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Stepan Co. (NYSE:SCL)

Q3 2008 Earnings Call

October 22, 2008 2:00 pm ET

Executives

James E. Hurlbutt – Chief Financial Officer

Analysts

George Gasper – Robert Baird

[Daniel Reisel] – Sidoti & Company

Steve Schwartz – First Analysis

Operator

Welcome to the Stepan Company’s third quarter 2008 earnings conference call. (Operator Instructions). I’d now like to turn the conference over to James Hurlbutt, Vice President and Chief Financial Officer. Please go ahead sir.

James Hurlbutt

Good afternoon and thank you for joining us. Before I begin please note that information in this conference call contains forward looking statements which are not historical facts. These statements involve risks and uncertainties that could cause actual results to differ materially. Including but not limited to prospects for our foreign operations, global and regional economic conditions and factors detailed in the company’s Securities and Exchange Commission filings.

I am pleased to report record quarterly and year-to-date earnings which benefited from profits on the sale of a product line inland. Our strong third quarter financial performance excluding the asset sales was driven by our surfactant business and higher levels of operating income associated with improved customer and product mix, reduced outsourcing and our success in recapturing margins that had been adversely affected by rising raw material costs.

Polyol volume continued to grow due to higher global insulation sales. While polyol margins declined in the third quarter, we have announced polyol price increases which will take effect in the fourth quarter and should help restore margins for this segment.

If we look at our third quarter profitability excluding the positive nonrecurring gains associated with the sale of product lines and the landfill. We continue to see solid earnings momentum in our core business, setting the stage for a record full year 2008 earnings.

At this point let me walk you through our third quarter 2008 operating results. Total net sales for the third quarter were $432 million, up 28% year-over-year, benefiting primarily from higher selling prices, which accounted for 23 percentage points of net sales growth, increased volume which accounted for 3% of sales growth and foreign exchange currency translation which accounted for two percentage points of net sales growth.

Total net sales for the nine months of 2008 were $1.23 billion up 25% year-over-year benefiting primarily from higher selling prices, which accounted for 22 percentage points of net sales growth. And the positive effect of foreign exchange currency translation which accounted for three percentage points of net sales growth.

Total volume was flat year-over-year. Net income for the third quarter was $17 million or $1.59 per diluted share compared to net income of $3.1 million or $0.31 per diluted share in the year ago quarter.

Net income for the first nine months of 2008 increased to $35.5 million or $3.39 per diluted share, compared to net income of $13.5 million or $1.34 per diluted share in the year ago period.

Please note that the affect of some exceptional items which impacted our third quarter in year-to-date 2008 net income including our previously announced sale of certain eurothane product lines to Bayer Material Science which resulted in a pretax gain of $9.9 million or $6.1 million after tax or $0.57 per diluted share.

We will continue to manufacture a full range of polyester polyols and especially eurothane system products for military and aerospace as well as coatings, adhesive sealants and elastomers which we view as solid growth drivers for Stepan.

Secondly the sale of company owned farmland adjacent to our Millsdale, Illinois facility which resulted in an $8.5 million pre-tax gain or $5.2 million after tax or $0.49 per diluted share.

We intend to use these proceeds for the acquisition and renovation of a 60,000 square foot office building near our corporate headquarters. This building will be occupied by the current personnel presently working in nearby space, which is coming to the end of its lease term.

The two transactions are being completed through a tax deferred like kind exchange. And lastly the results were impacted by $2.8 million in deferred compensation plan expense, versus just $0.9 million the year ago period.

As you recall the economy requirements for the company fully funded deferred compensation plan, results in an expense being recorded when the price of Stepan Company stock or mutual funds held in the plan rise and income being recognized when they decline.

Third quarter gross profit which excludes the SSL gains increased 23% on sales volume growth of 3%. Nine month gross profit increased 28% year-over-year on flat volume.

Turning to operating expenses, third quarter operating expenses totaled $32.4 million up 22% quarter-over-quarter and up 18% in the nine month year-to-date comparison. The major contributors to higher operating expenses across all categories were incentive-based compensations and pension expense.

We’ve also incurred consulting expenses associated with the engineering of our purchasing function which is expected to drive broad-based savings company wide.

Also note that in light of the current economic environment during the third quarter we recorded $700,000 in higher bad debt reserves for potential risk at specific customers.

