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Operator
Good morning, my name is Jennifer and I will be your conference operator today. At this time, I would like to welcome everyone to the Schweitzer-Mauduit Second Quarter 2006 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [OPERATOR INSTRUCTIONS]. Thank you. At this time, I would like to turn the call over to Mr. Roberts, Chief Financial Officer. You may begin your conference.
Paul Roberts - Chief Financial Officer and Treasurer
Thank you Jennifer. Good morning. I am Paul Roberts, Chief Financial Officer of Schweitzer-Mauduit International. With me is Wayne Grunewald, our Corporate Controller. I would like to introduce Pete Thompson, who will be replacing me as CFO, effective August 1. Pete will be leading our conference call today.
Pete Thompson - President, US Operations
Thank you Paul and good morning. I am Pete Thompson. Thank you for joining us for a review of our second quarter 2006 financial results. Various comments or remarks that we make during today's conference call constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and are subject to the Safe Harbor created by that act. Actual results may differ materially from the results suggested by these statements for a number of reasons. Such factors are discussed in more detail in the Company's Securities and Exchange Commission reports, including the Company's annual report on Form 10-K for the year ending December 31, 2005.
Prior to a detailed discussion of our financial results, I will review the highlights of the quarter. Diluted earnings per share were $0.04, compared with diluted earnings per share of $0.38 in the second quarter of 2005, a decline of 89%. Restructuring expenses of 3.4 million or $0.14 per share were incurred during the quarter. Earnings without restructuring expenses were $0.18 per share for the quarter, a decline of 53%. Schweitzer-Maudit made decisions in the first half of 2006 to recognize restructuring expenses related to the shutdown of certain production equipment in the United States and France. The restructuring expenses totaled $3.4 million during the second quarter of 2006 and $3.9 million for the first six months of the year. Net sales totaled $162.1 million, 4% below the prior-year quarter, due to decreased sales volumes and unfavorable currency impacts, partially offset by somewhat higher average selling prices and an improved mix of products sold. Operating profit was $4.2 million, a decline of $6.5 million or 61% from the prior-year quarter. Excluding restructuring expenses, operating profit was $7.6 million for the quarter, a decrease of $3.1 million or 29%. The company's growth profit margin, which doesn't include restructuring expenses was 13.7%, compared with 15.6% in the prior-year quarter. The decline of profitability excluding restructuring expenses compared with the second quarter of 2005 was the result of the inability to fully offset unabsorbed fixed costs and inflationary cost increases to improve mill operations or higher selling prices. The unabsorbed fixed costs were caused by lower production volumes and increased operating expenses by $5.4 million or roughly $0.22 per share. Inflationary cost increases unfavorably impacted operating results by $3.7 million in the quarter or roughly $0.15 per share. Although overshadowed by these unfavorable cost factors, significant operational improvements were achieved in each of our business units. I will now provide a more detailed review of our second quarter financial results and our outlook for the year.
