| SCHWEITZER MAUDUIT INTERNATIONAL INC Item 1A Risk Factors Factors That May Affect Future Results Many factors outside of our control could impact future financial results |
| While not an exhaustive list, the following important factors could cause our actual results for 2006 and beyond to differ materially from those expressed in any forward-looking statements we have made, or that have been made on our behalf |
| International Business Risks In addition to our US operations, we have manufacturing facilities in France, the Philippines, Indonesia, Brazil and Canada |
| Principally through our French, Philippine, Indonesian and Brazilian subsidiaries, we market and sell products in over 90 countries, many of which are third-world markets which are subject to international business risks, including unsettled political and economic conditions; expropriation; import and export tariffs, regulatory controls and restrictions; monetary exchange controls; inflationary economies; changes in currency value; changes in business and income tax regulations and risks related to restrictions on repatriation of earnings or proceeds from liquidated assets of foreign subsidiaries |
| 12 ______________________________________________________________________ Tax and Repatriation Matters We are subject to various business and income tax laws in each of the countries in which we do business through wholly-owned subsidiaries and through affiliates |
| Although we believe we comply with the many business and income tax requirements of each of our operations, we are exposed to the possibility of changes in enacted laws and interpretations of laws which could have a material adverse impact on our financial condition or results of operations |
| Also, we evaluate our overall financing plans in the various jurisdictions in which we operate and manage international movements of cash from and amongst our foreign subsidiaries in a tax-efficient manner; however, an unanticipated international movement of funds due to unexpected changes in our business or in needs of the business could result in a material adverse impact on our financial condition or results of operations |
| Market Risk As a multinational entity, we are exposed to changes in foreign currency exchange rates, interest rates and commodity prices |
| We utilize a variety of practices to manage these market risks, including operating and financing activities and, where considered appropriate, utilizing derivative instruments |
| We use derivative instruments only for risk management purposes and not for trading or speculation |
| All derivative instruments we use are either exchange traded or are entered into with major financial institutions in order to reduce credit risk and risk of nonperformance by third parties |
| Foreign Currency Risk—We have subsidiaries located in France, the Philippines, Indonesia, Brazil, Canada, Hong Kong and Spain |
| Together with our subsidiaries, we conduct business in over 90 countries worldwide transacting much of our business in foreign currencies |
| Changes in foreign currency exchange rates may have an impact on our operating profit |
| Since we transact business in many other countries, some of those sale and purchase transactions are denominated in a currency other than the local currency of our operations |
| As a result, changes in exchange rates between the currency in which the transaction is denominated versus the local currency of our operation into which the transaction is being recorded can impact the amount of local currency recorded for such transaction |
| This can result in more or less local currency revenue or cost related to such transaction, and thus have an effect on our operating profit |
| This “currency transaction risk” is mitigated partially in France since some of the revenue and expense transactions of our French subsidiaries are denominated in US dollars, providing a degree of natural hedging |
| Our Brazilian operations are more fully exposed to this “currency transaction risk |
| ” Additionally, changes in foreign currency exchange rates may have an impact on the amount reported in other income (expense), net |
| Once the above-indicated receivables and payables from the sale and purchase transactions have been recorded, to the extent currency exchange rates change prior to settlement of the balance, a gain or loss on the non-local currency denominated asset or liability balance may be experienced, in which case such gain or loss is included in other income (expense), net |
| We utilize forward and swap contracts and, to a lesser extent, option contracts to selectively hedge our exposure to foreign currency transaction risk when it is practical and economical to do so |
| The use of these contracts minimizes transactional exposure to exchange rate changes because the gains or losses incurred on the derivative instrument will offset, in whole or in part, the loss or gain on the underlying foreign currency exposure |
| These instruments are entered into with well-known money center banks, insurance companies or government agencies (“counterparties”) |
| Usually these contracts extend for no more than 12 months |
| We believe that the foreign currency risks that would not be hedged were the counterparties to fail to fulfill their obligations under the contracts are minimal in view of the financial strength of the counterparties |
| Management of foreign currency transactional exposures was not changed during 2005, and we do not expect any significant change in such exposures or in the strategies we use to manage such exposures in the near future |
| As of December 31, 2005, a 10 percent unfavorable change in the exchange 13 ______________________________________________________________________ rate of our functional currencies and those of our subsidiaries against the prevailing market rates of non-local currencies involving our transactional exposures would have resulted in a net pre-tax loss of approximately dlra2 million |
| These hypothetical gains or losses on foreign currency contracts and transactional exposures are defined as the difference between the contract rates and the hypothetical exchange rates |
| While we believe the above loss resulting from the hypothetical unfavorable changes in foreign currency exchange rates would be material to our results of operations, we reduce this risk by selectively hedging our exposure when it is practical and economical to do so |
| In addition to currency transaction risks, we are also exposed to “currency translation risk |
| ” Since the financial results of our foreign subsidiaries are determined in the local currency of each foreign subsidiary, these financial results are translated into US dollars on a monthly basis in order to determine our consolidated financial results |
| A weakening of the US dollar versus the local currency of the foreign subsidiary will have a favorable currency translation impact when positive financial results of that foreign subsidiary are translated to US dollars |
| Our foreign currency translation effects typically offset to a significant degree the foreign currency transaction impacts in our operating results |
| Interest Rate Risk—We hold a combination of variable- and fixed-rate debt consisting of short and long term instruments |
| We selectively hedge our exposure to interest rate increases on our variable rate long-term debt when it is practical and economical to do so |