Now let’s move to a review of the performance of our three key business segments. First we’ll look at surfactants. The largest segment of our business accounting for 75% of total net sales in the first nine months of the year is up 27% year-over-year. Volume declined 1% in the nine month period as compared to the year ago.

Surfactant gross profit increased by $10.9 million or 46% to $32.2 million in the quarter driven by improved product and customer mix coupled with recovery of higher raw material costs and selling prices. For the nine month year-to-date period surfactant gross profit increased $31.3 million or 46% to $99 million. We continue to see strength and sales of higher value added surfactants in the distributor, agricultural and oil field markets.

Average [softener] margins showed a nice recovery over 2007 levels and biodiesel profitability improved as we migrated our feed stock formulation from the traditional soybean oil to lower cost tallow.

With regards to the decline in the price of crude oil it is yet to translate into lower raw material costs for Stepan. However, we currently expect to see some initial positive impact for more raw material pricing sometime in the coming quarter.

Moving now to our polymer segment, which represented 23% of total sales in the first nine months of the year, quarterly net sales of polymers were up 20% year-over-year. Volume grew 5% quarter-over-quarter and 4% in the nine month period as compared to the year ago. Polymer segment gross profit declined $1.1 million in the third quarter, down 11% to $8.9 million, while nine month polymer gross profit increased $0.5 million or 2% to $34.6 million.

The company’s polyol product experienced a 15% increase in volume. Though higher raw material costs and added shipping costs associated with the supplemental supply for the European market with product from our global manufacturing system facilities negatively impacted margins and gross profit, recent debottlenecking efforts in Germany has elevated production capacity, near the current demand levels.

European polyol demand continues to benefit from consumers looking for energy saving insulation materials as well as energy efficient regulatory standards in the European region.

Expansion of the Wesseling German facility is planned for a two phase process which will provide additional long-term capacity beyond the current debottlenecking product gains. While recessionary economic factors led to lower sale volume of phthalic anhydride or PA to the merchant market due to lower demand from sectors such as automotive, recreational vehicles and boating industries, we did experience higher internal demand within for Stepan for PA from our growing polyol product lines which provide some offset.

PA sales volume was down 15% year-to-date. I would point out that that we will be conducting our triennial maintenance turnaround for our phthalic anhydride and polyol manufacturing facilities at Millsdale, Illinois during the fourth quarter. As such we do expect slightly higher fourth quarter maintenance and outsourcing costs in our polymer segment. Longer term this maintenance exercise is expected to yield improved reliability in 2009 and beyond.

And finally our specialty product segment which accounted for 3% of the company sales in the first nine months of 2008, up 21% year-over-year. Specialty products third quarter gross profit declined 29% for the quarter and 10% for the nine month period, impacted by lower volume of higher margin pharmaceuticals and food ingredient products.

Looking at other income and expenses, interest expense rose 2% for the quarter in nine month period due to higher average debt levels bought out by increased working capital requirements.

Included in other net income and expense, we recorded a loss of $1.5 million for the quarter, associated with mutual fund investments held for the deferred compensation plan which is partially offset by quarterly foreign exchange gains of $900,000.

Our effective tax rates for the quarter in year-to-date were 30.2% and 31.3% respectively, compared to 32% and 33.1% in our respective year ago periods. The decline in the rate was primarily due to the favorable impact of increased foreign generated income, taxable at lower rates than here in the U.S.

Turning to the balance sheet, consolidated debt as of September 30, 2008 was $149.6 million, up from $139.1 million in the year ago period. Our total debt to total capitalization at quarter end was 38.3% compared to 40.8% in the third quarter of 2007.

Capital expenditures were $16.6 million in the third quarter, up 117% for the same quarter last year. Third quarter 2008 CapEx included the $6.4 million for the new office building. On a full year basis we expect our 2008 CapEx budget projection to be in the $50 million to $55 million range including the office building.

Dividend increase. We were pleased to announce that yesterday the Board of Directors approved a 4.8% increase in the company’s quarterly cash dividend to $0.22 per share. This brings the annual dividend rate to $0.88 per share and marks the 41st consecutive year in which the dividend on its common stock has been increased.

We’ve also previously announced a strategic joint venture with Nalco Holding Company to globally market custom engineering chemical solutions for maximizing the production of crude oil and gas from existing fields.

