Stepan Co (SCL) 2006 Q2 法說會逐字稿

Welcome to the Stepan Company second quarter earnings results conference call. (OPERATOR INSTRUCTIONS). As a reminder, this conference is being recorded Wednesday, July 19, 2006. I would now like to turn the conference over to Jim Hurlbutt, Vice President, Finance for Stepan Company.

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 contained in the Company's Securities and Exchange Commission filings.

I will now take a few minutes to review our second-quarter operating results. Net sales for the second quarter of 2006 increased 5% to 292 million from 278 million for the same period in 2005. Higher selling prices resulted in an 11% increase in sales that was partially offset by a 6% decline in sales due to lower sales volume.

The net income for the second quarter was 3.1 million, or $0.31 per diluted share, compared with net income of 6.2 million, or $0.64 per diluted share a year ago.

Gross profit declined by 1.5 million, or 4%, to 33.2 million, due to a decline in polymer earnings that more than offset improvement in surfactant earnings.

Operating income decreased 34% to 6.9 million for the second quarter of 2006, from 10.5 million for the same period a year ago. Operating expenses rose by 2 million, or 8%, due to higher deferred compensation expense and legal expenses.

Now I would like to highlight the performance in each of our three segments.

We begin with surfactants, which accounted for approximately 75% of the Company's sales for the second quarter. Surfactant earnings rose for the quarter on a favorable mix of higher-margin products and improved biodiesel sales volume that more than offset an overall decline in volume brought about by lower commodity laundry products volume in North America. Biodiesel sales reached $10.9 million, compared to 6.5 million in the year ago quarter.

European earnings remained unchanged, as improved profitability in the United Kingdom was offset by weaker results in France. Latin America posted higher earnings, due to continued growth in fabric softener sales volume.

Turning to our polymer segment, which represented 22% of our revenue in the second quarter, polymer earnings declined on flat volume. The nonrecurring polyurethane system order fulfilled in the year ago quarter is largely responsible for the decline in polymer earnings.

Polyurethane polyol earnings improved in North America, but were lower in Europe due to a decline in margins. The new Chinese polyol joint venture recorded a loss for the first six months, but passed the breakeven point late in the quarter, and is expected to achieve modest profitability in the second half of 2006.

Phthalic anhydride earnings declined due to higher plant repair and maintenance costs, while volume remained comparable to a year ago.

And finally, specialty products, which accounted for 3% of the Company's sales in the second quarter, decreased slightly on lower food ingredient margins. Sales volume of pharmaceutical products improved.

Turning back to operating expenses, operating expenses rose 2 million, or 8% for the quarter, and 5.3 million, or 11% for the year. Deferred compensation expense represented 1.3 and 3.3 million of the quarter and year-to-date increase, respectively.

The accounting requirement for the Company's fully funded deferred compensation plan results in expense when the price of Stepan Company stock or mutual funds held in the plan rise and income when they decline.

General administrative expense increased 1.2 million and 2.1 million for the quarter and year-to-date, due primarily to higher legal and consulting costs related to the recent pension plan changes, coupled with higher environmental and regulatory compliance costs. Marketing costs declined 2% on lower bad debt expense.

Looking at other income, interest expense increased by 9% during the second quarter and 11% for the year, due to higher-than-average debt levels and interest rates.

The Philippine joint venture has recorded losses for the quarter and year-to-date periods. The new fabric softener plant at our Philippine operation was completed during the second quarter and commercial operations are scaling up. We expect the joint venture to achieve profitability later this year.

Turning to the balance sheet, total debt as of June 30th was 132.4 million, up from 125.7 million at the end of 2005. Our total debt to total capitalization at the quarter end was 43%, down from 44.1% at the same time last year.

Capital expenditures were 11.8 million for the second quarter and 21 million for the first six months. Full year capital expenditures are projected to be in the range of 45 to $50 million.

Looking ahead, we expect continued improvement in the surfactant earnings due to more favorable product mix and increased biodiesel volume. However, we expect commodity laundry product volumes in North America to fall short of last year. Biodiesel earnings will improve over the balance of the year, and we continue to evaluate alternatives for greater participation in the biodiesel market. The polymer group also expects improved volume and earnings in the second half. Volume growth is primarily coming from sales of polyurethane polyol into the rigid foam insulation market.

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

(OPERATOR INSTRUCTIONS). [Beverly Machtinger], [Grace & White].