Net sales were $162.1 million, a decrease of $6.1 million, or 4%, compared with the second quarter of 2005. Unit sales volumes decreased by 2% compared with the prior year and had an unfavorable $7.2 million impact on net sales. Excluding sales volume from our operation in the Philippines, which was acquired in June 2005, unit sales volume decreased by 4%. Sales volume in the United States decreased by 17%, reflecting a reduction of commercial and industrial paper sales as a result of paper machine rationalization as well as lower sales in tobacco related papers. Sales volumes for cigarette paper for lower ignition propensity cigarettes increased. Sales volumes for the French segment increased by 3% from the prior year quarter. Sales volumes increased for reconstituted tobacco leaf products, primarily due to lower margin tender business and for tobacco related papers in both the Indonesian and Philippines operations. Sales volumes were lower for all tobacco related paper products in France. Sales volumes in Brazil were essentially unchanged. Higher average selling prices had a favorable $2.4 million impact on the net sales comparison. Higher average selling prices in the United States were partially offset by lower average selling prices in our French operations. The increase in average selling prices in the United States was largely attributable to a change in the mix of products sold. Changes in currency exchange rates decreased net sales by $1.3 million or 1% compared with the prior year quarter. The euro was approximately 1.5% weaker versus the dollar accounting for the negative impact. During the quarter, the Brazilian real was approximately 14% stronger versus the dollar partially offsetting the impact of the weaker euro on the net sales comparison. Gross profit was $22.2 million, a decrease of $4 million from the prior year quarter. The gross profit margin was 13.7%, declining from 15.6% in the second quarter of 2005. Gross profit was unfavorably impacted by lower production volumes and significant inflationary cost increases. These negative factors were partially offset by improved mill operations and the somewhat higher average selling prices. Reduced paper machine operating schedules and lower production volumes were experienced primarily in our French and US operations. This resulted in unfavorable fixed cost absorption impacts that increased operating expenses by $5.4 million. Inflationary cost increases unfavorably impacted operating results by $3.7 million during the quarter. Purchased energy cost increased by $3 million compared with the second quarter of 2005. Higher energy costs were experienced in all business units related to higher electricity, natural gas, and fuel oil costs. Changes in the per ton cost of wood pulp increased our operating expenses by $500,000. The higher wood pulp costs were experienced in all business units.
The list price of northern bleached softwood kraft pulp or NBSK, a bellwether pulp grade, averaged $705 per metric ton in the United States during the quarter, compared with $655 per metric ton in both the second quarter of 2005 and the first quarter of this year. The world pulp market continued to tighten during the quarter with higher world pulp shipments and increasing pulp prices. Market pulp inventories as measured by days of supply declined to a three-year low as of June 30. The list price of NBSK in the United States increased each month during the quarter from $660 per metric ton in March to $725 per metric ton in June. Pulp prices are likely to increase further during the year. Although new market pulp production capacity is being added, greater demand from China and the closure of formerly integrated pulp mills are helping to keep the market in balance. Pulp mill operating rates continue to be high on a global basis. Changes in labor rates also increased manufacturing expenses by $500,000 during the quarter. These unfavorable cost factors were partially offset by improved mill operations. Significant operational improvements were achieved in each of our business units through increased productivity and reduced waste. Non-manufacturing costs were $900,000 less than the prior year quarter, a decrease of 6%. Research, selling and general expenses were all lower, reflecting cost reduction efforts in these areas. Non-manufacturing expenses were 9% of net sales in the second quarter, down slightly from 9.2% in the prior year period.
In May, Schweitzer-Mauduit announced the decision to cease the production and sale of decor papers made at its mill in Lee, Massachusetts. Schweitzer-Mauduit is working with its customers to provide products until those customers can secure alternative decor paper supply. We ceased production in July. In 2001, Schweitzer-Mauduit decided to enter the decor papers market as part of a strategy to diversify its non-tobacco papers. Decor papers are sold to customers to saturate and laminate the paper to particle board for use in furniture, cabinet and flooring applications.
Although we have been successful in qualifying our products with our customers, we have not been able to achieve an acceptable manufacturing cost structure or develop and manufacture decor papers that generate acceptable profitability. With this decision, we have ceased operation of a paper machine in Lee, which is resulting in accelerated depreciation and other expenses totaling approximately $4.5 million, including cash costs of approximately $500,000 that are partly related to employee severance expenses. This cessation is resulting in the loss of approximately 25 jobs in total at the Lee Mills and at our US headquarters in Alpharetta, Georgia.
Our ongoing operating results are expected to improve by approximately 1 to $2 million annually, as a result of the exit of the decor papers business and associated restructuring activities. In addition to the decor papers decision, during the first quarter, decisions were made to recognize accelerated depreciation on certain production equipment in both the United States and France. This accelerated depreciation as well as related employee severance expenses primarily in the United States is expected to total approximately $2 million during 2006.
