its financialstatements to depict more favorable financial positions. Research and development did have tobe restated; however it did not make any major impacts on the financial statements. Goodwilldid not need to be restated as it did not represent a large enough portion of total assets.Additionally in the financial analysis, we were able to forecast future expectations for the firm.By analyzing the industry and historical evidence from the firm we were able to establishgrowth rates. These rates and previously discovered ratios allowed us to forecast the incomestatement, balance sheet, and the statement of cash flows. When forecasting the incomestatement, sales dropped by two percent in 2009 in response to the recent recession sweepingthe country. In 2010 sales recovered and returned to a six percent growth rate and began tolevel off following 2010.In order to forecast the balance sheet, the asset turnover ratio was computed to be 1.0.Other ratios used to forecast the balance sheet were the accounts receivable ratio computed tobe 8.9, inventory turnover calculated at 5.8 and the plant property and equipment turnoverratio at 1.9. The statement of cash flows was forecasted using logically computed growth ratesof cash flow from financing activities, cash flow from net income, and cash flow fromoperations.A regression analysis was performed in order to derive a beta and cost of capital forSchweitzer-Mauduit. The beta with the highest adjusted r squared was 1.49, which onlyexplains 34.04% of the overall risk of the firm. The beta of 1.49 is put into the CAPM equationto determine the cost of equity. Our results from the CAPM show the cost of equity to be183

12.32%. The upper and lower bounds are the 95% confidence intervals that show the cost ofequity to be between 5.44% and 19.28%, which is true. Once we calculated the cost of debt of3.57%, we were able to put both inputs into the weighted average cost of capital equation. TheWACC before tax was evaluated to be 6.9%, and 6.18% after taxes. The principal material forour valuation analysis were the forecasted financial statements, cost of capital figures (Ke), andthe weighted average cost of capital before tax (WACCbt).The equity valuation analysis was able to find an intrinsic value of Schweitzer-Mauduit.In order to determine its value, two different valuation analyses were conducted; the method ofcomparables and the intrinsic valuation analysis. The method of comparables has many flawsand cannot be weighted on too much. After observing the numbers and ratios of SWM and itscompetitors, we were only able to compute few comparable prices. The prices were comparedto the observed price of $50.95 with a 15% fairly valued position, meaning anything between$43.31 and $58.60 would consider SWM to be fairly valued. Any price above $58.60 wouldmean SWM is undervalued, and any price below $43.31 would mean SWM is overvalued.Overall, the method of comparables gave us a highly overvalued firm.The next valuation was the intrinsic analysis which is much more reliable than themethod of comparables. Five models were evaluated in order to determine value; thediscounted dividends model, the free cash flows model, the residual income model, the long runresidual income model, and the AEG model. All of these models are very effective, howeversome more than others. The discounted dividends and the discounted free cash flows accountfor dividends in their models, which is very unreliable. Forecasting dividends is difficult for anoutsider because it is up to management’s discretion. Nonetheless, both models proved SWM tobe overvalued. The last three intrinsic valuations are of the highest explanatory power, which iswhere most base their conclusions. After all of the computed stock prices were compared to theobserved price (with the same 15% fairly valued approach), it has shown SWM to beovervalued, as well. Taking all of this into account, especially the high explanatory models, weare confident in saying that SWM is a highly overvalued firm. This being said, we would advisethat any investor’s or stock holders sell any stock they currently hold in Schweitzer-Mauduit asin the stock is significantly over valued.184

AppendicesSales Manipulation DiagnosticsNet Sales/ Cash From Sales 2004 2005 2006 2007 2008 SWM 0.117452662 1.175087719 1.156983931 1.163790296 1.277916459 AOI 1.316316533 1.20289186 1.179072117 1.123635325 10.9615108 UVV 1.076345769 1.069412336 1.064461591 1.14953103 1.12070047 Industry Average 0.836704988 1.149130638 1.13350588 1.145652217 4.453375908 Net Cash/ Cash From Sales (change) 2004 2005 2006 2007 2008 SWM 1.454253612 1.205882353 3.945945946 1.244258873 -­‐3.9924812 AOI 1.05630472 1.142862166 4.380126545 -­‐0.02055062 UVV 3.882512849 1.054066669 1 0.968781863 0.82201615 Industry Average 2.66838323 1.105417914 2.029602704 2.197722427 -­‐1.06367189 Net Sales/ Accounts Receivable 2004 2005 2006 2007 2008 SWM 6.729785056 6.711422846 7.37007874 7.105367793 8.826436782 AOI 4.161390238 5.928733965 6.584342325 9.088303232 11.11346044 UVV 14.09830285 19.05725804 16.51311377 7.687575161 9.284971896 Industry Average 8.329826049 10.56580495 10.15584495 7.960415395 9.741623041 Net Sales/ Accounts Receivable Change 2004 2005 2006 2007 2008 SWM 15.62 0.170731707 5.857142857 5.094017094 -­‐0.0577802 AOI -­‐35.32 18.76050024 19.9486166 1.295846912 -­‐0.88197693 UVV 1.74 92.94348872 5.776029264 -­‐31.0326614 -­‐4.61848728 Industry Average -­‐5.98666667 37.29157356 10.52726291 -­‐8.2142658 -­‐1.85274814 Net Sales/ Inventory 2004 2005 2006 2007 2008 185

SWM 5.497491639 5.600334448 5.326829268 5.448170732 6.485641892 AOI 1.701512959 2.622421687 2.736142409 3.039633477 2.920207252 UVV 2.695297489 3.304582153 3.111883369 3.152380534 3.324242804 Industry Average 3.298100696 3.842446096 3.724951682 3.880061581 4.243363983 Net Sales/ Inventory Change 2004 2005 2006 2007 2008 SWM 4.099547511 1.23 -­‐4.29411765 7.268292683 0.9609375 AOI 26.30790945 20.43136692 2.940141839 1.103743112 0.859372929 UVV -­‐6.14888455 6.75643603 3.832527 3.613105633 0.491261537 Industry Average 8.086190804 9.472600983 0.826183731 3.995047143 0.770523989 Expense Manipulation DiagnosticsAsset Turnover2004 2005 2006 2007 2008 SWM 2.837721191 2.759785744 2.78098472 2.891585761 3.362084063 AOI 0.926649745 1.494635894 1.544135758 1.748867567 1.687686577 UVV 1.602721127 2.119924419 1.94792849 1.122128255 1.391309366 Industry Average 1.789030688 2.124782019 2.091016323 1.920860527 2.147026668 Asset Turnover (change) 2004 2005 2006 2007 2008 SWM -­‐0.22414646 1.118181818 2.056338028 5.137931034 -­‐2.82446809 AOI 0.963125975 116.2818118 1.630537602 0.564779236 0.538299356 UVV 0.442636565 7.832157749 0.914637702 109.0688905 -­‐0.56021403 Industry Average 0.393872026 41.74405046 1.533837777 38.25720026 -­‐0.94879425 CFFO / OI 2004 2005 2006 2007 2008 SWM 0.993067591 0.969465649 9.773584906 3.983240223 1.970414201 AOI -­‐29.6156757 0.088561597 -­‐0.33103056 1.64883905 0.404177574 UVV 1.391144635 1.250538157 7.463979849 3.683080808 1.607245963 Industry Average -­‐9.07715448 0.769521801 5.6355114 3.105053361 1.327279246 186

