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Stepan Company (NYSE:SCL)

Q2 2013 Earnings Conference Call

July 24, 2013, 2:00 PM ET

Executives

Quinn Stepan, Jr. – President, Chief Executive Officer

Jim Hurlbutt – VP, Chief Financial Officer

Analysts

Jason Rogers – Great Lakes Review

Beverly Machtinger – Grace & White

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Second Quarter 2013 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). And as a reminder, today’s conference is being recorded Wednesday, July 24, 2013.

It is now my pleasure to turn the conference over to Jim Hurlbutt, VP and CFO. Please go ahead, sir.

Jim Hurlbutt

Good afternoon, and thank you for joining the Stepan Company’s second quarter 2013 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 Security 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 thank you all for joining us today. Looking at our second quarter 2013 performance, Stepan delivered higher net income of $22.7 million, up 6% from the year ago quarter with volume growth of 4% and net sales increasing by 1%. Excluding deferred compensation net income was $20.4 million down 10%.

Within our core business lines, our Polymer and Specialty Products segments both delivered higher earnings as well as net sales growth. Surfactant earnings and sales declined, on a unfavorable sales mix and the utilization of higher raw material cost inventory build to support our Singapore plant start-up. This combined with a subsequent decline in commodity prices negatively impacted our first half surfactant results by $3 million. These factors and a rise in operating costs, which Jim will walk through later on the call, contributed to first half operating results below last year.

We remain optimistic about our long-term growth and are taking strategic steps to strengthen our platform for growth. To that point, during the quarter, we completed our largest acquisition as we purchased the North American polyester resin business from Bayer MaterialScience. This included the 21,000 ton expandable production facility located in Columbus, Georgia. The acquisition significantly expands Stepan’s polyol product offerings and strengthens Stepan’s position as the leading global producer of polyester polyol. This acquisition diversifies our polyol offerings and accelerates our efforts to grow in the coatings, adhesives, sealant and elastomers markets, or CASE markets, as well as the push of polyurethane system house applications.

We are already implementing projects to expand the capabilities at the plant site. The acquired business has annual sales of approximately $64 million, and we expect the acquisition to be slightly accretive to our 2013 earnings and be a future source of growth. As part of our comprehensive and ongoing approach towards generating shareholder value, Stepan returned $7.1 million to common and preferred stockholders during the first half through cash dividend distributions. The Board of Directors of Stepan Company has also declared a quarterly cash dividend of $0.16 per share, to common stockholders of record on August 30, 2013.

At this point, I would like Jim to walk through Stepan’s second quarter results.

Jim Hurlbutt

Thanks, Quinn. Turning to revenues, total net sales for the quarter were $474 million, up 1% versus the year ago quarter. The net increase in second quarter sales was primarily related to higher volumes which accounted for a 4 percentage point increase in sales. This was partially offset by lower selling prices which accounted for 3 percentage point decline in sales. The decline in selling prices was brought on by lower commodity raw material costs.

Net income attributable to Stepan Company on a GAAP basis for the second quarter totaled $22.7 million, up 6% from the year-ago quarter. GAAP EPS was $0.99 per diluted share, up 5% versus the year-ago quarter. The impact of deferred compensation reduced GAAP diluted earnings per share by $0.10 in the second quarter of 2013. Deferred compensation plan income was largely attributable to a decrease in the share price during the quarter.

Second quarter non-GAAP net income which excludes approximately $2.4 million in deferred compensation expense declined 10% to $20.4 million versus the year-ago quarter. Non-GAAP EPS was $0.89 per diluted share, down 10% from the year-ago quarter.

A detailed table outlining the financial effect of the deferred compensation plan has been provided in the earnings release as table two for your reference.

Also, please see table three in our earnings release for a summary of the effects of foreign currency translation on net sales and key income line items for the quarter and year-to-date periods.

Second quarter 2013 gross profit rose less than a percentage point year-over-year to $73.7 million. Core operating margins remain stable when excluding higher-priced methyl ester inventories built to support the Singapore plant startup combined with contractual selling price lags.