Restructuring expenses totaled $3.4 million during the second quarter of 2006 and $3.9 million for the first six months of the year. Operating profit was $4.2 million, a decline of $6.5 million or 61% compared with the second quarter of 2005. Operating profit return on sales was 2.6% compared with 6.4% in the second quarter of 2005. Excluding restructuring expenses of $3.4 million, operating profit was 7.6 million for the quarter, a decrease of $3.1 million or 29% from the second quarter of 2005. Operating profit return on sales excluding restructuring expenses was 4.7% for the quarter. Operating profit was lower in our French and Brazilian business units, but increased in our US operations. Operating profit in the French segment was $5.5 million, a decline of $6 million from the prior year quarter. The decrease in profitability was the result of a decline in production volume and increased purchased energy, wood pulp, and labor expenses. The unabsorbed fixed cost due to lower production volumes decreased operating profit by $3.8 million. The inflationary cost increases reduced operating profit by $2.4 million. Restructuring expenses of $500,000 were incurred during the second quarter. These unfavorable factors were partially offset by improved mill operations, positive exchange rate impacts related to the weaker Euro compared with the dollar, and reduced non-manufacturing expenses. Operating profit in the United States improved by $700,000 and totaled $700,000 for the quarter despite $2.9 million in 2006 restructuring expenses. The improvement in profitability reflected higher average selling prices, resulting primarily from an improved sales mix that included increased sales of cigarette paper for lower ignition propensity cigarettes, significant improvement in mill operations, primarily from cost reduction activities combined with improved machine efficiencies and lower non-manufacturing expenses. These positive factors were partially offset by $1.3 million of unabsorbed fixed expenses due to lower production volume and $1.1 million of inflationary cost increases primarily related to higher purchased energy costs. Our operating profit in Brazil declined by $1.3 million from the second quarter of 2005 to an operating loss of $300,000. The strengthening of the Brazilian real versus the dollar had an unfavorable impact on operating profit of $1 million. The lower profitability in Brazil also reflected inflationary cost increases of $200,000 related to wood pulp and purchased energy. Interest expense totaled $1.4 million during the second quarter, a decrease of $100,000 from the prior year quarter. Total debt declined slightly during the quarter and our total debt-to-capital ratio stood at 24% at June 30 compared to 26% at the end of March.
Other expense net was $600,000 for the quarter, unfavorable by 1.5 million compared with the second quarter of 2005, primarily due to foreign currency transaction losses in 2006 versus gains in 2005. Minority interest in earnings of subsidiaries decreased by $400,000 compared with the prior year quarter. This decrease reflected lower earnings at LTR Industries, a French subsidiary of the company, which has a minority owner that owns 28% of its shares. The $100,000 loss from equity affiliates represents Schweitzer-Mauduit’s 50% share of the pre-operating expenses associated with our recently formed joint venture in China.