CFFO/ OI Change 2004 2005 2006 2007 2008 SWM -­‐1.97368421 1.043478261 -­‐0.40294118 1.547619048 38 AOI 0.864731638 -­‐0.24440005 0.241876374 7.443123601 UVV -­‐0.48535708 0.583270172 0.977706144 2.865339193 0.373268809 Industry Average -­‐1.22952065 0.830493357 0.11012164 1.551611538 15.2721308 CFFO/ NOA 2004 2005 2006 2007 2008 SWM 0.137508999 0.101735648 0.000275368 0.167449507 0.092397336 AOI -­‐0.25867539 0.034203028 0.379408433 0.830875872 0.022536401 UVV 0.341659713 0.358283929 0.095024612 0.454220092 0.571965726 Industry Average 0.073497774 0.164740868 0.158236138 0.484181824 0.228966488 CFFO/ NOA (change) 2004 2005 2006 2007 2008 SWM 0.179856115 0.454976303 3.341463415 -­‐7.40E-­‐05 0.581039755 AOI -­‐10.0939119 -­‐2.5839031 1.54919657 -­‐5.84497731 -­‐0.10302286 UVV 0.716153895 0.797493994 -­‐3.59100859 -­‐0.39590986 -­‐1.10254689 Industry Average -­‐3.0659673 -­‐0.44381093 0.433217132 -­‐2.08032039 -­‐0.20817667 Total Accruals/sales 2004 2005 2006 2007 2008 SWM 0.031787072 0.027918782 0.08028083 0.103632479 0.044276599 AOI -­‐0.02733009 -­‐0.00527183 0.255566258 0.105640101 0.010424046 UVV 0.040503674 0.034353187 0.014616675 0.059403509 0.033719945 Industry Average 0.014986886 0.019000047 0.116821255 0.089558696 0.02947353 Liquidity RatiosCurrent Ratio 2004 2005 2006 2007 2008 SWM 1.122578 1.411047 1.415015 1.148699 1.158803 AOI 1.941308 2.166025 1.649853 1.887154 1.585657 187

UVV 2.048827 1.844586 1.922144 2.230048 3.522169 Industry Average 1.704238 1.807219 1.662337 1.7553 2.088876 Quick Asset Ratio 2004 2005 2006 2007 2008 SWM 0.979167 0.715698 0.676276 0.715698 0.54312 AOI 0.884065 0.93151 0.718489 0.93151 0.884065 UVV 0.929454 0.822306 0.799569 0.822306 0.929454 Industry Average 0.930895 0.823171 0.731445 0.823171 0.785547 Working Capital Turnover 2004 2005 2006 2007 2008 SWM 25.98814 9.299859 9.48191 22.3375 24.53355 AOI 1.911242 2.776458 3.920271 3.72019 4.569386 UVV 2.876587 3.99984 4.06032 2.354872 2.114665 Industry Average 10.25866 5.358719 5.820834 9.470854 10.40587 Accounts Receivable Turnover 2004 2005 2006 2007 2008 SWM 6.729785 6.711423 7.370079 7.373757 8.826437 AOI 4.16139 5.928734 6.584342 9.088303 11.11346 UVV 14.0983 19.05726 16.51311 7.687575 10.06922 Industry Average 8.329826 10.5658 10.15584 8.049879 10.00304 Day's Sales Outstanding 2004 2005 2006 2007 2008 SWM 54.2365 54.38489 49.52457 49.49987 41.35304 AOI 87.71107 61.56458 55.43454 40.16151 32.84306 UVV 25.88964 19.15281 22.10364 47.47921 36.24907 Industry Average 55.94574 45.03409 42.35425 45.71353 36.81506 Inventory Turnover 2004 2005 2006 2007 2008 SWM 4.476589 4.786789 4.643089 4.624238 5.61402 AOI 1.46675 2.229867 2.180096 2.704862 2.754529 188

UVV 2.170832 2.687889 2.78523 2.456522 2.657948 Industry Average 2.704723 3.234848 3.202805 3.261874 3.675499 Days' Supply of Inventory 2004 2005 2006 2007 2008 SWM 79.52484 76.25153 78.61145 78.93193 65.0158 AOI 242.7135 163.6869 167.4239 134.9422 132.5091 UVV 163.9924 135.7943 131.0484 148.5841 137.324 Industry Average 131.6216 112.8337 113.9626 111.8989 99.30624 Profitability RatiosGross Profit Margin 2004 2005 2006 2007 2008 SWM 18.57% 14.53% 12.84% 15.12% 13.44% Restated SWM 18.57% 14.53% 12.84% 15.12% 13.44% UVV 19.46% 18.66% 16.49% 22.11% 20.04% AOI 13.15% 14.33% 10.64% 14.94% 12.45% Operating Expense Ratio 2004 2005 2006 2007 2008 SWM 9.79% 8.66% 8.81% 9.26% 8.36% Restated SWM 8.66% 7.58% 7.92% 8.37% 7.50% UVV 18.38% 11.84% 7.13% 12.42% 10.52% AOI 10.99% 0.95% 7.77% 8.00% 7.83% Operating Profit Margin 2004 2005 2006 2007 2008 SWM 8.78% 5.87% 4.03% 5.86% 5.08% Restated SWM 9.91% 6.94% 4.91% 6.76% 5.94% UVV 1.08% 6.82% 9.37% 9.69% 9.53% AOI 2.16% 13.38% 2.87% 6.94% 4.62% Net Profit Margin 2004 2005 2006 2007 2008 SWM 5.54% 2.90% -­‐0.12% 0.48% 0.09% 189

Restated SWM 6.08% 3.64% 0.55% 1.23% 0.83% UVV 4.39% 2.93% 0.23% 2.21% 5.55% AOI -­‐4.10% 1.01% -­‐21.18% -­‐1.09% 0.84% Asset Turnover 2004 2005 2006 2007 2008 SWM 103.40% 93.40% 94.85% 102.61% 99.08% Restated SWM 101.89% 92.21% 93.63% 101.55% 98.07% UVV 101.25% 131.13% 121.70% 69.18% 92.14% AOI 59.28% 96.61% 150.47% 103.94% 121.62% Return on Assets 2004 2005 2006 2007 2008 SWM 5.72% 2.71% -­‐0.12% 0.49% 0.09% Restated SWM 6.20% 3.36% 0.51% 1.25% 0.82% UVV 4.44% 3.84% 0.28% 1.53% 5.12% AOI -­‐2.43% 0.98% -­‐31.87% -­‐1.13% 1.02% Return on Equity 2004 2005 2006 2007 2008 SWM 14.55% 6.63% -­‐0.27% 1.12% 0.20% Restated SWM 15.99% 8.34% 1.23% 2.89% 1.87% UVV 16.06% 12.64% 0.97% 4.60% 11.56% AOI -­‐7.23% 3.20% -­‐108.00% -­‐10.08% 7.48% Internal Growth Rate 2004 2005 2006 2007 2008 SWM 4.33% 1.44% -­‐1.48% -­‐0.86% -­‐1.12% Restated SWM 4.82% 2.11% -­‐0.83% -­‐0.09% -­‐0.38% UVV 3.16% 2.18% -­‐1.24% 1.53% 5.12% AOI -­‐3.18% -­‐0.02% -­‐32.52% -­‐1.13% 1.02% Sustainable Growth Rate 2004 2005 2006 2007 2008 SWM 10.99% 3.52% -­‐3.48% -­‐1.97% -­‐2.55% Restated SWM 15.79% 8.23% 1.21% 2.86% 1.85% UVV 11.44% 7.18% -­‐4.35% 4.59% 11.56% AOI -­‐9.46% -­‐0.07% -­‐110.19% -­‐10.08% 7.48% 190

Capital Structure RatiosDebt to Equity2004 2005 2006 2007 2008SWM 1.45 1.36 1.29 1.19 1.63SWM Restated 1.41 1.37 1.22 1.16 1.58UVV 2.27 2.47 1.98 1.25 0.91AOI 2.27 2.39 7.89 6.33 6.22Times Interest Earned2004 2005 2006 2007 2008SWM 15.6 6.34 0.96 3.03 1.61SWM Restated 17.6 7.5 2.02 4.12 2.24UVV 5.47 3.58 1.28 3.04 4.57AOI -0.67 0.46 -3.9 -0.02 0.919Debt Service Margin2004 2005 2006 2007 2008SWM 1.85 0.75 1.72 4.17 2.35SWM Restated 2.09 0.74 0.13 0.3 0.27UVV -0.26 -1.9 0.51 28.65 0.55AOI -44.73 2.16 26.34 6.67 7.23Z-Score2004 2005 2006 2007 2008SWM 2.8 2.35 2.17 2.06 2.01SWM Restated 2.41 2.14 2.24 2.1 2.05UVV 2.38 2.42 2.32 2.71 3.39AOI 1.36 1.79 0.72 1.75 1.6191

