Luis Rojo - VP & CFO Quinn Stepan - Chairman, President & CEO.

David Stratton - Great Lakes Review Michael Harrison - Seaport Global Securities Curtis Siegmeyer - KeyBanc Capital Markets.

Ladies and gentlemen, thank you for standing by. Welcome to the Stepan Third Quarter 2018 Earnings Call. [Operator Instructions]. As a reminder, this conference is being recorded, Wednesday, October 24, 2018. I would now like to turn the conference over to Luis Rojo, Vice President of Finance and Chief Financial Officer. Please go ahead, sir..

Good morning, and thank you for joining Stepan Company's third quarter 2018 financial review. Before we 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 of our foreign operations, global and regional economic conditions and factors detailed in our Securities and Exchange Commission filings.

Whether you're joining us online or over the phone, we encourage you to review the investor slide presentation, which we have made available at www.stepan.com under the Investor Relations section of our website.

We make these slides available at approximately the same time as when the earnings release is issued, and we hope that you find the information and perspectives helpful. Now with that, I would like to turn the call over to Quinn Stepan Jr., our Chairman, President and CEO..

Thank you, Luis. Good morning, and thank you all for joining us today. Stepan Company had a good third quarter, contributing to the record reported and adjusted net income for the first 9 months of 2018. Third quarter and the first 9 months adjusted net income were $26 million and $90.1 million, respectively. Up 21% and 7% from the prior year period.

These results were driven by record Surfactant earnings and a lower 2018 effective tax rate. Surfactant operating income was a record third quarter, up 38% over the prior year due to higher sales volume and improved customer and product mix as well as lower manufacturing costs.

Polymer operating income was down versus the prior year due to continued margin challenges and the lingering effects of 2017 MDI shortage in Europe, which we have previously communicated. Global rigid polyol volumes were up 4% versus the prior year quarter.

Our Specialty Products business results were up for the quarter due to the partial catch up of order timing differences encountered in the first half of the year.

The company increased its quarterly cash dividend in the fourth quarter of 2018 by $0.025 per share or 11%, marking the 51st consecutive year that the company has increased its cash dividend to shareholders. At this point, I'd like Luis to walk through a few more details about our third quarter results..

Thank you, Quinn. My comments will generally follow the slide presentation. Let's start with Slide 4 to recap the quarter. As Quinn has stated, adjusted net income for the third quarter 2018 was $26 million or $1.11 per diluted share, a 21% increase versus $21.4 million or $0.92 per diluted share in the third quarter of 2017.

Because adjusted net income is a non-GAAP measure, we provide full reconciliations to the comparable GAAP measures, and that -- and these can be found in Appendix II of the presentation and Table 2 of the press release.

Specifically, adjustments to reported net income this quarter consist of adjustment for deferred compensation expenses and resulting expenses.

Adjusted net income for the quarter exclude deferred compensation expenses of $2.6 million or $0.11 per diluted share compared to deferred compensation income of $0.8 million or $0.03 per diluted share in the same period last year. Naturally, all employee compensation expenses are reflected in our normal operating income.

However, we allow employees the opportunity to defer their incentive payouts until some future date, and the future payment changes based on the company's stock price. When the stock price increases, expense is generated as we mark this item to market value.

Because the future liability of employee compensation only changes consistently with the change in the stock price, we exclude this item from our operational discussion. The current quarter adjusted net income also excluded $1.2 million or $0.05 per diluted share of after-tax business restructuring charges.

These charges related to $1 million of after-tax assets and spare parts write-down, related to the third quarter shutdown of Surfactant operations at our German plant and $200,000 of after-tax decommissioning expense related to our prior year Canadian plant closure.

We expect an additional $500,000 of after-tax restructuring charges in 2018 related to decommissioning costs at both our Canadian and Fieldsboro plants and an additional $1 million of after-tax decommissioning expenses at our German plant in 2019.

Slide 5 shows the total company earnings bridge for the third quarter compared to last year's third quarter and breaks down the increase in adjusted net income. Because this is net income, the figures noted here are on an after-tax basis.

We will cover each segment in more detail, but to summarize, Surfactants and Specialty Products were up while Polymers was down versus the prior year. Corporate expenses were higher during the quarter due to the previously disclosed employee separation costs and higher salaries and incentive-based compensation expense.