I was wondering if you could talk a little bit more about biodiesel. One of the things we keep reading about now is the ethanol market, and the demand for corn and things like that. Can you talk a little bit about what your feed sources are, and perhaps the competitive issues that go on in that market? And also, is it cheaper to use this versus diesel? Because we know that ethanol kind of increases the cost of gas right now. And I guess if you could just talk a little bit about what's happening in the biodiesel market.

First, let me make sure everyone understands the distinction of what we're producing. We're producing biodiesel. So, we take a soybean feedstock today and process it into a biofuel, which is then blended into diesel, typically at least at a 10% ratio of our biodiesel from soybeans, with traditional diesel from crude oil.

The ethanol is going into gasoline, and that is traditionally -- as far as I know, almost all of the ethanol in the United States is produced from corn. Brazil does it from sugar cane. So that's a distinction in the two markets.

Our biodiesel feedstock gives us a cost position that would be probably equal to or -- depending on the price at any given time of diesel, equal to or slightly above or below the price of diesel. However, there's a $1-a-gallon credit from the IRS for recovering the excise tax. So, the tax incentives [are] what has driven the biodiesel market. Those tax incentives have pushed -- are legislated out through 2008. Most people feel that there's two directions the United States will go, either further extensions of those tax credits, and/or mandatory use percentages.

Europe has evolved much further in biodiesel. Most countries there have a mandatory use percentage, which, ranging anywhere from 2 to 5 or 6%, is a way of reducing their dependence on crude oil. So the direction seems to be that this market is probably going to have some longevity to it, barring crude oil plummeting anytime soon. Certainly with crude at the prices it's at, it makes the biodiesel market even more attractive than it was when we first got into it.

So if I understand you correctly, it's just really reducing the amount of crude in the diesel fuel, it's really not lowering the cost per se? You're saying it costs about as much to make it?

Net of the tax, it's less. If you didn't get the $1-a-gallon tax credit, you would not be -- you would probably be -- at today's prices you would be about equivalent to diesel. So it's -- with the $1-a-gallon credit, it makes it cheaper. Obviously, it's the government's desire to encourage the development of renewable resources. If crude gets high enough, then conceivably you could compete with alternative feedstocks without tax subsidies, which is the area we are interested in. People are currently already substituting soybean oil feedstock with tallow feedstocks. And as we explore expansion opportunities, we want to make sure we can operate our plant with alternative feedstocks. Tallow is slightly more difficult to process than soybean oil, but it's a much lower cost feedstock. If you start from tallow, you are at an advantage to the soybean-produced biodiesel.

When you talk about expansion opportunities, can you give us some idea just what you're talking about? What are those opportunities?

Our production of biodiesel is occurring entirely at our plant near Joliet, Illinois, which is our largest plant. We were able to use a fair amount of existing assets that we previously used to process coconut oil into detergent-type products; the same assets were capable of manufacturing biodiesel.

The next -- we're up to 140 million pounds a year of capacity. The next step we'd like to look at is how do we expand that capacity and be capable of processing multiple feedstocks, and be able to handle the larger infrastructure. We would have to consider some -- possibly some rail siding modifications and larger storage tank facilities, which kind of ups the ante on the cost of the capital. We got in fairly inexpensively. The expansions we're looking at might be fairly sizable, but we would want to make sure we have the infrastructure in place to support it. So it's -- and be able to handle multiple feedstocks.

So, we have not agreed on the process equipment we would want. There's alternative processing equipment, looking at distillation units that would make us -- want to make sure before we spend any money we're satisfied that we've got the appropriate design that we're going to construct. So we've not reached a consensus yet, but we're very seriously studying the options for much more significant biodiesel production capability.

I have a question on the North American commodity market here for detergent. Can you just give us an idea what's going on in the marketplace that volumes are lower? Is there more in-house processing going on, less demand? What seems to be driving this market right now?

Our understanding, it's a combination of several of those components. There's a little bit more in-house production going on at one company. We believe another company has lost market share to the private labels, and therefore their demand for feedstock from us has gone down. And we believe there's also some product reformulations going on, where they're substituting other feedstocks into their products, presumably at a lower cost than some traditional feedstocks, reducing the -- what we call the actives in the detergent product. So it's really a combination of both.

We've also heard there was a significant Wal-Mart inventory reduction initiative in the first half. We're not seeing the volume picking back up in this area, so we're more inclined to believe that it's the latter factors -- the competition of private labels and the internal capacities of some of our customers to take in more of the product than what they buy from us.

Is there anything that the Company can do to compensate or compete better?

