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Stepan Company (NYSE:SCL)

Q4 2012 Earnings Conference Call

February 20, 2013; 02:00 p.m. ET

Executives

Quinn Stepan Jr. - President & Chief Executive Officer

James Hurlbutt - Vice President & Chief Financial Officer

Analysts

Daniel Rizzo - Sidoti & Company

Greg Halter - Great Lake Review

Operator

Ladies and gentlemen, thank you for standing by and welcome to the fourth quarter and full year 2012 earnings conference call. During the presentation all participants will be in a listen-only mode. Afterwards we’ll conduct a question-and-answer session. (Operator Instructions).

I would now like to turn the conference over to James Hurlbutt, VP and CFO. Please go ahead.

James Hurlbutt

Good afternoon and thank you for joining the Stepan Company’s fourth quarter and full year 2012 financial review.

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.

That being said, I would now like to turn the call over to Quinn Stepan Jr., President and Chief Executive Officer of Stepan Company.

Quinn Stepan Jr.

Thank you Jim and good afternoon and thank you all for joining us today. 2012 was a good year for the company. We continue to advance our strategy, delivered our fifth consecutive record income year, increase dividends for the 45th consecutive year, increased retained earnings by $78 million and positioned the company for further growth.

Net income increased 10% to $79.4 million, while full year net income, excluding differed compensation increased 16% on 2% volume growth. Profitability improved in all three of our business segments. Net sales were $1.8 billion, down 2%, primarily related to lower selling prices, tied to lower raw material cost and foreign currency impact.

In 2012 Stepan paid $12.8 million in cash dividends to its common and preferred shareholders. Yesterday our Board of Directors announced the company’s quarterly cash dividend on its common stock of $0.16 per share and on its 5.5% convertible preferred stock of approximately $0.34 per share. Dividends remain a key part of our philosophy, of providing value to our shareholders.

Stepan’s stockholder equity has grown 70% over the last three years, from $289 million to $479 million. The health of the company’s balance sheet remains strong and will allow us to invest in attractive growth opportunities.

I am proud of what our team’s accomplished in 2012 and look forward to the challenges the New Year will bring. Overall we believe our business is positioned to deliver earnings growth in 2013.

At this point, I would like Jim to walk through Stepan’s fourth quarter and full year results.

James Hurlbutt

Thanks Quinn. I’ll start my review with a look at the top line. Total net sales for the fourth quarter were $427 million, down 4% versus the year ago quarter. The net decline in fourth quarter sales was primarily related to lower selling prices, which accounted for a 6-percentage point decline in sales. The decline in selling prices was brought on by lower commodity raw material cost.

Foreign exchange translations contributed to a 1-percentage point decline in fourth quarter sales, largely due to the weakening of the euro versus the dollar. The upper mentioned factors were partially off set by higher volumes, which accounted for a 3-percentage point increase in sales. Full year net sales declined 2% to just over $1.8 billion.

Net income attributable to Stepan Company on a GAAP basis for the fourth quarter totaled $15.4 million, up 17% from the year ago quarter. GAAP EPS was $0.68 per diluted share, up 15% versus the year ago quarter.

The impact of differed compensation reduced GAAP diluted earnings per share by $0.11 in the fourth quarter of 2012. GAAP net income for the full year rose 10% to $79.4 million, for GAAP EPS of $3.49 per diluted share.

Fourth quarter non-GAAP net income, which excludes approximately $4.1 million in differed compensation expense increased 17% to $18 million versus the year ago quarter. Non-GAAP EPS was $0.79 per diluted share, up 16% from the year ago quarter. Non-GAAP net income for the full year rose 16% to $84.8 million for non-GAAP EPS of $3.73 per diluted share.

Differed compensation expense is largely attributable to an increase in the share price of the company’s common stock, which rose $7.48 per share during the fourth quarter and $15.46 per share for the full year.

The detailed table outlining the financial effect to the differed compensation plan has been provided in the earnings release as Table II for your reference. Also please see Table III in our earnings release for a summary of the effects of foreign currency translation on net sales in key income line items.