Our enhanced oil recovery, or EOR technologies, operate under the TEORCO brand, with Nalco providing extensive reach in the global energy markets as well as its EO polymer and reservoir expertise. Stepan lend the JV its global surfactant technology and manufacturing capabilities. The joint venture is equally owned by Stepan and Nalco.

Before I open the call to questions, let me provide our perspective on the current economic environment, as well as our outlook for record 2008 earnings.

Overall, we believe we’ve been taking steps which should help Stepan navigate the current economic downturn, including implementing price increases to recover higher raw material prices, and as a significant portion of our surfactant sales are tied to consumer spending on laundry and personal wash products, we feel Stepan is better positioned from a recession perspective.

These segments have historically proven more recession proof than the broader economy. We continue to see strong demand for our polyol use in flat roof foam insulation. Energy savings and higher energy standards are expected to continue to drive the demand for polyol. We’ve only recently started to see some announced decreases in raw material costs.

We expect to see more of the favorable impact of raw material reductions in 2009. We believe the total company results for the fourth quarter should be stronger than last year and contribute to record results for 2008.

This concludes my prepared remarks. At this time I would like to turn the call over for questions. Operator, please review the instructions for the questioning portion of today’s call.

Question-and-Answer Session

Operator

(Operator Instructions). We do have a question from George Gasper – Robert Baird.

George Gasper – Robert Baird

I had a question in terms of product development on the oil seal side. Is there any update that you can give us for the past quarter and what the price prospects might be there?

James E. Hurlbutt

We are seeing pilot activity where we do have orders for pilot floods in 2009. Some of the pilot work that’s been done this year with small scale pilots reconfirm that the enhanced oil recovery technology works in the right field with the right chemistry, generates higher yields of oil. We still expect that market to develop.

People have asked about the impact of lower crude oil. I think most of the people pursing enhanced oil recovery had a longer term view. I don’t think many people feel that crude is not going to be more expensive over the long haul, so even at the current prices enhanced oil recovery is very attractive.

In terms of impact on financial results for 2009, probably not a significant contributor in 2009, but with continued success in pilots’ floods we would expect it to have a more material contribution to earnings in 2010.

George Gasper – Robert Baird

Then just an overview on the expansion domestically and internationally, both on the surfactant side and the polyol side at this point. Can you highlight if you’re making additions at this point in time and when they might be effective?

James E. Hurlbutt

As we previously announced, we are going ahead with an expansion in Germany that will roughly double the capacity of the German polyol units. That probably will, because of construction lead times, that would not add capacity until at this point, probably mid-2010, at the earliest.

And then in terms of surfactants we’ve added fabric softener capacity here in the U.S. in Winder, Georgia and brought that online this year. We added a multi-purpose reactor in Brazil last year. We have no current plans for further expansion, pending outcome of what enhanced oil recovery might bring.

We would like to use up our North American sulfination capacity for EOR, should that opportunity continue to develop. In terms of global footprint, the only site we are actively looking at is India, but we’re still studying that market and have not made a firm commitment to any firm assets on the ground in India.

George Gasper – Robert Baird

Then, lastly, the polyol, the insulation aspect of the market, can you describe where the strength is geographically on that?

James E. Hurlbutt

One of the pleasant surprises of the increased energy standards in Europe plus, I think, the global desire to improve, everyone’s desire to improve their green footprint is certainly helping, but the volume of growth has been in Europe primarily. But we’re seeing fairly strong volumes still in North America.

So, despite all of all the concerns about construction downturns, even though most of ours is in commercial construction that could slow down as well, but what we’re seeing is the fact that when you do go replace a roof, which approximately 70% of our material goes in replacement roofs, the tendency is to increase the thickness of the foam on the roof.

So even with fewer roof replacements, but a higher depth of insulation foam, we would stand to benefit over the short term. Still what we’re hearing from our customers and still what we believe is in store in the near term.

Operator

(Operator instructions) We have a question from [Daniel Reisel] from Sidoti & Company.

[Daniel Reisel] – Sidoti & Company

With the prices we see just initiated in polyols, I mean, are there going to be further price increases in either segment or in any of the segments, I should say?