Net income totaled $700,000, a decline of $5.1 million or 88% from net income of $5.8 million in the second quarter of 2005. Diluted earnings per share were $0.04 compared with diluted earnings per share of $0.38 during the second quarter of 2005. An 89% decline, the decline in both net income and diluted earnings per share compared with the prior year quarter was caused by the lower operating profit and the reduction in other income partially offset by the decline in minority interest. Earlier today, Schweitzer-Mauduit announced a quarterly common stock dividend of $0.15 per share. This dividend will be payable on September 11, 2006 to stockholders of record on August 14, 2006. The Company has paid quarterly dividends of $0.15 per share since 1996. Schweitzer-Mauduit recently announced the successful completion and signing of a new multi-currency revolving bank credit facility in the amount of approximately $195 million that will be effective July 31, 2006. This new five-year arrangement replaces an existing bank credit facility of approximately $135 million that has been in place since January 2002, and which would expire in January 2007. The new credit facility has less restrictive financial covenants and lower interest rate margins and will provide greater flexibility to pursue possible restructuring activities and strategic opportunities. Capital spending totaled $500,000 compared with $4.7 million in the second quarter of 2005. No single capital project accounted for a significant amount of the second quarter 2006 capital spending. During the second quarter of last year $400,000 was spent in Brazil to complete installation of a new cigarette paper machine. Schweitzer-Mauduit is expecting capital spending for 2006 to be approximately $20 million. In Mid 2005, Schweitzer-Mauduit announced a joint venture with the China National Tobacco Corporation to produce tobacco related papers both cigarette paper and porous plug wrap at a new state-of-the-art paper mill in China. The management team for the joint venture is in place, administrative practices and controls are being implemented, and detailed engineering and long lead item procurement is in process. A cornerstone laying ceremony for the new mill occurred earlier this month. Mill operations are currently expected to commence in early 2008. Momentum continues to build for lower ignition propensity cigarettes. Two US states, New York and Vermont, plus Canada have now implemented legislation requiring cigarettes to meet the same lower ignition propensity standards. An additional four US states have regulations that become effective between January 2007 and January 2008 with the states of Illinois, New Hampshire, and Massachusetts joining California in passing lower ignition propensity cigarette legislation. These six US states plus Canada with lower ignition propensity legislation are estimated to comprise approximately 23% of combined US and Canadian cigarette consumption. In addition to these six states 13 additional states have introduced legislation addressing lower ignition propensity properties for cigarettes. Outside of North America, Australia is the most active jurisdiction working on possible lower ignition propensity legislation. Legislation could be implemented in Australia this year, which would reportedly requiring compliance beginning in 2008. Cigarette consumption in Australia is estimated to be approximately equal in size to the state of California or the equivalent of roughly 7% of US demand. Schweitzer-Mauduit continues to benefit from increased production and sales of cigarette paper for lower ignition propensity cigarettes in support of the new regulations in Canada and Vermont. Sales of cigarette papers for lower ignition propensity cigarettes have and are expected to continue to contribute positively to operating results in future periods. These papers sell for a significantly higher price and a better margin than the conventional cigarette papers they replace. With increasing sales volumes of this cigarette paper, we are achieving improvement in our manufacturing cost for these products. However, we are experiencing increased weakness in our conventional tobacco-related product sales.
In particular, sales volumes of reconstituted tobacco leaf products and tobacco-related papers in France will be less than previously anticipated for 2006. Reduced demand for tobacco-related paper products in Western Europe and the United States, as well as below planned levels of growth in new markets for our reconstituted tobacco leaf products have also caused us to have excess production capacity and increased machine downtime. The unfavorable impact of this downtime reflecting an unabsorbed fixed cost is expected to increase our full year 2006 operating expenses by roughly $20 million or approximately $0.80 per share. The significant inflationary cost increases experienced in 2005 are continuing in 2006, reflected in higher purchased energy, labor, and wood pulp expenses. These inflationary cost increases are expected to have an unfavorable impact on the year of approximately $15 million or roughly $0.60 per share. With approximately $12 million of this amount related to higher purchased energy costs. With nearly 10 million in inflationary increases already realized this year, the rate of cost increases is expected to lessen somewhat in the second half of the year and increasingly be offset through improved mill operations and continued efforts to systematically control all areas of cost. In addition to decisions already made, management is continuing to evaluate how to operate our production facilities in France and the United States more effectively with the reduced tobacco-related paper volumes. During 2006, decisions have been made to recognize accelerated depreciation on certain production equipment in both countries. This accelerated depreciation as well as employee and other restructuring-related expenses are expected to total approximately 6 to $7 million or approximately $0.25 to $0.30 per share this year. Although analysis is ongoing, no further decisions have been made and we have not committed to any plan beyond the steps already taken. It appears likely that further changes could occur that would require additional write-offs or accelerated depreciation of some production equipment and could also possibly include associated restructuring expenses in France or the United States. With the current difficult business conditions lower than previously anticipated sales volumes, the unfavorable impact of reduced paper machine operating schedules, significant inflationary cost increases, and restructuring activities, 2006 will continue to be our most challenging year since Schweitzer-Mauduit's spin-off in 1995. It is likely that full year 2006 earnings, excluding restructuring expenses, will be in the range of $0.85 and $0.95 per share. We do expect the underlying profitability of our business to improve next year after the benefits of the announced restructuring activities further increased sales of reconstituted tobacco leaf products and cigarette paper for lower-ignition propensity cigarettes and improved fixed cost absorption from improved production schedules are realized. Earnings at or above the 2005 level of $1.26 per share, excluding any restructuring expenses, are expected to be achieved during 2007. That concludes our planned comments. Operator, please open the phone lines for questions. Jennifer?