Fourth quarter 2012 gross profit increased 17% year-over-year to $70.1 million and rose 14% for the full year to $291.6 million.

Turning to operating expenses, which rose $6.5 million or 17% versus the year ago quarter. Excluding differed compensation plan expenses, operating expense rose 19% for the quarter and 13% for the full year. Higher operating expenses included increased headcount. Global headcount rose from 1,848 people to 1,920 people during the year to support growth initiatives.

Fourth quarter research expense also included higher product registration cost in Europe. Also contributing to the higher expense in all categories was the effect of higher performance based compensation expense due to the strong operating results for the company.

Looking now to net interest expense for the quarter of $2.2 million, which reflects a decrease of 14% versus the year ago period, largely due to lower average debt levels. The effective tax rate was 31.1% in 2012 compared to 30.8% in 2011. The increase was primarily attributable to the expiration of the U.S. Research and Development Tax Credit, which was partially offset by an overall lower state effect of tax rate. The U.S. Congress has re-enacted their R&D credit in 2013, which will favorably impact the effect of tax rate in 2013.

Lets move now to review the performance of our three key segments. First, we’ll look at surfactants, the largest segment of our business, accounting for 73% of company wide sales in the fourth quarter. Net sales of surfactants totaled $310.5 million for the quarter, a decrease of 6% versus the year ago quarter. Full year net sales declined 4% for the year due to lower selling prices, which reflect lower raw material costs.

Surfactants sales volume rose 1% for the quarter and 2% for the full year. Higher value added surfactants used in agricultural products and household and industrial cleaning products posted higher sales volumes, whereas commodity surfactants used in North American consumer cleaning declined slightly as a result of lower usage levels, compensation and the weaker economy. Sales volumes in Latin America were up on gains in Brazil and Columbia.

Surfactants gross profit grew by 20% to $51.6 million for the quarter. Full year gross profit grew by 14% to $203.4 million. The gross profit improvement was largely attributable to improved product mix and margin recovery as raw material costs declined.

Value added surfactants used in agricultural products and household and industrial cleaning products posted higher sales volumes, also contributing significantly to the improvement where higher profits from Latin America, particularly Brazil due to the improved volume and operational efficiencies.

Moving onto our polymer segment, representing roughly 24% of sales in the fourth quarter, net sales totaled $103.1 million for the quarter, an increase of 9% versus the year ago quarter. Full year net sales rose 1%. Volume rose 10% for the quarter and 3% for the full year. The volume growth was primarily from polyol used in energy saving rigid foam insulation. The full year 3% volume growth included gains from new applications in metal panels and adhesives.

Polymer gross profit increased by 31% to $16.6 million for the quarter and a 10% increase in volume. The profit improvement came from both phthalic anhydride and polyol products. Polyol profit growth was attributable to a 12% quarterly volume growth, primarily from polyol used in rigid foam roof insulation.

Full year polymer gross profit rose 17% to $71.9 million. The gross profit improvement benefited from a favorable sales mix of higher value added polyol and polyurethane systems. Polyol volume rose 5% for the year. A large polyurethane systems order for an aircraft carrier and a business interruption insurance recovery related to a 2011 fire in our German polyol plant positively impacted the year.

Finally, we look at our specialty products segment, which accounted for 3% of sales in the fourth quarter. Full year sales rose 24% due to the company’s acquisition of the Lipid Nutrition business in June of 2011, but declined in the fourth quarter due to lower medium chain triglyceride volumes on increased global competition.

Specialty products fourth quarter 2012 gross profit declined to $2.9 million due to lower volume among both food ingredients and nutritional supplements. Full year gross margin grew 7% to $20.3 million, driven by the full year contribution of the Lipid Nutrition product lines.

Moving now to the balance sheet, total debt as of December 31, 2012 was $182.4 million, down $5.8 million from the sequential quarterly comparison and down $17.1 million versus the year ago period. As of December 31, 2012 net debt representing total debt minus cash was $105.5 million, down $3 million sequentially in the quarter due to lower seasonal working capital requirements.