James E. Hurlbutt

Well, you have to recall that going into the fourth quarter, we were still recovering from higher raw material costs and price increases handed to us effective October 1st. The impact of crude coming own has not yet been reflected in any of our raw material costs, so yes, we’ve got price increases through in the fourth quarter.

First quarter, boy, it’s going to a volatile situation because raw materials now do look like they’ll be heading down so I wouldn’t expect price increases going forward. The question is how much of the raw material savings do we keep versus share with our customers and that will be the challenge.

[Daniel Reisel] – Sidoti & Company

Okay, and that will be decided as you go along I would assume?

James E. Hurlbutt

Yes, I mean, it’s been so volatile with crude bouncing all over the place, but we have seen announced price reductions in some of the commodity type products for November and December.

[Daniel Reisel] – Sidoti & Company

With the current capacity you have, not with your building, what percentage are you operating at right now?

James E. Hurlbutt

You really have to separate the segments. In polymers, particularly polyol, we have a little bit of capacity left in North America. We’re probably at about 85% to 90%. We’re sold out in Europe. I mean we’re importing from the U.S. and China, and then China’s probably running at about 30% of capacity. So we have room in China to grow into that market. Unfortunately, the European market grew much faster than the Chinese market where we have excess capacity.

In terms of surfactants, we’re pretty tight across most our platform except for sulfination and primarily right here in Illinois, so the opportunity in EOR is really targeted to mesh nicely with available capacity right here in Illinois which we’re probably in the 75% to 80% of capacity.

[Daniel Reisel] – Sidoti & Company

And I mean, I know the people of long term use will still use EOR but have you seen any potential customers like maybe possibly not having the financing or not having the ability to buy surfactants given with what went on in maybe some of these small oil companies?

James Hurlbutt

We have not seen that yet. Now, will the volume of interest wane over time, I don’t know. In our traditional core business of polymers and surfactants we’re really seeing no disruption, quite surprisingly we’re seeing no disruption from the tightness in the credit markets. I mean our customers are ordering, they’re paying their bills on time, our suppliers are supplying

We’re seeing minimum disruption and so from that perspective no, we’re not seeing people coming back and saying we just can’t go forward with this because of cash.

Operator

Your next question is from George Gaspar – Robert Baird

George Gasper – Robert Baird

Yes, one question on the earnings thing – that you were to back out, Jim, the extraordinaries on land sale and the product sale and crank through the cross structure on incentive side, what would your number be for earnings versus last third quarter?

James Hurlbutt

Well we gave you the after tax on the two asset sales total $1.6 off the top of my head. You’re talking about the higher pension incentive-based compensation accruals?

George Gasper – Robert Baird

Yes.

James Hurlbutt

That would probably easily get to another $0.20 per share.

George Gasper – Robert Baird

And of course that is generally a flow through, that particular item is a normal flow through on a quarter-to-quarter basis?

James Hurlbutt

Yes, operating income; they get to charged operations.

George Gasper – Robert Baird

And then on the raw materials side, based on the decline in price, how far out have you bought raw material at potentially higher prices? Or maybe haven’t, could you give us a little bit of thought on where the company is on its raw materials costs going forward?

James Hurlbutt

Yes the vast majority of our raws are bought on spot pricing or we’ll get a quarterly quotation from suppliers. So we’re not out too long, I mean we’re going to have to consume some higher price raws in the fourth quarter. That’s why I indicated we’re not expecting to see a significant benefit from any raw material reductions in the fourth quarter.

We’ll probably see more of that in the first quarter and into 2009 as we consume our existing higher raw material costs. You had a second part to that question?

George Gasper – Robert Baird

Well the was just basically I was just thinking about the oil and gas aspect of what’s happened on the raw material decline side and how far out you've hedged and you pretty well have answered that.

James Hurlbutt

Yes, on the energy side we do have some contracts on natural gas so we have bought out on natural gas and natural gas has plummeted too. So we are over the market on natural gas. Should the current spot, forward prices stick but not, we don’t think we’re out – I mean it’s a big exposure for us and if natural gas comes back we’ll still be close to market.

George Gasper – Robert Baird

And then on your indication of some relief on your sales prices moving upwards, doing some adjustment, are you effectively able to get these sales price increases through at this point in time considering what’s happening in the economy? And is the market such that you feel that they can implement it and stick?