Operator
[OPERATOR INSTRUCTIONS] Jonathan Lichter, Sidoti & Company.
Jonathan Lichter - Analyst
Hi guys. How are you?
Pete Thompson - President, US Operations
Very good Jonathan.
Jonathan Lichter - Analyst
Are you expecting further deterioration in France for the remainder of the year?
Paul Roberts - Chief Financial Officer and Treasurer
The operating profit drivers in France that we signaled in the press release and the comments are going to continue to be challenging. We know that we have got continued below -- previous expectation levels of sales for reconstituted tobacco, as well as we are continuing to experience down time on the paper side of the operations with an imbalance between current demand level, sales levels, and our production schedules. So, we do anticipate that we are going to have as our full-year earnings guidance shows, more or less the second quarter repeating through the balance of the year.
Jonathan Lichter - Analyst
Okay. What happened with RTL, you mentioned new market weakness, which new markets were you expecting to grow faster than they did?
Paul Roberts - Chief Financial Officer and Treasurer
Basically outside of Western Europe. The majority of our recon business is currently in Western Europe and we are seeing kind of two levels of weakness, we are still growing in sales demand, but not at the rates expected. We are growing in the low single digits. The two factors that are really driving below levels of growth in recon sales are tax increases in Western Europe that are driving down cigarette consumption, a move to more value for money brands in Western Europe, which impacts the amount of recon that is required. Those two factors also impact on our paper business in France. And then below planned levels of growth on export markets or non-Western European markets. Part of the sales weakness too in recon in France is we have just completed a large tender order for recon that wasn't expected and is not repeating. So, it is more of a change in the drivers of where sales are occurring, rather than any loss of share or any change in the underlying fundamentals for recon requirements.
Jonathan Lichter - Analyst
And then moving to the US, would you expect margins here to increase because of the low-ignition papers coming out?
Paul Roberts - Chief Financial Officer and Treasurer
Yes. We are signaling that. As we have said, LIP, low ignition propensity cigarette papers do have a higher margin and with increased sales, we are simply seeing that benefit carry through to the overall business unit, as well as other improvements through cost reduction and restructuring.
Jonathan Lichter - Analyst
Thank you.
Paul Roberts - Chief Financial Officer and Treasurer
Thank you Jonathan.
Operator
Ann Gurkin, Davenport & Co.
Ann Gurkin - Analyst
Going back to RTL, can you tell me what volume was in the second quarter, what your expectations are for the second half and what you have built into the '07 number?
Pete Thompson - President, US Operations
Directionally the second-half volumes for RTL will be roughly the same as the first half volumes from a sales stand point. But, we are seeing a reduction in inventory that will cause us to have production levels to be lower than sales levels as we draw down inventories both through our customer adjustments as well as our own inventories. But, ongoing sales demand we expect to be roughly the same in the second half as the first half.
Ann Gurkin - Analyst
Which is low single digits?
Pete Thompson - President, US Operations
A low single digit growth, correct.
Ann Gurkin - Analyst
And what have you built-in for 2007?
Pete Thompson - President, US Operations
Continuing low single-digit growth.
Ann Gurkin - Analyst
Okay. Switching to cigarette paper in Western Europe, have you all permanently lost business to other competitors, maybe private competitors that have brought on capacity?