The company's effective tax rate was 18.6% for the first 9 months of 2018 versus 26.2% for the first 9 months of 2017. The decrease was mainly due to a lower U.S. statutory tax rate of 21% in the first 9 months of 2018 versus 35% in the first 9 months of 2017. We expect the full year 2018 effective tax rate to be in the range of 19% to 22%.

Slide 6 focuses on Surfactant segment results for the third quarter. Surfactant net sales were $347 million, up 8% from the same quarter a year ago. Volume increased 9%, while average selling prices increased 2%. Excluding foreign exchange translation and the first quarter acquisition in Mexico, net sales increased 7%, while sales volume increased 4%.

Organic volume growth was mainly due to higher North America consumer products and oilfield volumes. Higher North American agricultural volume and higher sales volumes to our distribution partners in North America also contributed to this increase.

The segment operating income increased $8.6 million or 38% versus the prior year, driven by the strong demand in North America, despite higher logistic cost and foreign exchange headwind.

In the bridge, we show North America and Asia in the same category because our Surfactant business in Asia is relatively small and most of the Surfactant production in that region is used to support business in the United States.

Latin America results were down, mainly due to favorable product mix, partially offset by a strong sales volume related to the Q1 acquisition in Mexico. We continue to believe that the acquisition should be slightly accretive for the year. European results were up primarily due to higher consumer products commodity volume and improved margin.

Now turning to Polymer on Slide 7. Net sales for the quarter were $142 million, down 4% from the prior year period. Total sales volume decreased 1% despite a 4% increase in global rigid polyol volume. Lower total sales volume was principally due to lower PA volume. The translation impact of a stronger U.S.

dollar negatively impacted net sales by 1%, while selling prices declined by 2%. Operating income was $17.4 million for the quarter versus $21.1 million in the same quarter last year. Operating income was down mostly due to lower global margin and reduced volumes in Europe.

Global polyol volumes increased 3% with Global Rigid Polyol volume growth of 4%. The increase was driven by higher volumes in North America as a result of share recapture and a continued strong rigid polyol market. European volume decreased due to the lingering effect of the 2017 MDI shortage.

We believe the market for insulation material remains strong due to continued global energy conservation efforts. PA results increased due to favorable production yield. A scheduled PA maintenance turnaround will negatively impact the fourth quarter of 2018.

Specialty Products operating income was $2.7 million for the quarter, an increase of $1.7 million versus the prior year quarter, primarily due to favorable quarter timing differences within our flavor business, which compensated for some of its first half shortfall.

Turning to Slide 8, our balance sheet remains strong as our net debt remains low at 2%. The company generated $18.2 million of free cash flow during the third quarter, which represents free cash flow conversion of 70%. We returned $6.6 million to our shareholders during the quarter via dividends and share repurchase.

Beginning on Slide 9, we'll now update you on our plans to increase shareholder value..

Thank you, Luis. After achieving record net income through the first 9 months, we remain optimistic about the balance of the year.

We believe our Surfactant business will continue to benefit from our diversification efforts into Functional Products, new technologies, improved internal efficiencies and expanded sales into our broad customer base globally.

Although we expect margins will continue to challenge our North American polymer business, we believe we will continue to benefit from the growing global market for insulation materials. We believe -- we continue to believe full year Specialty Product results should improve over 2017. Turning to Slide 10.

We strengthened our leadership position as a largest producer of anionic and amphoteric surfactants for the merchant market in the western hemisphere with the BASF, Ecatepec acquisition. Although the acquisition contributed minimally to the earnings growth for the quarter, it should be slightly accretive for the full year.

The acquisition includes sales and cost synergies should contribute between $4 million to $6 million operating income in 2019. Overall, we saw continued growth in the company's commodity surfactant volume in the quarter, driven by strong performance by our North American consumer product group.

We expect that commodity volumes for the balance of the year should remain strong. We believe that volume opportunities for our Global Rigid Polyol business in the fourth quarter will partially offset lower margin, as we have substantially recaptured previously lost polyol share in North America.

European volumes are not anticipated to recover until 2019. Our diversification efforts continue to be a key component of our long-term strategy.