James Hurlbutt

Well I think our customer base for the large part is pretty well informed about what our raw material costs have been doing for the last 18 months. So yes, I think the customer base understands and quite honestly as we’ve indicated with a significant portion of our volume in say surfactants being into laundry and cleaning compounds, these aren’t areas that are where people cut back on consumption dramatically.

So we’re not seeing pushback in terms of customers volume coming down or problems with their financing. So unless there’s going to be a delayed reaction, I mean we’re very pleased with the limited impact we’re seeing right now from the economic downturn.

George Gasper – Robert Baird

And then in terms of the impact there was– in your release you made a comment about maybe trying to get some sales opportunity in the quarter from possibly lower inventory levels incurred in the third quarter. Maybe something to do with the seasonal weather, hurricane situation; exactly what did that hurricane situation impact the company on and an you describe that at all?

James Hurlbutt

Sure, sure, just to back up after the most of the plants in the Gulf Coast went down on a planned preventative basis and when they, after the hurricanes didn’t really do much damage to the plants they were ready to come up but they were – the electrical supply was down in a large part of the area and they had one or two delays coming back up.

As a result a lot of their commodity feed stocks went on force majeure. From our standpoint we did a lot of juggling. We have a plant in Canada that they would get ethylene oxide from Dow's Canadian plant, so we were able to juggle and logistically provide most of our customers needs with minimal disruption.

That being said, inventory levels probably were depleted to a fairly low level, both in our tanks and our customer's tanks and certainly our supplier's tanks. So from the standpoint of – if we are truly heading into a recession the first thing people do to conserve cash is bring their inventory levels down.

I don’t think they’re going to have much ability to do that in the fourth quarter or first quarter next year. I think that’s already happened for the most part.

Operator

We have a question from Steve Schwartz – First Analysis

Steve Schwartz – First Analysis

Can you talk a little more about the supply and demand situation in Europe? In the release you mentioned debottlenecking helped you get close to demand levels. I think earlier in the call you mentioned the expansion would be done in 2010.

So it looks like the segment had a margin hit because of importing material. What do you see over the next couple of quarters, especially considering there’s a slowdown going in Europe. Do you think your margins will continue to be impacted for say the next two or three quarters?

James Hurlbutt

Well we don’t anticipate bringing much material from China or North America into Europe. We believe they’re going to be able to meet their – and there is some seasonality in the polyol business as construction slows down. So regardless of whatever recession impacts are there would normally be some seasonality.

So we think we’re going to be able to meet all of our sales requirements from local production. So that would help improve margins in the fourth quarter and first quarter of next year. Coupled with we did have price increases, so I mean we expect to see improved margins.

How quickly demands start to move up in Europe will dictate whether or not we’ll have further outsourcing next year. Our expectation is that by the second half of next year, we probably will have to start bringing some material into Europe from either North America or China. And so we could have a little bit of outsourcing premiums.

Steve Schwartz – First Analysis

Did your regional sales managers know when taking these orders that you guys might be paying a little more to get the materials? Or was there a strategic reason for taking the business or were they just trying to book as many orders as possible?

James Hurlbutt

Well we have the available capacity at other plants, so we hate to turn down an order and cause any inconvenience for our customer base if we got capacity in the system. And on a cash basis we weren’t losing money we were making money. It just wasn’t as much because we had the higher freight costs.

So strategically for our long-term relationship with our customers it absolutely makes sense. We want to make sure we’re based loaded for the expansion in Europe in 2010. So yes, all things considered these were all weighed into the decision to continue to supply from other locations.

Operator

We have another question from George Gaspar – Robert Baird.

George Gaspar – Robert Baird

Yes Jim, one follow -up on the currency translation, outlook considering comparisons and currency around the world at this present time. Do you see any factors – how would you see the factors plus and minus for the company in the fourth quarter?

James Hurlbutt

We’ll have, at least right now it’s probably one of the most volatile times I think most of us have ever seen in the foreign currency markets, but right now, we would probably expect to see net foreign exchange gain on foreign currency gains.

In terms of translating our profits back from foreign locations obviously that will incur a hit. But I don’t think net-net the combined effect would be a negative on the fourth quarter.

Operator

And we have no other questions at this time.

James Hurlbutt

Okay, well thank you very much for participating in today’s call. Goodbye.

Operator

Ladies and gentlemen that does conclude the conference call for today. Thank you for your participation.

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