Turning to quarterly operating expenses, which excluding deferred compensation increased by $4.3 million or 12% during the quarter, approximately $1.1 million of the increase relates to growth initiatives including patent expenditures for metathesis technologies, acquisition cost related to the business acquired from Bayer MaterialScience and European product registration costs for our Singapore-produced methyl esters. The majority of the remaining higher spending related to salary, travel and legal expenses to support global growth opportunities outside of North America, including support of our Lipid Nutrition business in Europe.

Looking now to net interest expense for the quarter of $2.3 million, which reflects a 12% - an increase of 12% versus the year ago period largely due to higher average debt levels resulting from the second quarter polyester polyol business acquisition from Bayer MaterialScience. Year-to-date effective tax rate was 27.5% compared to 31.7% a year ago. The lower rate was due to the retroactive reenactment of the U.S. research and development tax credit, which resulted in the 2012 and 2013 credit, all being recognized in the 2013 income tax provision. The retroactive component lowered our year-to-date effective tax rate by 2.8%.

Let’s move now to a review of the performance of our three key business segments. First, we look at surfactants, the largest segment of our business accounting for 70% of company-wide sales in the second quarter. Net sales of surfactants totaled $331.1 million for the quarter, a decrease of 1% versus the year ago quarter. Surfactant sales volume rose 5% for the quarter with all geographic regions contributing.

Sales of consumer cleaning products led the growth with surfactants used in agricultural products continuing to deliver strong volume growth. Sales of functional surfactants used in oilfield applications including enhanced oil recovery declined.

Latin American sales volume grew by 15% with Brazil contributing the majority of the increase. Surfactant gross profit declined by 7% to $48.3 million for the quarter. Lower North American sales of functional surfactants into the oilfield market including the enhanced oil recovery market combined with reduced profitability from our biodiesel sales both contributing to the weaker results.

North American consumer products, earnings were reduced by consumption of higher priced raw material inventories built to support our Singapore plant started up. Europe and Latin American surfactant profits were both higher and improved consumer product sales volume.

Moving on to our polymer segment representing 25.5% of total sales in the second quarter. Net sales totaled $121.3 million, a rise of 6% versus the year-ago quarter. Polymer sales volume grew by 1%. Polyol used primarily in the insulation foam grew by 6% with both North American and Europe contributing to the increase, while lower phthalic anhydride sales volume partially offset the growth in polyol volume.

Polymer gross profit grew by 15% to $19.9 million due to solid growth in polyol volume in North America and Europe. The contribution from China declined 1.1 as the plant shutdown as planned to relocate at the government’s request. Customers will continue to be supplied Stepan’s U.S. and European plants and toll production in China, which will result in near-term lower margins. Construction of our new plant in China is anticipated to take 18 to 24 months.

The polyol business acquired from Bayer MaterialScience added a small contribution to the quarter.

Finally, we’ll look at the specialty products segment, which accounted for approximately 4.5% of total sales in the second quarter with $22 million in net sales rising 4% from the year ago. Specialty products gross profit grew by 19% year-over-year to $6.6 million and sales volume rose 4%. The favorable sales mix of our nutritional supplement and pharmaceutical products led to the improvement.

Turning to the balance sheet, total debt as of June 30, 2013 was $285.4 million, up $91.5 million in the sequential quarterly comparison, and up $103 million versus the year-ago period. The increase in total debt includes the company securing $100 million through a new private placement done as well as the repayment of $60 million of U.S. revolver borrowings that had been used from the Bayer acquisition on June 3, 2013. The new 3.86% notes have a final maturity of 12 years was straight-line amortization in year 6 through 12, resulting in an average life of 9 years. Terms and conditions are substantially equivalent for those in our existing long-term debt agreements.

As of June 30, 2013, net debt representing total debt line of cash was a $178.6 million, up $39.5 million sequentially quarter, with total debt and balance sheet cash increasing by $91.5 million and $52 million, respectively. Net debt increased by $52.7 million from the same quarter a year ago, with total debt up $90.1 million and cash up $37.4 million.

As of June 30, 2013, inventories, net of LIFO reserves, totaled a $171,8 million, a decrease of $5.6 million versus the sequential quarterly comparison. Compared to one year earlier, inventories were up $33.9 million, reflecting higher levels to support the startup of the Singapore plant and to support the plan shutdown of the China polymer plant, as well as supporting improved customer service levels in general.