For the first 9 months of the year, volume from our diversification efforts was up significantly, with strong performance from our oilfield segment and our Tier 2 and Tier 3 consumer product customers, our local heroes. We believe that our diversification efforts will continue to contribute to our growth.

We remain optimistic about our CASE polyol business. Sales volume in North America increased 2% for the first 9 months of the year, supported by the new specialty polyol reactor in Columbus, Georgia. Collaborative chemistry is a key foundation of our long-term strategy.

As a leader in the rigid polyol market, we continue to work on developing the next generation of value-added technologies for our customer base and are excited about a few advances in our research pipeline.

As mentioned previously, we recently launched a new solvent for the personal care market and developed patent-pending technology for use in fracking oil wells. Our focus on operational excellence and internal efficiency remain key to our strategy. The restructure of our Fieldsboro, New Jersey plant is on track to deliver savings this year.

During the third quarter, we approved a plan to seize production -- surfactant production at our German plant to further reduce our fixed cost, refocus resources on higher-margin surfactant markets and repurpose assets to support future polyol growth.

We also believe that the application of sulfonation and best practices, network synergies and DRIVE opportunities will create value from our Ecatepec acquisition. Finally, we delivered record first 9 months results of both reported and adjusted net income.

We have returned $28.7 million to our shareholders via dividends and share repurchases thus far this year. We are well positioned to capture opportunities for you, our shareholders. This concludes our prepared remarks. At this time, we'd like to turn the call over for questions.

Christy, please review the instructions for the question portion of today's call..

[Operator Instructions]. Your first question is from the line of David Stratton of Great Lakes Review..

I think you mentioned logistics costs in Surfactants, and I was wondering if you can kind of give us some color as to what's going on there and what looks like going forward into the next quarters..

So the market for transportation, specifically, tank truck and truckload movement is very tight in North America. Quite frankly, it's also tight in Europe. There is a shortage of drivers in the United States. The American Chemistry Council estimates that there are 55,000 drivers short in the U.S. market, which represents about 8% of the total capacity.

So our logistics costs as are the logistics costs for the industry are up significantly. Our logistics costs for Surfactants in the quarter was up approximately about $2 million..

$2 million, yes. Got you. And then the....

And just a follow-up comment is that I would say that we would anticipate that logistics costs for the industry would continue to be tight as the economy is stronger, and we don't see relief unless the economy turns around..

Great. And then looking at the polyols and Polymers. Are you still seeing some of that competitive pressures? Or what's the main thing that's impacting results there? Do you want to -- could you give a little more color, please..

If we take a look at our Polymer business and let me talk about Europe first. European demand for PIR insulation has not recovered from the MDI shortage in 2017, as architects and building managers stacked in alternative forms of insulation, while MDI was short.

So talking with our customer base there, we would anticipate that we would start to see some growth in that segment beginning in 2019. We do not anticipate a recovery in the fourth quarter of this year. As we look at our U.S. business, as we've said, we've substantially recaptured the share that we've lost.

The margins are down due to competitive pressure. We don't see margins significantly improving in the quarter or kind of in the first part of 2019 at this point..

Great. And then the last one.

How impactful is the maintenance going to be in the PA side of the business?.

Order of magnitude of $1 million to $1.5 million....

$1 million to $1.5 million, yes..

Additional expense in the quarter..

Your next question comes from the line of Mike Harrison with Seaport Global Securities..

Maybe just to continue on the phthalic anhydride business. You mentioned the volumes there were weaker and that weighed on the Polymer segment a little bit, but that operating income in PA looks like it was up $1.1 million year-on-year.

Just wondering kind of what are some of the dynamics behind this volume down but margin up? I think you mentioned the yield improvement was part of that..

Yes. We benefited in the third quarter due to higher production rates in anticipation of the PA shutdown in the fourth quarter. So we were building inventory. Our yields were up slightly in that area, which also benefited results in the quarter.

Overall, the demand in the North American market, and we only are North American supplier of phthalic anhydride, is somewhat flat for the year, but we have seen some increase of imports into the United States..

And with some of the increase that we've seen in oil prices, have we seen PA prices go up as well?.

Typically, we sell phthalic anhydride with orthoxylene plus is kind of traditionally the way that the market has been sold for many, many years. So the 2 raw materials for PA are orthoxylene and air. So it tends to be orthoxylene plus.