Schweitzer Mauduit Balance SheetFor years ended December 31(Dollars in millions)Liabilities and Stockholders' Equity Interest Rate Weight WACDCurrent LiabilitiesCurrent Debt 34.9 5.40% 0.0773 0.00418Accounts Payable and Accrued Expenses 156.2 0.18% 0.3461 0.00062Current deferred revenue 6 1.99% 0.0133 0.00026Total Current Liabilities 197.1Long-term Debt 144.9 5.40% 0.3211 0.01734Pension and Post retirement Benefits 67.3 6.50% 0.1491 0.00969Deferred income tax liabilities 11 3.40% 0.0244 0.00083Deferred Revenue 12.3 1.99% 0.0273 0.00054Other Liabilities 18.7 5.40% 0.0414 0.00224Total Liabilities 451.3 Kd 0.0357Weighted Average Cost of CapitalBVL/MVF Kd Tax Rate MVE/MVF Ke WACCWACCbt 61.93% 3.57% 38.06% 12.32% 6.90%WACCat 61.93% 3.57% 35% 38.06% 12.32% 6.13%WACCbt(upper) 61.93% 3.57% 38.06% 19.28% 9.55%WACCbt (lower) 61.93% 3.57% 38.06% 5.44% 4.28%Restated Weighted Average Cost of CapitalBVL/MVF Kd Tax Rate MVE/MVF Ke WACCWACCbt 61.93% 3.57% 38.06% 12.32% 6.90%WACCat 61.93% 3.57% 35% 38.06% 12.32% 6.13%WACCbt (upper) 61.93% 3.57% 38.06% 19.28% 9.55%WACCbt (lower) 61.93% 3.57% 38.06% 5.44% 4.28%192

3MonthRatesSUMMARY OUTPUT Regression Statistics Multiple R 0.462631 R Square 0.214028 Adjusted R Square 0.202799 Standard Error 0.105291 Observations 72 ANOVA Regression Residual Total do SS MS F 0.2113 0.21131 2 2 0.7760 0.011070 29 86 0.987371 49 Significance F 19.06165 4.28E-­‐05 Coefficients Intercept 0.01996 X Variable 1 1.250513 Standard Error t Stat P-­‐value 0.01241 0.286423 1.608464 4.365965 Lower 95% 0.112235 -­‐0.00479 4.28E-­‐05 0.67926 Upper 95% 0.04471 1.821766 Lower 95.0% -­‐0.004789757 0.679260425 Upper 95.0% 0.044710451 1.82176609 SUMMARY OUTPUT Regression Statistics Multiple R 0.454332 R Square 0.206418 Adjusted R Square 0.192735 193

Standard Error Observations 0.113394 60 ANOVA Regression Residual Total df SS MS F 0.1939 0.19391 81 81 0.7457 0.012858 7 58 0.939759 51 Significance F 15.08631 0.000266 Coefficients Intercept 0.02076 X Variable 1 1.234967 Standard Error t Stat P-­‐value 0.014654 0.317954 1.416698 3.88411 Lower 95% 0.16192 -­‐0.00857 0.000266 0.598513 Upper 95% 0.050092 1.87142 Lower 95.0% -­‐0.008572611 0.598513415 Upper 95.0% 0.050091899 1.871419684 SUMMARY OUTPUT Regression Statistics Multiple R 0.496406 R Square 0.246419 Adjusted R Square 0.230037 Standard Error 0.117885 Observations 48 ANOVA Regression Residual Total df SS MS F 0.2090 0.20901 34 34 0.6392 0.013846 53 97 0.848247 87 Significance F 15.04189 0.000333 194

Coefficients Intercept 0.035115 X Variable 1 1.320331 Standard Error t Stat P-­‐value Lower 95% 0.0170 2.0558 0.04548 96 93 0.000734 0.3404 3.8783 0.000333 87 33 0.635075 Upper 95% 0.069496 2.005587 Lower 95.0% 0.000734458 0.635074775 Upper 95.0% 0.069495928 2.005586599 SUMMARY OUTPUT Regression Statistics Multiple R 0.564102 R Square 0.318211 Adjusted R Square 0.298159 Standard Error 0.124691 Observations 36 ANOVA Regression Residual Total df SS MS F 0.2467 0.24671 24 24 0.5286 0.015534 23 48 0.775335 47 Significance F 15.86882 0.000339 Coefficients Intercept 0.053801 X Variable 1 1.46989 Standard Error t Stat P-­‐value Lower 95% 0.0209 2.5635 0.014987 76 54 0.011151 0.3689 3.9835 0.000388 68 39 0.720016 Upper 95% 0.096451 2.219765 Lower 95.0% 0.011150898 0.720015646 Upper 95.0% 0.096451097 2.219764638 SUMMARY OUTPUT Regression Statistics Multiple R 0.600507 195

R Square Adjusted R Square Standard Error Observations 0.360609 0.331545 0.134745 24 ANOVA Regression Residual Total df SS MS F 0.2252 0.22521 77 77 0.3994 0.018122 37 56 0.624723 14 Significance F 12.40772 0.001918 Coefficients Intercept 0.075526 X Variable 1 1.486313 Standard Error t Stat P-­‐value Lower 95% 0.0284 2.6576 0.014318 34 79 0.01659 0.4219 3.5224 0.001953 6 18 0.611235 Upper 95% 0.134462 2.36139 Lower 95.0% 0.016589587 0.611235474 Upper 95.0% 0.134462213 2.361389533 1 Year Rates SUMMARY OUTPUT Regression Statistics Multiple R 0.483509 R Square 0.233781 Adjusted R Square 0.222835 Standard Error 0.103959 Observations 72 ANOVA Regression Residual df SS MS F 0.23082 0.230821 3 3 0.75652 0.0108070 5 8 Significance F 21.35767 1.69E-­‐05 196

Total 71 0.987349 Intercept X Variable 1 Coefficients 0.020133 1.316021 Standard Error t Stat P-­‐value Lower 95% 0.01225 1.64310 0.104843 5 6 -­‐0.0043 0.28476 4.62143 1.69E-­‐5 6 05 0.748076 Upper 95% Lower 95.0% 0.044571 -­‐0.0043 1.88396 0.748076 6 Upper 95.0% 0.044571 1.883966 SUMMARY OUTPUT Regression Statistics Multiple R 0.47685 R Square 0.227386 Adjusted R Square 0.214065 Standard Error 0.111885 Observations 60 ANOVA Regression Residual Total df SS MS F 0.21368 0.213681 6 6 0.72606 0.0125158 5 8 0.9397559 1 Significance F 17.06982 0.000117 Intercept X Variable 1 Coefficients 0.021428 1.308571 Standard Error t Stat P-­‐value Lower 95% 0.01446 1.48134 0.143925 2 8 -­‐0.00753 0.31672 4.13156 0.000115 4 7 0.674576 Upper 95% 0.050383 1.942565 Lower 95.0% -­‐0.00753 0.674576 Upper 95.0% 0.050383 1.942565 SUMMARY OUTPUT Regression Statistics Multiple R 0.51748 197

R Square Adjusted R Square Standard Error Observations 0.267785 0.251868 0.116201 48 ANOVA Regression Residual Total df SS MS F Significance F 0.22715 0.227151 9 9 16.8231 0.000166 0.62112 0.0135046 8 3 0.8482847 7 Intercept X Variable 1 Coefficients 0.035591 1.389285 Standard Error t Stat P-­‐value Lower 95% 0.01684 2.11333 0.040021 6 7 0.001692 0.33871 4.10159 0.000168 8 6 0.707481 Upper 95% 0.069491 2.071088 Lower 95.0% 0.001692 0.707481 Upper 95.0% 0.069491 2.071088 SUMMARY OUTPUT Regression Statistics Multiple R 0.578439 R Square 0.334591 Adjusted R Square 0.315021 Standard Error 0.123184 Observations 36 ANOVA Regression Residual df SS MS F 0.25942 0.259421 5 5 0.51592 0.0151734 3 4 Significance F 17.09642 0.00022 198

Total 35 0.775347 Intercept X Variable 1 Coefficients 0.052853 1.516243 Standard Error t Stat P-­‐value 0.02069 2.554103 4 0.366704 Lower 95% 0.015298 0.010799 4.134782 0.00022 0.77101 Upper 95% Lower 95.0% 0.09490 0.010796 9 2.261476 0.77101 Upper 95.0% 0.094906 2.261476 SUMMARY OUTPUT Regression Statistics Multiple R 0.607551 R Square 0.369118 Adjusted R Square 0.340441 Standard Error 0.133845 Observations 24 ANOVA Regression Residual Total df SS MS F Significance F 0.23059 0.230591 3 3 12.8718 0.001639 0.39412 0.0179122 1 5 0.6247123 4 Coefficients Standard Error t Stat P-­‐value Lower 95% 0.02796 2.56616 0.01761Intercept 0.071765 6 8 5 0.013767 0.00163X Variable 1 1.498489 0.41767 3.58773 9 0.632293 Upper 95% 0.129762 2.364684 Lower 95.0% 0.013767 0.632293 Upper 95.0% 0.129762 2.364684 2 Year RatesSUMMARY OUTPUT Regression Statistics 199