Net debt was down $9.9 million for the same quarter a year ago due to the deflationary impact of lower commodity raw material costs on receivables, partially offset by higher quantities of inventory on hand.

As of December 31, 2012 inventories net of LIFO reserves totaled $162 million, an increase of $6.8 versus the sequential quarterly comparison. Compared to one year earlier, inventories were up $50.9 million, primarily due to higher quantities related to the Singapore start up, Brazil operations and a planned inventory build in China.

Our total debt to total capitalization as of December 31, 2012 was 27.5% compared to 33% for the year ago period. The ratio of net debt to capitalization as of December 31, 2012 was 18% compared to 22.1% for the year ago period. Capital expenditures were $22.3 million for the fourth quarter of 2012. Full year CapEx totaled $83.2 million, lower than anticipated due to timing of certain capital projects.

Looking forward we project full year 2013 capital expenditures to be within the range of $110 million to $115 million. As we undertake the relocation process of our polymer plant in China in 2013, we will also look to increase the production capacity of that facility from 20,000 to 50,000 tons annually.

Turning to cash flows, fourth quarter cash flow from operations was a source of $31 million compared to a source of $64.8 million for the same quarter in 2011. For the fourth quarter of 2012 inventories were at $6.2 million cash used versus a $25.1 million cash source for the comparable year ago quarter. On a full year basis Stepan generated $109 million in cash flow from operating activities versus $77.4 million in 2011.

During the fourth quarter Stepan purchased 23,000 common shares in the open market and yesterday the Board of Directors approved a new treasury share repurchase authorization of up to 1 million shares.

Before we open the call to questions, Quinn will provide some perspective on Stepan’s forward-looking outlook.

Quinn Stepan Jr.

Thanks Jim. Despite the headwinds from the global economy, we believe our strategy and ability to execute, provide us with an opportunity for continued earnings growth in 2013.

Our Surfactants business will continue to evolve. We will extend our commodity, consumer product business, which provide us economies of scale into emerging markets. We will improve our global product mix with greater sales into the agricultural, oil field and household and industrial cleaning markets.

Demand for crop protection chemicals is expected to remain strong. We are positioned for further profit growth in Brazil. Our Singapore plant is now operational and should contribute modestly to 2013 earnings. We believe our Surfactant business is positioned for earnings growth in 2013.

Polymers will experience continued growth from polyol use in energy saving rigid foam insulation for new and replacement roofs. New applications for our polyols in metal panels and cash products will also contribute.

Polymers will face higher cost in China in 2013 and 2014, as we complete the government-mandated relocation of our plant. We will continue to supply Asian customers with product produced from an outsourced location in China or another Stepan sites.

We anticipate the higher costs of operating in China may limit overall profit earnings growth in 2013. The company will use its strong balance sheet to pursue internal and external opportunities to accelerate and deliver value to you, our shareholders.

This concludes our prepared remarks. At this time, we would like to turn the call over for questions. Tara, please review the instructions for the question portion of today’s call.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And our first question comes from the line of Daniel Rizzo with Sidoti & Company.

Daniel Rizzo - Sidoti & Company

Good afternoon guys. With polyol sales being relatively strong, geographically where was it the strongest? Was it more of a North American thing or is Europe rebounding at all?

Quinn Stepan Jr.

Europe had a pretty good fourth quarter. It was a little bit surprising to us. It had a poor third quarter, bounced back pretty well in the fourth quarter, but the North American business kind of remains strong to the fourth quarter as well.

Daniel Rizzo - Sidoti & Company

Is it that what’s leading growth in North American?

Quinn Stepan Jr.

Our Surfactant business had a record year in North American in 2012 as well. So both our U.S. polyol business and our North American U.S. Surfactant business performed well in 2012.

Daniel Rizzo - Sidoti & Company

Okay and then you indicated you wanted to extend more into the emerging markets, and I think in the past you’ve talked about building possibility a second plant in Brazil. Is that something that’s ongoing or I don’t know if you mentioned that already or are you expanding the plant that’s already there.

Quinn Stepan Jr.

We are in the process of looking at options to expand our plant that’s already there. We will continue to look for a second site in Brazil as well.