Our total debt-to-capitalization as of June 30, 2013 was 35.9% compared to 30.5% for the year-ago period. The ratio of net debt to capitalization as of June 30 was 26% compared to 21.9% for the year-ago period.

Capital expenditures were $21 million for the second quarter and $42 million for the first half. Looking forward, we project full-year 2013 capital expenditures to be within the range of $100 million to $110 million.

Turning to cash flow, second quarter cash flow from operations was the source of $51.7 million compared to a source of $32.1 million for the corresponding quarter in 2012. For the second quarter of 2013, inventories were $12.5 million cash source versus $4.8 million use for the comparable year ago quarter. Following the expansion of our share repurchase authorization, during the second quarter Stepan purchased 27,000 common shares in the open market for a total of $1.4 million.

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

Quinn Stepan, Jr.

Thanks, Jim. As we look at the second quarter, or look at the second half, global surfactant consumer product volumes should continue to grow, particularly in Brazil. Higher raw material cost inventory build to support our Singapore plant startup and the subsequent decline in commodity prices will potentially negatively impact our second half by up to $1.7 million.

The Singapore methyl ester plant is operational, and should contribute to earnings. Surfactant sold for used and enhanced oil recovery are expected to improve compared to the slow first half. Demand for agricultural surfactants should remain strong.

The polymer segment is experiencing steady improvement in polyol volume after a slow start due to the protracted winter weather delaying many roofed installation projects. The second quarter acquisition of the North American polyester resin business from Bayer should be modestly accretive to earnings in 2013 and more so, as we add capacity to manufacture additional polyol products.

The slow start to the year will make full year earnings growth an aggressive target. We remained focused on our strategy and will continue to pursue investments that can accelerate our growth.

Before I open the call to questions, Jim Hurlbutt will be retiring from Stepan following a successful 31-year run with the company. On behalf of myself and the Board of Directors, I would like to take a moment to personally thank Jim for his contributions and service to Stepan.

Jim will remain on for a period of time to assist with the smooth transition as Scott Beamer takes on the role of Vice President and Chief Financial Officer on August 15. Scott will join me on our next quarterly call. Scott comes to Stepan after a 16-year career at PPG industries, most recently as Assistant Corporate Controller, prior to that acquisition, Scott was chief Financial Officer of the European region for PPG.

This concludes our prepared remarks. At this time, we would like to turn over the call for questions. Jennifer 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 Jason Rogers with Great Lakes Review. Please go ahead.

Jason Rogers – Great Lakes Review

Hi, guys.

Quinn Stepan, Jr.

Hello, Jason.

Jason Rogers – Great Lakes Review

Jim, congratulations on the retirement.

Jim Hurlbutt

Thank you, Jason.

Jason Rogers – Great Lakes Review

Just looking at the release, you’ve mentioned some bad debt expense related to European customer risk, and I’m wondering if you could expand on that.

Jim Hurlbutt

Yeah, what we’ve been doing because of the economic situation in Europe, we do not want to turn down new business or customers trying to grow their businesses, but we have built some incremental reserves relative to specific accounts where we think there is an opportunity to grow with them but where they may not have the balance sheet that gets us as comfortable as we would normally like when we extend credit. So we have accrued some incremental reserves relative to the risk associated with probably less than a dozen accounts in Europe, and we monitor that situation. They are not yet bad debts in the sense that they’re not write-off. So we’re working with those customers and we hope that, if they’re prosperous and get through this recession in Europe, we won’t need those reserves, but we tend to be conservative from a balance sheet and a risk standpoint.

Jason Rogers – Great Lakes Review

Okay. And Jim, could you – if you have it mention what the accounts receivable and accounts payable were?

Jim Hurlbutt

Yeah, no problem. So the accounts receivable at June 30 were $283.5 million compared to year-end of $255.9 million, and payables were $156.8 million compared to $141.7 million at year end and then if you didn’t pick up the inventory earlier, it’s $171.8 million versus $162 million at year end.

Jason Rogers – Great Lakes Review

Okay. And then looking at that $1.7 million, or up to $1.7 million for the higher cost inventory, will the majority of that hit the third quarter or is that going to be evenly spread in the second half?

Jim Hurlbutt

Probably the majority will hit in the third quarter and that number could go up or down depending on any further movements in the price of coconut oil.