| We utilize various forms of interest rate hedge agreements, including interest rate swap agreements and forward rate agreements |
| Our strategy to manage exposure to interest rate changes did not change during 2005, and we do not expect any significant changes in our exposure to interest rate changes or in how such exposure is managed in the near future |
| Various outstanding interest-bearing instruments are sensitive to changes in interest rates |
| Interest rate changes would result in gains or losses in fair market value of fixed-rate debt due to differences between current market interest rates and the rates governing these instruments |
| With respect to our fixed-rate debt outstanding at December 31, 2005, a 10 percent change in interest rates would not result in a material change in the fair market value of such debt and with respect to our variable-rate debt outstanding at December 31, 2005, a 10 percent change in interest rates would not result in a material impact to our future annual pre-tax earnings |
| Commodity Price Risk—We are subject to commodity price risks, the most significant of which relates to the price of wood pulp, which is our largest single component of cost |
| The per ton cost of wood pulp is cyclical in nature and more volatile than general inflation |
| We consumed 109cmam400, 105cmam100 and 97cmam000 metric tons of wood pulp in 2005, 2004 and 2003, respectively |
| During the period from January 2003 through December 2005, the US list price of northern bleached softwood kraft pulp, a representative pulp grade that we use, ranged from a low of dlra480 per metric ton in January 2003 to a high of dlra680 per metric ton in June through August 2004 and in February through April 2005 |
| We normally maintain approximately 30 to 60 days of inventories to support our operations |
| As a result, there is a lag in the impact of changes in the per ton list price of wood pulp on our cost of products sold |
| Selling prices of our paper products are influenced, in part, by the market price for wood pulp, which is determined by worldwide industry supply and demand |
| Generally, over time, we have been able to increase our selling prices in response to increased per ton wood pulp costs and have generally reduced our selling prices when wood pulp costs have significantly declined |
| Increases in prices of wood pulp could adversely impact our earnings if selling prices are not increased or if such increases do not fully compensate for or trail the increases in wood pulp prices |
| We have not utilized derivative instruments to manage this risk |
| With respect to our commodity price risk, a hypothetical 10 percent change in per ton wood pulp prices would impact our future annual pre-tax earnings by approximately dlra7 million, assuming no compensating change in our selling prices |
| We believe that, while our exposure to commodity price risk is material to our results of operations, our customers understand such risk and over time changes in the price of wood pulp are typically reflected in selling prices |
| 14 ______________________________________________________________________ Energy Supply and Cost Volatility The papermaking processes use significant amounts of energy, primarily electricity, natural gas and fuel oil, to run the paper machines and other equipment used in the manufacture of pulp and paper |
| In France and in the United States, availability of energy is generally not expected to be an issue, although prices can fluctuate significantly based on variations in demand |
| In Brazil, where that country’s production of electricity is heavily reliant upon hydroelectric plants, availability of electricity has been affected in the past by weather and rain variations |
| Our Brazilian business currently has a sufficient supply of energy to continue its current level of operation |
| Like many other manufacturing businesses, we experienced significant increases in energy costs in 2005 |
| With little ability to reduce our per unit consumption of energy, our per unit cost to make product increased significantly |
| Due to the competitive pricing in the markets for most of our products, we have been unable to fully pass through these higher energy costs to our customers |
| With respect to our purchased energy price risk, a hypothetical 10 percent change in per unit prices would impact our future annual pre-tax earnings by approximately dlra7 million, assuming no compensating change in our selling prices |
| Periodically, when we believe it is appropriate to do so, we enter into agreements to procure energy for future periods in order to reduce the uncertainty of future energy costs |
| However, in recent years this has only marginally slowed the increase in energy costs due to the volatile changes in energy prices we have experienced |
| In France, we have entered into agreements with an energy cogeneration supplier whereby the supplier will construct and operate cogeneration facilities at our Spay and Quimperle Mills and supply steam, which will be used in the operation of our mills |
| The Spay cogeneration facility was completed in late 2005 and the Quimperle cogeneration facility will be completed in 2006 |
| These cogeneration facilities are expected to provide energy cost savings and improved security of supply at those mills |
| General Inflation and Selling Prices In addition to changes in wood pulp and energy costs discussed above, costs of our operations are also impacted by general inflation |
| Our main costs impacted by general inflation are wages and salaries, chemicals, employee benefit costs, primarily medical and pension expenses, and costs of insurance |
| Due to competitive pressures, we are not always able to pass along our cost increases through increased selling prices |
| Seasonality Sales of our products are not subject to seasonal fluctuations, except in the United States and Brazil |
| In the United States, customer shutdowns typically occur in July and December and typically have resulted in reduced net sales and operating profit during those two months |
| Additionally, the US mills shut down equipment to perform additional maintenance during these months, resulting in higher product costs and reduced operating profit |
| In Brazil, customer orders are typically lower in December due to a holiday season during much of January and February |
| Environmental Matters We are subject to federal, state, local and foreign environmental protection laws and regulations with respect to the environmental impact of air, water and other emissions from our mills as well as the disposal of solid waste generated by our operations |
| We believe we are operating in compliance with, or are taking action aimed at ensuring compliance with, such laws and regulations |
| While we have incurred in the past several years, and will continue to incur, capital and operating expenditures in order to comply with these 15 ______________________________________________________________________ laws and regulations, such costs are not expected to materially affect our business or results of operations |
| However, there can be no assurance that a material adverse effect on our financial statements will not occur at some future time as a result of environmental matters |
| Additional information concerning environmental matters is disclosed in Note 7 of the Notes to |