Daniel Rizzo - Sidoti & Company

When would you have that, I mean that kind of -- I know what you are doing there, do you have any timeframe?

Quinn Stepan Jr.

We will let you know at the appropriate time.

Daniel Rizzo - Sidoti & Company

Okay.

James Hurlbutt

Dan, I think what I alluded to before is that if we are unsuccessful fighting an acceptable second site, then we would clearly have to be forced into a situation of expanding the existing site, and that would probably come sooner rather than later.

Daniel Rizzo - Sidoti & Company

Okay, great. And then you indicated that, I mean (inaudible) raw material cost declines during the quarter. What are we doing now? Is it kind of evened out or is it still going down in terms of most of your raw materials?

Quinn Stepan Jr.

I think on the Polymer side of our business we are still seeing some increasing raw materials as it’s related to petroleum oil. On the Surfactant side, they have seen stabilized at a fairly low level for coconut oil and palm oil since kind of the mid fourth quarter of 2012.

Daniel Rizzo - Sidoti & Company

Okay, thank you guys. Nice quarter.

Quinn Stepan Jr.

Thank you very much.

Operator

Thank you. (Operator Instructions). And our next question comes from the line of Greg Halter with Great Lake Review. Please proceed.

Greg Halter - Great Lake Review

Hello guys and good afternoon.

Quinn Stepan Jr.

Good afternoon.

Greg Halter - Great Lake Review

I wonder if you could comment on where you see your tax rate going for 2013. It looks like the first quarter you’ll probably get some benefit from the reinstatement of the R&D credit in the U.S., but overall where would you see your rate for the year?

James Hurlbutt

Yes, it’s down slightly. Clearly the R&D credit, its going to carry over a bit, because you get to double up, because what you weren’t able to take last year, you get to take this year in the first quarter. So I mean first quarter should be lower than the year ago first quarter and the full year should be down slightly. I wouldn’t look for a significant draft in the full year rate, but it should be down slightly year-over-year.

Greg Halter - Great Lake Review

And is that on an adjusted basis or does that include the differed comp when you are looking at that number, because I think there’s a difference, its like…

James Hurlbutt

They are all in, it’s all in.

Greg Halter - Great Lake Review

Okay, and the R&D was up quite a bit in the fourth quarter and you made some comments about product registration costs in Europe. Could you elaborate a little bit more on that aspect of the business and whether or not that continues into 2013 and whether or not that’s a good or a bad thing I guess.

James Hurlbutt

It’s actually a good thing, but let me explain why. We’ve been at this for quite a few years now. Europe has a regiment of registration of chemicals and to the extent people are unwilling to register products, they drop out of the market place. Now, that’s a small part of the benefit, but there is some benefit to it.

Particularly year-over-year though these costs have been going up for several years, but last year in the fourth quart we had a cost sharing arrangement where we got more reimbursements from other participants. So we had low costs in the fourth quarter of last year and there were…

Quinn Stepan Jr.

2011.

James Hurlbutt

2011, and then we had a more normal run rate in the full year 2012. We do not expect these costs to come down significantly in the near terms. These costs are going to go on for several more years until the extent of the registration starts to decline. But everybody in the industry is doing this; the whole chemical industry is required to register their products in Europe. Mostly it relates to toxicity testing and other types of testing.

Greg Halter - Great Lake Review

Okay, thank you. Just a couple of housekeeping items, what was the receivables balance at year end and payables and what was depreciation and amortization for the full year 2012.

James Hurlbutt

The receivables were $255.8 million compared to $260.8 million in the prior year. Inventories were $162 million versus $111 million in the prior year, and payables were $141.7 million compared to $137.8 million in the prior year and D&A for the full year was $51.3 million and that will be creeping up, should creep up several million in 2013.

Greg Halter - Great Lake Review

Okay. Relative to the plant in China and that required move, do you have any timing on that yet, the location, cost, either for that…

Quinn Stepan Jr.