Multiple R R Square Adjusted R Square Standard Error Observations 0.48281 0.233105 0.22215 0.104005 72 ANOVA Regression Residual Total df SS MS F 0.23015 0.230151 6 6 0.75719 0.0108170 2 7 0.9873471 9 Significance F 21.27721 1.75E-­‐05 Coefficients Intercept 0.020337 X Variable 1 1.31493 Standard Error t Stat P-­‐value Lower 95% 0.01225 1.65893 0.101609 5 3 -­‐0.00411 0.28506 4.61272 1.75E-­‐6 3 05 0.746384 Upper 95% 0.044787 1.883476 Lower 95.0% -­‐0.00411 0.746384 Upper 95.0% 0.044787 1.883476 SUMMARY OUTPUT Regression Statistics Multiple R 0.475961 R Square 0.226539 Adjusted R Square 0.213203 Standard Error 0.111947 Observations 60 ANOVA df SS MS F Significance F 16.9875Regression 1 0.21289 0.21289 8 0.000121 Residual 58 0.72686 0.01253 200

Total 59 1 2 0.939751 Coefficients Intercept 0.021548 X Variable 1 1.306561 Standard Error t Stat P-­‐value Lower 95% 0.01447 1.48865 0.141995 8 5 -­‐0.00743 0.317000.000123 4.1216 1 0.67201 Upper 95% Lower 95.0% 0.05052 -­‐2 0.00743 1.941113 0.67201 Upper 95.0% 0.050522 1.941113 SUMMARY OUTPUT Regression Statistics Multiple R 0.5162 R Square 0.266462 Adjusted R Square 0.250516 Standard Error 0.116306 Observations 48 ANOVA Regression df SS MS F 0.22603 0.226031 6 6 0.013527 Residual 46 0.62225 0.84828Total 47 7 Significance F 16.70977 0.000173 Coefficients Intercept 0.035656 X Variable 1 1.386126 Standard Error t Stat P-­‐value Lower 95% 0.01685 2.11505 0.039878 8 2 0.001722 0.33909 4.08775 0.000172 9 3 0.703569 Upper 95% 0.069591 2.068683 Lower 95.0% 0.001722 0.703569 Upper 95.0% 0.069591 2.068683 SUMMARY OUTPUT Regression Statistics 201

Multiple R R Square Adjusted R Square Standard Error Observations 0.577407 0.333399 0.313793 0.123294 36 ANOVA df SS MS F Regression 1 0.2585 0.2585 0.51684 0.01520Residual 34 7 1 0.77534Total 35 7 Significance F 17.00505 0.000227 Coefficients Intercept 0.052968 X Variable 1 1.514061 Standard Error t Stat P-­‐value Lower 95% 0.02071 2.55686 0.015196 5 7 0.010868 0.36715 4.12371 0.000229 8 7 0.767904 Upper 95% 0.095067 2.260219 Lower 95.0% 0.010868 0.767904 Upper 95.0% 0.095067 2.260219 SUMMARY OUTPUT Regression Statistics Multiple R 0.606955 R Square 0.368395 Adjusted R Square 0.339686 Standard Error 0.133922 Observations 24 ANOVA df SS MS F 0.23014 0.23014Regression 1 1 1 Residual 22 0.39457 0.01793 Significance F 12.83189 0.001661 202

Total 23 3 5 0.624714 Coefficients Intercept 0.07208 X Variable 1 1.498629 Standard Error t Stat P-­‐value Lower 95% 0.02800 2.57409 0.017302 3 9 0.014007 0.41835 3.58216 0.001669 2 1 0.631006 Upper 95% 0.130152 2.366252 Lower 95.0% 0.014007 0.631006 Upper 95.0% 0.130152 2.366252 5 Year RatesSUMMARY OUTPUT Regression Statistics Multiple R 0.480205 R Square 0.230597 Adjusted R Square 0.219605 Standard Error 0.104175 Observations 72 ANOVA Regression Residual Total df SS MS F 0.22767 0.227671 9 9 0.75966 0.0108570 9 2 0.9873471 9 Significance F 20.97959 1.97E-­‐05 Intercept X Variable 1 Coefficients 0.020924 1.307794 Standard Error t Stat P-­‐value Lower 95% Upper 95% 0.01228 1.70356 0.092892 3 9 -­‐0.00357 0.04542 0.28552 4.58034 1.97E-­‐1.877253 9 05 0.738337 2 Lower 95.0% Upper 95.0% -­‐0.00357 0.04542 0.73833 1.877257 2 SUMMARY OUTPUT 203

Regression Statistics Multiple R 0.472968 R Square 0.223699 Adjusted R Square 0.210314 Standard Error 0.112152 Observations 60 ANOVA Regression df SS MS F 0.21022 0.210221 1 1 0.012578 Residual 58 0.72953 0.93975Total 59 1 Significance F 16.71325 0.000136 Intercept X Variable 1 Coefficients 0.021964 1.297376 Standard Error t Stat P-­‐value Lower 95% 0.01450 1.51399 0.135458 2 9 -­‐0.00708 0.31734 4.08818 0.000138 5 6 0.662135 Upper 95% 0.051004 1.932616 Lower 95.0% -­‐0.00708 0.662135 Upper 95.0% 0.051004 1.932616 SUMMARY OUTPUT Regression Statistics Multiple R 0.51322 R Square 0.263395 Adjusted R Square 0.247382 Standard Error 0.116549 Observations 48 ANOVA Regression df SS MS F Significance F 0.22343 0.22343 16.44861 5 5 9 0.000191 204

Residual Total 46 47 0.624852 0.848287 0.013584 Intercept X Variable 1 Coefficients 0.036096 1.376995 Standard Error t Stat P-­‐value Lower 95% 0.01690 2.135235 5 0.0381 0.002068 0.33952 4.05569 0.000191 8 1 0.693574 Upper 95% 0.070123 2.060415 Lower 95.0% 0.002068 0.693574 Upper 95.0% 0.070123 2.060415 SUMMARY OUTPUT Regression Statistics Multiple R 0.575273 R Square 0.330939 Adjusted R Square 0.311261 Standard Error 0.123521 Observations 36 ANOVA Regression Residual Total df SS MS F 0.25659 0.256591 3 3 0.51875 0.0152534 4 7 0.7753435 7 Significance F 16.81751 0.000242 Intercept X Variable 1 Coefficients 0.053637 1.507855 Standard Error t Stat P-­‐value Lower 95% 0.02077 2.58161 0.014317 7 8 0.011414 0.36768 4.10091 0.000247 6 2 0.760624 Upper 95% 0.095861 2.255086 Lower 95.0% 0.011414 0.760624 Upper 95.0% 0.095861 2.255086 SUMMARY OUTPUT 205

Regression Statistics Multiple R 0.605721 R Square 0.366898 Adjusted R Square 0.338121 Standard Error 0.134081 Observations 24 ANOVA Regression Residual Total df SS MS F 0.22920 0.229201 7 7 0.39550 0.0179722 7 8 0.6247123 4 Significance F 12.74955 0.001708 Intercept X Variable 1 Coefficients 0.073146 1.496956 Standard Error t Stat P-­‐value Lower 95% 0.02810 2.60268 0.016244 8 8 0.014862 0.41923 3.57065 0.001709 2 8 0.627508 Upper 95% 0.131431 2.366403 Lower 95.0% 0.014862 0.627508 Upper 95.0% 0.131431 2.366403 10 Year RatesSUMMARY OUTPUT Regression Statistics Multiple R 0.47821 R Square 0.228685 Adjusted R Square 0.217666 Standard Error 0.104304 Observations 72 ANOVA df SS MS F Significance F Regression 1 0.22579 0.22579 20.7540 2.15E-­‐05 206