Pete Thompson - President, US Operations
That is one of the factors. There is, I think you are aware, been any addition of capacity over the last several years, especially cigarette paper in Western Europe. And we have seen both the combination of decreasing demand due to lower cigarette production in Western Europe as well as that additional capacity impact our sales levels.
Ann Gurkin - Analyst
At what point do you just take a line down permanently?
Pete Thompson - President, US Operations
I am sorry. Say it again?
Ann Gurkin - Analyst
At what point you just take a manufacturing line down permanently?
Pete Thompson - President, US Operations
Well, we are evaluating right now and studying what our restructuring plans could be both in the US and France as we noted. Though no decisions have been made and the process really requires that we first work with the appropriate union and government officials to decide. We realize we have a need to rebalance capacity with demand. At this point though what exactly that looks like, we are not sure and we are still studying it. One other comment I would make is that in terms of our sales projections for our business in Western Europe or in general served out of France, we don't anticipate that we have seen permanent reductions in our business in terms of any share levels. The short answer is we don't yet know what our restructuring plans will be.
Ann Gurkin - Analyst
But you are in discussions with the French Government regarding --?
Pete Thompson - President, US Operations
No, not yet.
Ann Gurkin - Analyst
Not, yet. Okay. In the US, what are you modeling for this year and next year for consumption of cigarettes, overall industry consumption of cigarettes?
Pete Thompson - President, US Operations
We are continuing to use the same projections, which is roughly a 2% annual decline in US consumption.
Ann Gurkin - Analyst
Okay. Now, switching to free cash flow, what is the projected capital spending for 2007?
Pete Thompson - President, US Operations
I would anticipate -- we are projecting full-year spending this year to be 20 million. I would anticipate we would be up slightly from that in 2007.
Ann Gurkin - Analyst
Okay. And then, depreciation, amortization can you give me that for 2006?
Pete Thompson - President, US Operations
I am going to defer it to Paul on that question.
Paul Roberts - Chief Financial Officer and Treasurer
Ann, through the first six months, we have got 22 million of depreciation and amortization. It is going to be not quite double that for the full year because that does include some accelerated depreciation. Last year for the full year, we were a bit under $40 million and we will probably be slightly above 40 million for the full year because of the accelerated depreciation that we are taking as part of the write-offs.
Ann Gurkin - Analyst
Okay. And then, can you review the priority use of free cash flow?
Paul Roberts - Chief Financial Officer and Treasurer
The priority use of free cash flow will be for continuing investments, capital spending requirements, as well as any restructuring activities that are identified, and then as we signaled opportunities that we would have from a strategic standpoint that would arise. And of course we use cash flow to maintain our continued dividend payment.
Ann Gurkin - Analyst
Isn’t that dividends, opportunities, strategic, any acquisitions out there, is that what it means?
Paul Roberts - Chief Financial Officer and Treasurer
No, there are really four drivers. One would be ongoing capital requirements for our business, and that will be more in line with what we have been doing here historically. 20 million this year and then that number probably slightly higher next year. Restructuring activities beyond what we have already announced, any strategic opportunities that arise, which we have none to announce today, just if any do arise, and then ongoing meeting of our dividend payment.
Ann Gurkin - Analyst
And then can you review your hedge for these [new] commodities for the balance of 2006?
Pete Thompson - President, US Operations
We really don't hedge any commodities. I think the most significant thing to talk about in that area would be what we said we've done regarding energy purchases. In response to the significant increases in energy pricing, we have begun to implement and we really have largely implemented buying ahead our energy requirements, but not through hedging, through actual contracting of consumption at a set rate in France, Brazil and the US.
Ann Gurkin - Analyst
And what percentage have you [bought] ahead?
Pete Thompson - President, US Operations
It varies by location, but usually at least into 2007 in the US and 2008 in Brazil, even beyond that.