Typically, in an inflationary environment, you may be incrementally adding to your margin a little bit as the prices move up and conversely, as prices move down, you may be losing some of that margin..

Okay. And then over on the Surfactant side, it sounds like the functional Surfactants business continues to be pretty good. Just wondering as we kind of get into the outlook for 2019 and the ag business as well as oilfield demand, if you can give us any thoughts on the momentum that you're seeing in ag and oilfield..

Yes. So first I'll talk about oilfield. As we look at our presence in the oilfield market, most of our growth that we're getting is from new technology. So relatively small presence in the big picture in the oilfield market. So we're gaining share with new technology that we're presenting to the marketplace.

And I guess, the other area is there's -- we are selling increased biocides and -- specifically, for production in the oilfield market. So those are the 2 areas that are growing for us, and we would anticipate additional momentum carrying over into 2019.

From an agricultural perspective, which is the other kind of larger segment, what we have seen is kind of increased business in North America and Europe with a slight decrease in our business in Brazil primarily as a result of the down economy.

So, again, in this area, we intend to growing our business with new business to customers, helping our customers develop new formulations for herbicides around the world. We have not got any tailwinds associated with -- from higher crop prices.

So we would anticipate incremental share growth due to new technology in new customer formulations in 2019 that we have in our pipeline. And then we would be hopeful that we get some improvement in commodity crop prices, corn, soybean, wheat that would benefit the farmers and encourage greater use of herbicides and pesticides..

And then last question from me is on the Wesseling, Germany plant shut down.

Just give us a little bit more detail on the timing and maybe the expected benefits as well as just what that means for your overall manufacturing footprint in Europe? How many plants do you have -- Surfactant plants do you have in Europe currently?.

We have three Surfactant plants in Europe today with Wesseling being one of them. We discontinued surfactant production at that site in early October. So we are no longer making surfactants at that site. We are planning on repurposing those assets longer term to support diversification and expansion of our polyol business at the site.

So the Surfactant business at that site was more or less breakeven business. And so we weren't getting a return on our invested capital associated with that. We've transferred some of that business at that site to our Stalybridge facility. So we've increased utilization at our Stalybridge, U.K. facility.

So our 2 plants that are left from a surfactant supply position in Europe are Stalybridge in the U.K and Voreppe in France..

[Operator Instructions]. Your next question comes from Curt Siegmeyer with KeyBanc Capital Markets..

I think needs to happen on the margin....

Curt, you're just coming on the speaker now. You can start over and ask your question again..

Sure. I was just wondering on the Polymer business, how the results this quarter compare to your internal expectations.

And then what sort of needs to happen in that business to kind of get margins back to where you'd like to see them? I know you said another quarter of headwinds, but just sort of trying to directionally think about how we should think about margins in '19.

Are there mix improvement opportunities or other leverage you can pull to sort of drive improvement there?.

So first of all, relative to our expectations, we are somewhat disappointed with the recovery of volume in the European marketplace. We were anticipating that we would have had -- PIR insulations would have recaptured its share kind of in the second half of 2018, which it has not done. So we're a little disappointed and frustrated by that.

From a margin perspective, what I said was I didn't think there was going to be a significant improvement in margins in 2019 -- or 2018, and I think, we would anticipate a slight margin improvement as we move into 2019..

Got it. Okay.

And then just on acquisitions kind of post BASF, what are your thoughts going forward as you head into the New Year in terms of where you would kind of focus acquisitions and how active you might be on that front?.

Well, we have a very healthy balance sheet that positions us to be active in the acquisition space. And so we would like to be more inquisitive in terms of targets that we'd be interested in.

We're interested in adding new chemistry platforms to support our Surfactant business, specifically in the oilfield and the agricultural business and potentially personal care specialties would be the kind of the 3 areas that we would highlight and that we would want to -- would be interested in and are currently working on..

And Mr. Rojo, there are no further questions at this time. I will now turn the call back to you. Please continue with your presentation or closing remarks..

Closing remarks. Thank you very much for joining us on our call today. We appreciate your interest and ownership in Stepan Company. We look forward to reporting to you on our year-end 2018 call. Have a great day. Thank you..

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