Residual Total 70 71 1 1 6 0.76155 0.010877 9 0.987349 Intercept X Variable 1 Coefficients 0.021502 1.301565 Standard Error t Stat P-­‐value Lower 95% 0.012300.084872 1.74787 1 -­‐0.00303 0.28570 4.555663 2 Upper 95% 0.046038 2.15E-­‐05 0.731749 1.87138 Lower 95.0% Upper 95.0% -­‐ 0.046030.00303 8 0.731749 1.87138 SUMMARY OUTPUT Regression Statistics Multiple R 0.470764 R Square 0.221619 Adjusted R Square 0.208198 Standard Error 0.112302 Observations 60 ANOVA Regression Residual Total df SS MS F 0.20826 0.208261 6 6 0.73148 0.0126158 5 2 0.9397559 1 Significance F 16.51359 0.000147 Intercept X Variable 1 Coefficients 0.02244 1.289988 Standard Error t Stat P-­‐value Lower 95% 0.01453 1.54381 0.128075 4 3 -­‐0.00666 0.31744 4.06369 0.000142 2 7 0.654558 Upper 95% 0.051535 1.925418 Lower 95.0% -­‐0.00666 0.654558 Upper 95.0% 0.051535 1.925418 SUMMARY OUTPUT 207

Regression Statistics Multiple R 0.511102 R Square 0.261225 Adjusted R Square 0.245165 Standard Error 0.116721 Observations 48 ANOVA Regression Residual Total df SS MS F 0.22159 0.221591 4 4 0.62669 0.0136246 3 4 0.8482847 7 Significance F 16.26527 0.000205 Intercept X Variable 1 Coefficients 0.036608 1.369748 Standard Error t Stat P-­‐value Lower 95% 0.01694 2.16060 0.035963 9 9 0.002503 0.33963 4.03302 0.000203 3 5 0.686102 Upper 95% 0.070713 2.053393 Lower 95.0% 0.002503 0.686102 Upper 95.0% 0.070713 2.053393 SUMMARY OUTPUT Regression Statistics Multiple R 0.573968 R Square 0.329439 Adjusted R Square 0.309717 Standard Error 0.12366 Observations 36 ANOVA df SS MS F Significance F Regression 1 0.25543 0.25543 16.7038 0.000252 208

Residual Total 34 35 0.519917 0.775347 0.015292 3 Intercept X Variable 1 Coefficients 0.054378 1.503283 Standard Error t Stat P-­‐value Lower 95% 0.02082 2.61103 0.013336 2 4 0.012054 0.36781 4.08703 0.000258 2 2 0.755787 Upper 95% 0.096701 2.250778 Lower 95.0% 0.012054 0.755787 Upper 95.0% 0.096701 2.250778 SUMMARY OUTPUT Regression Statistics Multiple R 0.605343 R Square 0.36644 Adjusted R Square 0.337642 Standard Error 0.134129 Observations 24 ANOVA df SS MS F Regression 1 0.22892 0.22892 0.39579 0.01799Residual 22 4 1 0.62471Total 23 4 Significance F 12.72443 0.001723 Intercept X Variable 1 Coefficients 0.074238 1.496459 Standard Error t Stat P-­‐value Lower 95% 0.02818 2.63381 0.015166 8 3 0.015783 0.41951 3.56713 0.001723 1 3 0.626442 Upper 95% 0.132693 2.366476 Lower 95.0% 0.015783 0.626442 Upper 95.0% 0.132693 2.366476 209

Method of ComparablesP/E TrailingComparablesCompany PPS EPSP/ETrailingIndustryAve.SWN PPSSWM 50.95 0.05 5.995 0.29975SWM Restated 50.95 0.42 5.995 2.5Universal Corp. 43.53 8.84Alliance One 4.59 3.15Forecasted P/ECompany PPS EPS 1 Year OutP/EForecastSWM 50.95 0.12 N/ASWM Restated 50.95 0.25Universal Corp. 43.53 N/AAlliance One 4.59 N/AIndustryAve.ComparablesSWN PPSPrice/BookCompany PPS BPS P/BIndustryAve.ComparablesSWN PPSSWM 50.95 18.11 2.81 1.22 22.09SWM Restated 50.95 18.11 2.81 1.22 22.09Universal Corp. 43.53 34.65 1.26Alliance One 4.59 3.88 1.18Dividends/PriceCompany PPS DPS D/PIndustryAve.SWM 50.95 0.6 0.012 N/A N/ASWM Restated 50.95 0.6 0.012 N/A N/AUniversal Corp. 43.53 1.88 0.043Alliance One 4.59 N/A N/AComparablesSWN PPS210

Price Earnings Growth(P.E.G.)Company P/E Growth P.E.G.IndustryAve.ComparablesSWN PPSSWM 1019 2.49 N/A n/a N/ASWM Restated 121.31 2.49 N/A N/AUniversal Corp. 8.84 N/A N/AAlliance One 3.1 N/A N/APrice/EBITDACompany MKT Cap EBITDA P/EBITDAIndustryAve.ComparablesSWN PPSSWM 780.554 13.5 57.82 2.76 2.43SWM Restated 780.554 20.1 38.83 2.76 3.62Universal Corp. 1,080.41 283.17 3.82Alliance One 409.244 239.17 1.71MKT Cap and EBITDA in millionsEnterprise Value/EBITDACompany EV EBITDA EV/EBITDAIndustryAve.ComparablesSWN PPSSWM 1,204.55 13.5 89.23 6.078 -22.05SWM Restated 1,204.55 20.1 5.992 6.078 -19.7Universal Corp. 1,741.50 283.17 6.15Alliance One 1,435.74 239.17 6.003MKT Cap and EBITDA in millionsP/FCFCompany MKT Cap FCF P/FCFIndustryAve.ComparablesSWN PPSSWM 780.554 -61.8 -12.63 -5.47 22.07SWM Restated 780.554 -61.8 -12.63 -5.47 22.07Universal Corp. 1,080.41 111.17 9.72Alliance One 409.244 -19.8 -20.66MKT Cap and EBITDA in millions211

Discounted Dividends ApproachFigures in Millionst 0 1 2 3 4 5 6 7 8 9 10Year 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019DPS (Dividends Per Share) 0.66 0.72 0.77 0.82 0.87 0.92 0.97 1.02 1.07 0.66PV Factor 0.86 0.74 0.64 0.55 0.47 0.41 0.35 0.30 0.26 0.22YBY PV Annual Dividend 0.57 0.53 0.49 0.45 0.41 0.37 0.34 0.31 0.28 0.15Schweitzer-­‐Mauduit's Discounted Dividends Sensitivity Analysis Total PV of YBY Dividends 3.888488978 Growth Rate PV TV Perp 0Cost of Equity 0.00% 1.04% 2.70% 4.05% 5.40% 6.75% 8.10% Model Value 12/31/2008 3.888488978 8.39% 9.92 10.5 11.86 13.73 17.28 26.69 123.72Time Consistent Price 4.40833923 9.70% 8.75 9.14 9.99 11.04 12.77 16.06 24.9311.01% 7.84 8.11 8.67 9.33 10.3 11.89 14.95Observed Share Price11/1/2009 $50.95 12.32% 7.12 7.31 7.69 8.13 8.74 9.63 11.1Initial Cost of Equity (YouDerive) 16.25% 13.63% 6.52 6.6 6.94 7.24 7.64 8.19 9.02Perpetuity Growth Rate (g) 8.10% 14.94% 6.02 6.13 6.33 6.55 6.82 7.19 7.716.25% 5.6 5.77 5.83 5.99 6.19 6.44 6.78Overvalued < $43.31 15% Analyst Position $43.31 < Fairly Valued < $58.60 Undervalued > $58.60 212