Ann Gurkin - Analyst
Okay. And then can you tell me, will we ever see earnings above $2 again for this company?
Pete Thompson - President, US Operations
I wouldn't venture to offer my opinion on that. We've given the guidance for 2007, which we feel pretty good about. Coming back on that hedging question and Paul had an item to add.
Paul Roberts - Chief Financial Officer and Treasurer
Just to mention Ann that you may notice that the guidance that we are giving in terms of the impact of energy versus the prior year is less this quarter than last quarter, and part of that does reflect the benefits of some of the full repurchases of energy that we have done already during the first six months of this year where we -- when there were opportunities to lock in at relatively attractive rates, we were able to do so, and we as a result, we do expect inflation to be a little bit less of a factor and a little bit diminishing and impact the balance of this year, especially compared to guidance we gave in the first quarter.
Ann Gurkin - Analyst
Okay. All right. That's all. Thank you.
Pete Thompson - President, US Operations
Thank you, Ann. Jennifer, can you please ask again if there are any other questions?
Operator
[OPERATOR INSTRUCTIONS] [Duane Kennmore, Clover Partners]
Duane Kennmore - Analyst
Hello gentlemen. I have a few questions. First of all, just quickly, what was your free cash flow number for this quarter?
Paul Roberts - Chief Financial Officer and Treasurer
Duane, we did provide in the earnings release the year-to-date information, I don't have it immediately available as far as just for the quarter itself.
Duane Kennmore - Analyst
Okay.
Pete Thompson - President, US Operations
Our cash provided by operations was $22 million for the first six months of the year.
Duane Kennmore - Analyst
All right.
Pete Thompson - President, US Operations
And after cash for investing we were at $11 million.
Duane Kennmore - Analyst
Okay.
Pete Thompson - President, US Operations
We were able to reduce our debt by about $11 million during the quarter, during the first six months of the year.
Duane Kennmore - Analyst
Okay. Now, in terms of managing your commodity exposure, you have indicated that you don't hedge it, but you started to discuss a few minutes ago, some plan for managing that. Could you go over the specifics of that again for me, I didn't quite catch it?
Pete Thompson - President, US Operations
Sure. Basically, what we are doing is in two areas, one would be purchased materials, there we negotiate annual requirements and negotiate prices on those requirements. In some cases, it's even on a lot-by-lot basis. What we are doing in terms of inflation management on commodities, purchased materials is to look at one is waste reduction, two is substitution. In our industry substitution is always with the consideration of what's qualified to our customers. And also, there are two primary tools we are using in terms of commodity inflation. The more significant new action we have undertaken, widely across the company is to identify energy contracts, electricity, natural gas, and to a much lesser extent fuel oil, where we buy ahead at a set price or a mix of a set price and a variable price, the market price. And that's been quite successful for us since we began to implement that late last year and through this year, [at least] holding a line on inflation with energy prices. Eventually you still pay the market rate, but having a more stable energy price situation.
Duane Kennmore - Analyst
Right, okay.
Pete Thompson - President, US Operations
And we plan to continue to do that.
Duane Kennmore - Analyst
All right. In your restructuring plan, I know that of course with these sorts of things, you have to take the long-term view because these things do take time and it doesn't happen overnight. But just so, with that to start off with, how do you see the general economics of your market shaping up in -- not in a quarter or two out, but say three years out. What are you seeing there and how do you see yourself aligning the company to profit well by it. I know, there is a lot of moving parts in that question. But --
Pete Thompson - President, US Operations
Sure. No, I am going to have Paul take that one especially in his new role now working on strategic projects.
Duane Kennmore - Analyst
Okay.