Jason Rogers – Great Lakes Review

Okay. And then do you have a estimate for the tax rate for the second half of the year?

Quinn Stepan, Jr.

The full year, I think we’re looking at probably 30.

Jim Hurlbutt

Let me just double – I’ve got something, I can double check that one.

Jason Rogers – Great Lakes Review

Okay. While you’re looking at that, just wanted to get an update on the enhanced oil recovery. I guess the release mentioned you expect some improvement there going forward?

Quinn Stepan, Jr.

We expect some improvement in the second half versus the first half. A number of projects have been delayed into second half of 2013 and into 2014. So we still have a fairly robust portfolio of opportunities that we’re working on, over 28 at this point in time that are active projects in our portfolio, but the timeframe for our customers implementing those continues to be extended. So we would anticipate is the moderate improvement in – second half of 2013 and with continued gains in 2014, but not a breakthrough performance in either the second half of 2013 nor in 2014.

Jason Rogers – Great Lakes Review

Thank you very much.

Jim Hurlbutt

Jason, the full year tax rate is expected to be around 30%.

Jason Rogers – Great Lakes Review

Thanks a lot.

Operator

(Operator Instructions). And our next question comes from the line of Beverly Machtinger with Grace & White. Please go ahead.

Beverly Machtinger – Grace & White

Hi, Jim and let me congratulate you also on your retirement.

Jim Hurlbutt

Well, thank you, Beverly.

Beverly Machtinger – Grace & White

Yeah. This is good news to you. I have a question a little bit about your operating expenses in this quarter in both selling and general administrations really had a pop with – I don’t know, I guess my question is how many – how much of that pop is really non-recurring and what do you feel is going to be the...

Jim Hurlbutt

Yeah. We think for the quarter that at least $1.1 million was clearly identifiable was non-recurring. Some of the other legal expenditures while recurring, we wouldn’t expect to continue quite at that rate, but yeah, keep in mind, some of this was planned growth and operating expenses to support what we are trying to accomplish from a growth standpoint around the world.

Beverly Machtinger – Grace & White

So would the second quarter numbers be a fair reflection of what to expect in the third quarter or might we see a little bit of a dip down going forward?

Jim Hurlbutt

No, no. It should not be, we would expect to be probably at least a $1.1 lower in the third quarter.

Beverly Machtinger – Grace & White

Okay, great.

Quinn Stepan, Jr.

And we are also trying to reduce our expenses across the board a little bit to help improve the results for the second half.

Beverly Machtinger – Grace & White

Okay. And also I was wondering if you could just give us some sort of idea of what’s going on in the markets in Europe and how things are progressing. Are you starting to see a general recovery or are things still as weak as they’ve been for the past 1 to 2 years?

Quinn Stepan, Jr.

I would say overall our business in Europe is flat for the most part. We have seen increased price activity in our surfactant market and also in the polymer market. So we have, specifically in polymers, our volume is growing, but it really is as we move into the adjacent metal panel market versus the historic lamination market. So we have some increased volume and also some enhanced price competition in the marketplace for polymers; for surfactants business is relatively flat over year-on-year as well with some minimal price activity, particularly in the UK.

Beverly Machtinger – Grace & White

So is that just do you feel just the general weak economic conditions or do you think that there is increased competition or perhaps…?

Quinn Stepan, Jr.

We do believe there is weak economic conditions in the UK, I’m sorry, in overall and Europe, which is causing some increased competitive activity.

Beverly Machtinger – Grace & White

Okay, great. Thank you.

Quinn Stepan, Jr.

Thank you, Beverly.

Operator

There are no further questions at this time. I will now turn the call back to management.

Quinn Stepan, Jr.

Great. Thank you. And I’d like to thank everyone for joining Jim and I on the call today, as well as the entire Stepan team worldwide for their dedication and ability to deliver value to you, our shareholders.

Jim and Scott planned to visit many of you in the next several weeks as part of the transition. Scott and I look forward to reporting back to you on our third quarter 2013 results call.

As this is your last call, Jim, any final comments?

Jim Hurlbutt

I would just like to say thank you to everyone and I’ve had the pleasure to work with the people of Stepan and accomplished much particularly over the last five years, and the future is full of opportunity. Thank you.

Operator

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

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