Discounted Free Cash Flowt 0 1 2 3 4 5 6 7 8 9 10Year 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019Cash FlowFromOperations(Millions) 63.97 67.80 71.19 74.75 77.74 80.85 84.09 87.03 90.08 93.23 96.49Cash FlowFromInvestingActivities 141.8645 119.654178 125.64 123.12 128.05 133.17 133.55 138.23 143.06 148.07 153.25FCFFirm'sAssets 205.8306 187.4582122 196.83 197.88 205.79 214.02 217.64 225.26 233.14 241.3 249.74PV Factor(WACC orKe?) 1.0000 0.9187 0.8440 0.7754 0.7123 0.6544 0.6012 0.5523 0.5074 0.4662 0.4283PV YBYFree CashFlows 172.2170071 166.13 153.43 146.59 140.06 130.85 124.42 118.3 112.49 106.96Perp.Total PVYBY FCFFCF Perp$1,371.44 Schweitzer-­‐Mauduit's Free Cash Flow Sensitivity Analysis $- Growth Rate MarketValue ofAssets(12/31/87)BookValueDebt &PreferredStock$1,371.44 0.00% 1.04% 2.70% 4.05% 5.40% 6.75% 8.10% $451.30 4.95% 2.94 3.5 5.47 12.45 N/A N/A N/AMarketValue ofEquity $920.14 5.60% 2.55 2.96 4.7 7.17 N/A N/A N/Adivide byShares toGet PPSWeighted Average Cost at 12/31 $0.60of Capital 6.25% 2.25 2.55 3.39 5.01 11.76 N/A N/ATimeconsistentPrice(11/1/88) 0.64 6.90% 2.01 2.24 2.83 3.83 6.62 59.68 N/AObservedSharePrice(11/1/88) 50.95 7.55% 1.81 1.98 2.42 3.09 4.59 11.15 N/A8.20% 1.64 1.78 2.11 2.58 3.5 6.13 79.83WACC 8.85% 8.85% 1.49 1.6 1.86 2.21 2.82 4.21 10.63PerpGrowthRate 6.75%15% Analyst Position $43.31 < Fairly Valued < Overvalued < $43.31 $58.60 Undervalued > $58.60 213

Residual Income As-Stated Sensitivity AnalysisAll Items in Millions of Dollarst 0 1 2 3 4 5 6 7 8 9 10 PerpYear 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019NetIncome(Millions) 1.88 17.15 19.26 20.40 21.22 24.26 26.71 27.65 28.61 29.61TotalDividends(Millions) 10.18 10.97 11.75 12.53 13.32 14.10 14.88 15.67 16.45 17.23BookValueEquity(Millions) 277.4 269.10275.28282.80290.67298.57308.73320.56332.53344.69357.08AnnualNormalIncome(Benchmark) 45.0775AnnualResidualIncome (43.20)43.729(26.58)44.7333(25.47)45.9544(25.55)47.2338(26.01)48.5175(24.26)50.1679(23.46)52.0903(24.45)54.036(25.42)56.013(26.40)(25.34)pv factor 0.8602Present-Value of37.157974Annual RI19Change inResidual0.7400-19.6670.6365-16.2120.5476-13.9910.4710-12.2530.4052-9.83010.3485-8.17580.2998-7.32910.2579-6.55690.2219-5.8567Income 16.62 1.11 (0.08) (0.46) 1.75 0.80 (0.99) (0.98) (0.98)0.006 0.060 0.066 0.068 0.068 0.075 0.080 0.080 0.080ROE8 65 28 34 73 67 32 2 1-33.24PercentChange(0.887)(0.085)(0.030)(0.006)(0.092)(0.058) 0.002 0.001BookValueEquity(Millions)Total PVof YBY RI277.40 278.06% Schweitzer-­‐Mauduit's As-­‐Stated Residual Income Sensitivity Analysis 0.96-170.27 -170.67% Growth Rate Cost -­‐ -­‐of -­‐ 50.00 60.00Equity 0.0% -­‐10.0% -­‐20.0% -­‐30.0% 40.00% % % TerminalValuePerpetuity -7.37 -7.39%MVE12/31/87 99.76 100.00% 8.39% 18.01 17.58 17.45 17.38 17.35 17.32 17.31divide byshares 15.32 9.70% 12.01 13.9 14.52 14.82 15.01 15.13 15.22ModelPrice on12/31/87 6.512 11.01% 7.42 10.75 11.93 12.54 12.91 13.15 13.33timeconsistentPrice7.3824 12.32% 3.78 8.02 9.63 10.49 11.01 11.37 11.6313.63% 0.82 5.63 7.58 8.64 9.3 9.75 10.08ObservedShare 50.95 14.94% N/A 3.53 5.73 6.96 7.74 8.28 8.67214

Price(11/1/1988)Initial Costof Equity(YouDerive)PerpetuityGrowthRate (g)16.25% 16.25% N/A 1.66 4.07 5.43 6.31 6.93 7.38-60.00% 15% Analyst Position SharesOutstanding 15.32 Overvalued < $43.31 $43.31 < Fairly Valued < $58.60 Undervalued > $58.60 Residual Income Re-Stated Sensitivity AnalysisAll Items in Millions of Dollars0 1 2 3 4 5 6 7 8 9 10 PerpYear 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019NetIncome(Millions) 3.76 21.14 23.45 24.08 25.79 29.01 31.66 32.76 33.91 35.10TotalDividends(Millions) 10.18 10.97 11.75 12.53 13.32 14.10 14.88 15.67 16.45 17.23BookValueEquity(Millions) 285.7 279.28289.45 301.15 312.70 325.17 340.08 356.86 373.95 391.41 409.28AnnualNormalIncome(Benchmark)46.42625AnnualResidualIncome (42.67)45.38347.0356348.9368850.8137552.84013 55.26357.9897560.7668863.60413(24.24) (23.59) (24.86) (25.02) (23.83) (23.60) (25.23) (26.86) (28.50)(27.36)pv factor 0.8602Present-Value of36.702Annual RI2ChangeinResidual0.7400 0.6365 0.5476 0.4710 0.4052 0.3485 0.2998 0.2579 0.2219-- - - - - -17.93 - 13.610 11.786 9.6553 8.2265 7.5643 6.9265 -91 15.013 5 6 6 3 1 8 6.3238Income 18.42 0.66 (1.27) (0.17) 1.19 0.23 (1.63) (1.63) (1.65)0.012 0.0701 0.0749 0.0740 0.0758 0.0812 0.0846 0.0836 0.0828ROE99 98 92 54 35 92 64 97 53PercentChange (0.815) (0.064) 0.013 (0.023) (0.067) (0.040) 0.012 0.010-35.8872BookValueEquity(Millions)285.70-Total PV 169.6of YBY RI 4TerminalValuePerpetuity -7.96 -7.36%264.28% Schweitzer-­‐Mauduit's Restated Residual Income Sensitivity Analysis -156.92% Growth Rate Cost of Equity 0.0% -­‐10.0% -­‐20.0% -­‐30.0% -­‐40.00% -­‐50.00% -­‐60.00% 215

MVE12/31/87108.10100.00% 8.39% divide byshares 15.32 9.70% ModelPrice on11/2/09 7.056 11.01% Timeconsisten 7.999t Price7 12.32% 13.63% $21.45$14.40$9.01$4.76$1.31ObservedSharePrice(11/1/1988) 50.95 14.94% N/AInitialCost ofEquity(You 16.25Derive) % 16.25% N/APerpetuity GrowthRate (g)$20.03$15.82$12.21$9.08$6.36$3.95$1.82$19.61$16.28$13.34$10.73$8.40$6.31$4.42$19.41$16.51$13.92$11.60$9.51$7.62$5.89-60.00% 15% Analyst Position SharesOutstanding 15.32 Overvalued < $43.31 $19.29$16.65$14.28$12.14$10.21$8.45$6.85$19.21$16.74$14.51$12.50$10.68$9.03$7.51$19.16$16.80$14.68$12.77$11.03$9.45$8.00$43.31 < Fairly Valued < $58.60 Undervalued > $58.60 216