Paul Roberts - Chief Financial Officer and Treasurer
Our industry is shifting as a lot of industries are where demand is declining in developed countries and yet still increasing in developing countries. And one of the issues that we do have to do deal with is that we do have -- our higher cost production facilities are in France and the United States and that is where we are under some pressure in terms of declining cigarette consumption and some impact on demand. From -- that's why really our restructuring is focused on better aligning what we see as our production capacity in both North America and in France to be more in line with demand. That's why we are realigning some equipment, writing off some assets that we believe will not be fully utilized in the future. And we are spending strategically to increase our capacity for -- and quality of products produced in Indonesia, in the Philippines and with our joint venture in China. Really, what we see is kind of the model three to four years out is that we will have streamlined our operations in North America, we will have strengthened our operations, increased the production coming out of Brazil, Indonesia, the Philippines and China. And again that will allow us to take advantage of some fairly meaningful cost differentials between our production of product in the developing countries that have posted a production of the product in the developed countries. And we would expect to begin as we said just the exiting of the decor business for instance, should be benefiting us to the tune of 1 to $2 million a year. Some of the restructuring activities we are undertaking, we will begin to be seeing some benefits in 2007.
Operator
James Vanasek, VN Capital Management.
James Vanasek - Analyst
Hi, good morning gentlemen. British American Tobacco and then Philip Morris announced some earnings recently and they all seem to be pretty good, and yet you guys continue to take it on the chin. I think we are in our sixth quarter now of increasing commodity costs and we hear a lot from you guys about better operations in the mills, but still very little on the hedging and very little on trying to seek price increases from Philip Morris and from some of your other customers. Why do you have such little pricing power when we are 18 months into a rising commodity cycle, other areas of the economy seem to be on passing on prices, building materials, and few other sectors seem to be doing a good job of that. What are the particular economics working in your business that prevent you from getting some escalations when your customers are reporting sales and earnings that are pretty decent?
Pete Thompson - President, US Operations
The primary issue that prevents us from getting more of recovery through price increases than we have seen, and we have seen some, as we noted, we have seen some price increase realizations, but the main reason is continuing excess capacity for our primary tobacco related papers that really dampens the ability of any seller to be able to raise prices. So, there are some price increases, but they are [boarded] by continuing excess capacity.
James Vanasek - Analyst
Right. Can we assume that you can use your pricing on LIP paper to offset some of this or to sort of recast, I guess the leverage of the balance you have with your customers, or will too aggressive pricing backfire on the LIP?
Pete Thompson - President, US Operations
I think LIP in and of itself is more profitable, is higher priced and that really reflects the value that technology provides specific to its application. The ability to use LIP cigarette paper as a means to leverage pricing in other areas, for other products, I would not anticipate that would occur.
James Vanasek - Analyst
So is it -- do we run the risk of getting [inaudible] sort of commodity problem? Let us assume that maybe we are at a plateau of high energy prices or even we will experience higher energy prices. Is the LIP paper exposed in the same way that the conventional paper is, in terms of the pricing agreements you made with your customers, where you are locked in and have to eat commodity cost increases?
Pete Thompson - President, US Operations
Well, two parts to the question you asked. First of all, in terms of competitive threats to our current two primary technologies for lower ignition propensity cigarettes, we have not seen any significant competitive threats at all, anywhere in the world. So, we continue to enjoy a good position with our technologies and they are proving to be good technologies. So, that gives protection to them from a pricing standpoint. In terms of the commoditization of LIP, at this point, we are not aware of anything; we don't see anything immediate occurring. So, we think we will continue to hold that position.
James Vanasek - Analyst
Does your Chairman and CEO make a habit of skipping the conference calls, does he not like talking to investors?
Paul Roberts - Chief Financial Officer and Treasurer
No, Wayne enjoys it, and he is sitting here right in front of me.
James Vanasek - Analyst
Okay, that's good to know. Thank you.
Paul Roberts - Chief Financial Officer and Treasurer
Thank you.
Operator
At this time, there are no further questions.
Paul Roberts - Chief Financial Officer and Treasurer
Thank you. Thank you Jennifer and thank you all for taking the time to join us today. Bye.
Operator
This concludes today's conference call. You may now disconnect.