We have a location picked out. The land is soon to be available to us. We probably will not start construction for another three or four months at a minimum and we would look to start off sometime in 2015. So we are going to be out of production for the majority of ‘13 and ‘14 or all of ‘14. And then we will continue to supply, we have approved a toll manufacturer in China and then we will also supply from other sites in our network, Europe and the United States.

Greg Halter - Great Lake Review

And what does that do to your cost. You made some commentary about it, that it will limit your growth there.

Quinn Stepan Jr.

We made money in China in 2012 and we will probably be looking at breaking even in that business over the next couple of years.

Greg Halter - Great Lake Review

Okay. The results of some commentary relative to the fourth quarter in the specialty products area, competitive pressure and I wonder if you could comment on that and what you see going forward.

Quinn Stepan Jr.

We’ve seen increased competitive pressure on the median chain triglyceride product line, which is our historic product line within Stepan. Increased competition from the backward integrated Asia suppliers, who have been looking to move at their 8/10 chain links into new and different markets.

So its kind of a bit of a paradigm shift in the market place and so in the past there was limited competition from outside the United States in four MCT’s and we are seeing that now. In 2013 we’ve gone back, we recaptured some of that business and the volumes will be up for 2013, but it will be at reduced margins.

Greg Halter - Great Lake Review

Okay. And from a capital allocation standpoint, I’m just wondering if you could comment on your thoughts relative to the dividend, which I presume you will continue to raise share repurchase and then mergers and acquisitions.

Quinn Stepan Jr.

From a capital perspective, Jim mentioned we have between $110 million and $115 million we are currently forecasting. We spend roughly half of that on base capital to maintain our existing facilities, but we are planning on spending about -- actually just a little less than half on gross projects throughout the world.

If we look at that from a regional perspective, roughly 50% will be spent in the United States and 50% will be spent outside of the United States.

From a dividend perspective, it is our intent to continue to pay increased dividends if we can and we are anticipating being able to do so in 2013.

James Hurlbutt

And then treasury stock, Greg is opportunistic. Our priority is to put our cash back into the business organically, whether its as Quinn said through CapEx or through acquisition opportunities that takes a higher priority than treasury stock purchases.

And we’re actively looking for acquisitions in the market place. Most of those will fall into the bolt on category that either add a new geographical location to one of our existing businesses or extend the technologies that we have to horizontal or adjacent market places. So we’d like to use some of our healthy balance sheet to do that in 2013.

Greg Halter - Great Lake Review

All right, and I know its usually asked, but wanted to get your thoughts on the performance of the elements in the EOR joint ventures and what you see going forward with each of those?

Quinn Stepan Jr.

We are out in the market introducing the elements technology or the first three technologies to our customer base today and waiting for feedback from them in terms of if they see the value in the technology that we see, and we’ve got another three of four different technologies as well that we’ll introduce sometime in 2013. So that’s proceeding according to plan and waiting for customer feedback at this point.

Form an EOR perspective, our TIORCO joint venture, we still remain enthusiastic and excited about the opportunity for the use of Surfactants to wash oil off of rocks. We are very pleased with the quality of projects within our pipeline, our project pipeline. We are disappointed with the speed at which our customers are implementing capital projects within their sites to implement the technology in the field.

So we don’t see a significant improvement or benefit from being an enhanced oil recovery Surfactants in 2013 and we remain optimistic about ‘14 and ‘15.

Greg Halter - Great Lake Review

And is that business still at a breakeven?

Quinn Stepan Jr.

It’s generating a loss today.

Greg Halter - Great Lake Review

Okay.

Quinn Stepan Jr.

Investment, an investment, its not a loss.

Greg Halter - Great Lake Review

Okay, thank you.

Operator

Thank you. (Operator Instructions). Thank you. I’ll now turn the call back over to you, to the senior management.

Quinn Stepan Jr.

I’d like to thank everyone for joining Jim and I on the call today, as well as the entire Stepan team for their dedication and their ability to deliver value to you our shareholders. We look forward to reporting back to you on our first quarter 2013 results. Have a great day.

Operator

Thank you. Ladies and gentlemen, that does conclude the conference call for toady. We thank you for your participation and ask that you please disconnect your lines.

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