Figures in Millions (Except per Share) AEG Valuation Model0 1 2 3 4 5 6 7 8 9 102008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019Net Income (Millions) $1.88$17.15$19.26$20.40$21.22$24.26$26.71$27.65$28.61$29.61Total Dividends (Millions) $10.18$10.97$11.75$12.53$13.32$14.10$14.88$15.67$16.45$17.23Dividends Reinvested at K E (DRIP) $1.65 $1.78 $1.91 $2.04 $2.16 $2.29 $2.42 $2.55 $2.67Cum-­‐Dividend Earnings $18.80 $21.05 $22.31 $23.26 $26.42 $29.00 $30.06 $31.16 $32.29Normal Earnings $2.19$19.94$22.39$23.72$24.67$28.20$31.05$32.14$33.26Abnormal Earnings Growth (AEG) $16.62 $1.11 ($0.08) ($0.46) $1.75 $0.80 ($0.99) ($0.98) ($0.98) ($1.15)PV Factor 0.0192 0.0004 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000PV of AEG $0.32 $0.00 ($0.00) ($0.00) $0.00 $0.00 ($0.00) ($0.00) ($0.00)Residual Income Check Figure $ 16.26 $ 1.37 $ 0.24 $ (0.13) $ 2.09 Perp.$ 1.24 $ (0.48) $ (0.47) $ (0.46) 0.469960773Assume AEG of the perpetuity is118% of AEG 2019% ofValue-483% Schweitzer-­‐Mauduit's As-­‐Stated AEG Sensitivity Analysis Core Net Income 1.88Total PV of AEG $0.32 -82% Growth Rate Value of Terminal Perpetuity PV of Terminal Value Total Average Net Income Perp (t+1) $(1.51)Cost of Equity 0.0% -­‐10.0% -­‐20.0% -­‐30.0% -­‐40.00% -­‐50.00% -­‐60.00% $(0.39) 100% 8.39% 1.7 1.76 1.78 1.79 34.73 1.79 1.8$1.81-466% 9.70% 0.9 1.25 1.36 1.41 1.45 1.47 1.49Share Outstanding 15.32 11.01% 0.5 0.93 1.08 1.16 1.21 1.24 1.27Average EPS Perpetuity $0.12 12.32% 0.3 0.74 0.9 0.99 1.04 1.08 1.1Capitalization Rate (perpetuity) 16.25% 13.63% 0.21 0.61 0.77 0.86 0.92 0.96 0.98Model Price 0.73 14.94% 0.17 0.53 0.69 0.77 0.82 0.86 0.89Time Consistent Model Price $0.82 16.25% 0.17 0.48 0.62 0.7 0.75 0.79 0.82Observed Price (11/2/09) $50.95 15% Analyst Position Ke 16.25% Overvalued < $43.31 $43.31 < Fairly Valued < $58.60 Undervalued > $58.60 g -60%217

Figures in Millions (Except per Share) AEG Valuation ModelPerp.Net Income (Millions) Total Dividends (Millions) 0 1 2 3 4 5 6 7 8 9 102008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019$3.76$10.18$21.14$10.97$23.45$11.75$24.08$12.53Dividends Reinvested at K E (DRIP) $1.65 $1.78 $1.91 $2.04 $2.16 $2.29 $2.42 $2.55 $2.67Cum-­‐Dividend Earnings $25.79$13.32$29.01$14.10$31.66$14.88$32.76$15.67$33.91$16.45$35.10$17.23$22.79 $25.23 $25.99 $27.83 $31.17 $33.95 $35.18 $36.46 $37.77$4.37$24.58$27.26Normal Earnings Abnormal Earnings Growth (AEG) $18.42 $0.66 ($1.27) ($0.17) $1.19 $0.23 ($1.63) ($1.63) ($1.65) ($1.94)PV Factor 0.0192 0.0004 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000PV of AEG $0.35 $0.00 ($0.00) ($0.00) $0.00 $0.00 ($0.00) ($0.00) ($0.00)Residual Income Check Figure $ 18.15 $ 1.09 $ (0.77) $ 0.32 $ 1.72 $ 0.86 $ (0.91) $ (0.90) $ (0.91) % 0fValue$27.99$29.98$33.72$36.80$38.08Assume AEG of the perpetuity is 118% ofAEG 2019Core Net Income 3.76 -572% Schweitzer-­‐Mauduit's Re-­‐Stated AEG Sensitivity Analysis $39.42Total PV of AEG $0.35 -54% Growth Rate Value of Terminal $ (2.55) Cost of Perpetuity Equity 0.0% -­‐10.0% -­‐20.0% -­‐30.0% -­‐40.00% -­‐50.00% -­‐60.00% PV of Terminal Value $ (0.66) 100% 8.39% 1.87 2.72 2.97 3.09 3.16 3.21 3.24Total Average Net Income Perp (t+1) $ 3.46 -526% 9.70% 1.06 2.04 2.37 2.53 2.62 2.69 2.73Share Outstanding 15.32 11.01% 0.68 1.63 1.97 2.14 2.24 2.32 2.37Average EPS Perpetuity $0.23 12.32% 0.51 1.37 1.69 1.86 1.97 2.04 2.09Capitalization Rate (perpetuity) 16.25% 13.63% 0.46 1.2 1.5 1.66 1.76 1.83 1.88Model Price $ 1.39 14.94% 0.45 1.09 1.36 1.51 1.61 1.67 1.72Time Consistent Price $ 1.59 16.25% 0.47 1.01 1.26 1.39 1.48 1.54 1.59Observed Price (11/2/09) $50.95 15% Analyst Position Ke 16.25% Overvalued < $43.31 $43.31 < Fairly Valued < $58.60 Undervalued > $58.60 g -60%218

Growth Rate RestatedReturn on Equity-0.16 -0.08 0 0.08 0.16 0.24 0.328.39% -­‐38.03 -19.02 - 19.02 38.03 57.05 76.079.70% -­‐33.23 -16.61 - 16.61 33.23 49.84 66.46Cost of 11.01% -­‐29.57 -14.78 - 14.78 29.57 44.35 59.13Equity 12.32% -­‐26.68 -13.34 - 13.34 26.68 40.02 53.3613.63% -­‐24.35 -12.18 - 12.18 24.35 36.53 48.714.94% -­‐22.43 -11.21 - 11.21 22.43 33.64 44.8616.25% -­‐20.82 -10.41 - 10.41 20.82 31.23 41.6315% Analyst Position Undervalued > $58.6 $58.60 < Fairly Valued < $43.31 Overvalued < $43.31 Return on Equity RestatedGrowth RateKe -30% -20% -10% 0% 10% 20% 30% 40% 50%8.39% 19.74 19.67 19.52 19.02 24.77 20.61 20.3 20.19 20.139.70% 19.28 18.99 18.41 16.61 134.3 23.47 21.83 21.27 20.99Cost of 11.01% 18.85 18.37 17.43 14.78 -40.29 27.16 23.57 22.46 21.92Equity 12.32% 18.45 17.8 16.57 13.34 -17.71 32.1 25.56 23.75 22.913.63% 18.07 17.27 15.8 12.18 -11.43 39.08 27.88 25.17 23.9614.94% 17.71 16.78 15.12 11.21 -8.48 49.67 30.59 26.74 25.0916.25% 17.37 16.33 14.5 10.41 -6.77 67.65 33.83 28.49 26.31Undervalued > $58.6 15% Analyst Position $58.60 < Fairly Valued < $43.31 Overvalued < $43.31 219

Cost of Equity RestatedReturn on Equity-0.16 -0.08 0 0.08 0.16 0.24 0.32-30% 6.8 10.68 14.56 18.44 22.33 26.21 30.1-20% 2.54 7.63 12.71 17.8 22.88 27.97 33.05-10% -5.52 1.84 9.2 16.57 23.93 31.3 38.66Growth 0% -26.68 -13.34 - 13.34 26.68 40.02 53.36Rate 10% -230.24 -159.4 -88.55 -17.71 53.13 123.98 194.8220% 96.3 74.9 53.5 32.1 10.7 -10.7 -32.130% 53.45 44.16 34.86 25.56 16.23 6.97 -2.3240% 41.56 35.63 29.69 23.75 17.81 11.88 5.9450% 35.99 31.62 27.26 22.9 18.54 14.18 9.8115% Analyst Position Undervalued > $58.6 $58.60 < Fairly Valued < $43.31 Overvalued < $43.31 Cost of EquityReturn on Equity-0.14 -0.07 0 0.07 0.14 0.21 0.28-30% 7.54 10.84 14.14 17.44 20.74 24.04 27.34-20% 3.7 8.02 12.34 16.66 20.98 25.31 29.63Growth -10% -3.57 2.68 8.94 15.19 21.45 27.71 33.96Rate 0% -22.67 -11.33 - 11.33 22.67 34 45.3410% -206.36 -146.17 -85.98 -25.79 34.39 94.58 154.7720% 88.31 70.13 51.95 33.77 15.58 -2.6 -20.7830% 49.64 41.75 33.85 25.95 18.05 10.15 2.2540% 38.92 33.87 28.83 23.78 18.74 13.69 8.6550% 33.88 30.18 26.47 22.76 19.06 15.35 11.6515% Analyst Position Undervalued > $58.6 $58.60 < Fairly Valued < $43.31 Overvalued < $43.31 220

Return on EquityGrowth RateKe -30% -20% -10% 0% 10% 20% 30% 40%8.39% 18.66 18.42 17.9 16.16 36.08 21.68 20.61 20.22 20.019.70% 18.23 17.78 16.88 14.11 195.59 24.69 22.16 21.3 20.87Cost of 11.01% 17.82 17.2 15.98 12.56 -25.79 28.56 23.93 22.45 21.79Equity 12.32% 17.44 16.66 15.19 11.33 -17.2 33.77 25.95 23.78 22.7613.63% 17.08 16.17 14.49 10.34 -16.65 41.11 28.3 25.21 23.8114.94% 16.74 15.71 13.86 9.53 -12.35 52.24 31.06 26.78 24.9416.25% 16.42 15.29 13.29 8.84 -9.85 71.16 34.34 28.52 26.15Undervalued > $58.6 15% Analyst Position $58.60 < Fairly Valued < $43.31 Overvalued < $43.31 50%Growth RateReturn on Equity-0.14 -0.07 0 0.07 0.14 0.21 0.288.39% -­‐32.31 -16.16 - 16.16 32.31 48.47 64.639.70% -­‐28.23 -14.12 - 14.11 28.23 42.34 56.4611.01% -­‐25.12 -12.56 - 12.56 25.12 37.68 50.24Cost of 12.32% -­‐22.67 -11.33 - 11.33 22.67 34 45.34Equity 13.63% -­‐20.69 -10.34 - 10.34 20.69 31.03 41.3814.94% -­‐19.06 -9.53 - 9.53 19.06 28.58 38.1116.25% -­‐17.69 -8.84 - 8.84 17.69 26.53 35.3715% Analyst Position Undervalued > $58.6 $58.60 < Fairly Valued < $43.31 Overvalued < $43.31 221

Schweitzer-­‐Mauduit Schweitzer-­‐Mauduit Restated Income Statement (in millions) Fiscal Year (dollar in millions) 2004 2005 2006 2007 2008 Net Sales 657.5 669.8 655.2 714.8 767.9 Cost of Goods Sold 535.4 572.5 571.1 606.7 664.7 Gross Profit 122.1 97.3 84.1 108.1 103.2 Selling expense 27.1 24.4 22.7 22.8 23.1 Research expense 1.86 1.8 1.5 1.6 1.7 General expense 28 24.6 27.7 35.4 32.8 Total nonmanufacturing expenses 65.1 46.5 32.2 48.3 45.6 Restructuring and Impairment expense -­‐ -­‐ 21.1 24 22.1 Operating Profit 65.1 46.5 11.1 24.3 23.5 Interest expense 3.7 6.2 5.5 5.9 10.5 Other expenses 1.5 2.5 -­‐0.5 0.1 3.4 Income before Income Taxes 59.9 37.8 6.1 18.3 9.6 Provision for income taxes at 27% 13 7.6 -­‐1.8 1.5 -­‐1 Minority interest in earnings of subsidiaries 7 5.8 4.1 8 0.2 Loss from equity affiliates -­‐ -­‐ 0.2 -­‐ 4 Net Income 40 24.4 3.6 8.8 6.4 222

Schweitzer-­‐Mauduit Restated Balance Sheet in Millions For years ended December 31 Fiscal Year 2004 2005 2006 2007 2008 Assets Current Assets Cash and cash equivalents 4.5 5.1 13.7 4 11.9 Accounts Receivable 97.7 99.8 88.9 100.6 87 Research and Development 9.3 9 7.3 8 8.3 Inventories 119.6 123 119.2 131.2 118.4 Other Current Assets 9.9 14.8 13.8 11.4 11.1 Total Current Assets 241 251.7 242.9 255.2 236.7 PP & E 453.2 414 416.8 456 407.8 Deferred Income Tax Benefits -­‐ -­‐ -­‐ 15.2 26.4 Goodwill and Intangible Assets -­‐ -­‐ -­‐ 2.8 15.6 Investment in Equity Affiliates -­‐ -­‐ -­‐ 15.4 15.4 Other Assets 32.2 34.1 44.2 38.4 35.1 Total Assets 726.4 699.8 703.9 783 737 Liabilities and Stockholders' Equity Current Liabilities Current Debt 50.9 30 17.1 13.6 34.9 Accounts Payable 71.3 64.3 62.5 84.3 64.5 Accrued Expenses 76.7 71.7 80.9 111.3 91.7 Current deferred revenue 7.5 6 6 6 6 Total Current Liabilities 206.4 172 166.5 215.2 197.1 Long-­‐term Debt 63 83.7 80.2 87.3 144.9 Pension and Post retirement Benefits 47.8 38.1 54.2 38.9 67.3 Deferred income tax liabilities 39.3 40.2 29 25 11 Deferred Revenue 35.9 30 24.1 18.1 12.3 Other Liabilities 18.7 20.1 23 22.7 18.7 Minority Interest 13.4 13.8 15.6 26 -­‐ Total Liabilities 424.5 397.9 392.6 407.2 451.3 Common Stock 1.6 1.6 1.6 1.6 1.6 Additional Paid-­‐in-­‐Capital 63.3 63.8 63.6 68 64.6 Treasury Stock -­‐22.3 -­‐15.6 -­‐11.4 -­‐12.3 -­‐14.1 Retained Earnings 280.8 280.6 289.1 272.6 264.2 Unearned compensation on stock -­‐0.5 -­‐0.3 -­‐ -­‐ -­‐ Accumulated OCI -­‐21 -­‐38.4 -­‐21.1 19.9 -­‐30.6 Total Stockholders' Equity 292.6 292.9 304 341.8 277.4 Total Liabilities & Stockholders' Equity 726.4 699.8 703.9 783 737 223

Work Cited “Form 10k.” Schweitzer Mauduit. 06 March 2009. 31 December 2009.“Snus Use In Figures.” www.swedishmatch.com. Swedish Match. 9 May 2008.Rodu, B., & Cole, P. “Point / Counterpoint: Would a Switch from Cigarettes toSmokeless Tobacco Benefit Public Health?”. 1 October 1995.“Smoking and Tobacco Use”. www.cdc.gov. Center for Disease Control and Prevention.29 May 2009.Hall, John R. “The Coalition for Fire Safe Cigarettes”. Coalition for Fire Safe Cigarettes.November 2008.http://firesafecigarettes.org/itemDetail.asp?categoryID=86&itemID=1188&URL=About %20fire-safe%20cigarettes/Fast%20facts“Global Cigarette Market Share”. The Tobacco Atlas. 2007.http://www.tobaccoatlas.org/companies.htmlPalepu, Krishna G., and Paul M. Healy. Business Analysis and Valuation Using FinancialStatements. Thomas South-Western. 2008.224

Heakal, Reem. "What Are Economies of Scale?" Investopedia 06 Sep 2009http://investopedia.com/articles/03/012703.asp“Form 10k.” Schweitzer Mauduit. 06 March 2009. 31 December 2009.“Snus Use In Figures.” www.swedishmatch.com. Swedish Match. 9 May 2008.Rodu, B., & Cole, P. “Point / Counterpoint: Would a Switch from Cigarettes toSmokeless Tobacco Benefit Public Health?”. 1 October 1995.“Smoking and Tobacco Use”. www.cdc.gov. Center for Disease Control and Prevention.29 May 2009.Hall, John R. “The Coalition for Fire Safe Cigarettes”. Coalition for Fire Safe Cigarettes.November 2008.http://firesafecigarettes.org/itemDetail.asp?categoryID=86&itemID=1188&URL=About %20fire-safe%20cigarettes/Fast%20facts“Global Cigarette Market Share”. The Tobacco Atlas. 2007.http://www.tobaccoatlas.org/companies.htmlPalepu, Krishna G., and Paul M. Healy. Business Analysis and Valuation Using FinancialStatements. Thomas South-Western. 2008.Heakal, Reem. "What Are Economies of Scale?" Investopedia 06 Sep 2009http://investopedia.com/articles/03/012703.asp225