We've certainly been pushing to take any of our excess capacity towards the private-label market by working with other potential customers who service the private-label market. So, we do have a few new customers, relatively smaller volumes in the private-label market. But we actively engaged in trying to gain market share in the private-label market.

And then, our manufacturing equipment for detergents is primarily a sulfonation technology, and the primary feedstocks are alcohol and (indiscernible) benzene. And there's renewed interest in methyl esters masters as a feedstock for detergents. But we've been in the -- methyl esters is really the chemistry that I alluded to before relating to processing coconut oil. The biodiesel market is effectively a methyl ester chemistry. We feel that if -- and it's a lower-cost potential feedstock for detergent producers. So we're very interested in continuing to pursue a sulfonated methyl ester formulation for the laundry cleaning market.

Lastly, you're pretty optimistic about the polymer market recovering a little bit. Particularly, you mentioned just in your opening statement about the polyurethane polyol market. My understand -- is that not used in home insulation?

Fortunately for us, no. The majority of our rigid insulation foam goes into flat roof commercial. It's the large slab stock foam panels that go on the top of a flat warehouse-type building or a commercial building. So we don't -- we're not seeing -- in actuality we're seeing a pickup, not a decline, in volume. We do sell some into the siding of the residential construction market, which is clearly the area where people are concerned about housing starts and what's likely to happen in the next six months now that real estate appears to have cooled off a little bit.

Fortunately for us, with the majority going into commercial, we're not seeing that slowdown in commercial. There is residual repair work going on because of the hurricane season the last few years. And people have deferred maintenance on roofs, and you can't defer it indefinitely. So -- and there was a spike in costs last year that made people apparently defer replacing roofs, but you can't defer it indefinitely. So we're seeing a pickup in volume.

A little bit about the natural gas market. It seems prices, certainly in the Northeast, have come down somewhat, and (indiscernible) would be down compared to last winter. But I was wondering if there's any hedging going on by you to sort of get you through next winter, because one good hurricane could send those prices right through the roof again.

Yes. We learned our lesson. We bought out two years ago very well, and then we went a little lean on buying out last year and it cost us. So this year we bought -- I think we're partly well covered through December of this year. And then we have -- I don't know the exact percentage, but we're buying next winter's gas as we speak in increments, so that we will be, hopefully, fully covered by the time hurricane season really gets in full force. So we've greatly reduced our exposure.

Now the downside to that is, obviously, we're buying forward pricing that's higher than today's $6 a therm. But it's the insurance policy. We can afford $8 or $9 natural gas; we can't afford $14 natural gas.

George Gaspar, Robert W. Baird.

First question, a bit of a follow-up on the biodiesel area. You mentioned in the last conference call that your company was doing some R&D to possibly extend biodiesel for year-round use. Can you report anything on that?

The formulations -- when I alluded to an expansion opportunity, that -- and knowing which technology we want to use for an expansion, is because we've been exploring the alternative technologies that give you a pure product. The fewer impurities you have in the final product, the less chance you have of that thickening or coagulation that occurs in winter, which occurs even in just diesel from crude at cold temperatures. So we've studied the different technologies, we've studied additives that can be added. And between the combination of the two, I think we're fairly confident now that we can stay in -- fairly confident we're going to be okay in the winter months coming.

The other alternative is we're looking at alternative customer base, electrical utilities, railroads, and people who might have applications where they're less concerned about the cold-weather use of biodiesel. We're pretty optimistic that that vulnerability of the market is probably going to be resolved, or pretty well resolved.

In terms of the report that you put out here for the quarter on biodiesel sales, if I recall, you may not have had on for the whole second quarter the expansion program -- correct me on that if that's not right -- and I'm just wondering what we're looking at in terms of potential capacity on a quarterly basis in terms of revenue stream from what you've got on the basis of 140 million pounds of capacity per year.

You're right; we did not hit the 140 million pound rate in the second quarter of this year. In fact, I can give you the actual volumes we were able to get sold, get out the door. It was just shy of 29 million pounds. So that's closer to -- not quite the 120 million pound annualized rate. So we do hope to get up to the 140 million pound rate.

The plant can produce at that rate. It's more of the logistical issues of getting it out of the and into transportation or storage fast enough to keep the reactors turning over as fast as they possibly can. But we think we can probably get pretty close to that number. And the other improvement is that the markets firmed up; we're sold out; we can sell every pound we can produce. So as long as we can turn over those reactors, we can sell the product.

There are other companies in the market on this biodiesel that are expanding their capacities. Is there a possibility that you're going to make a decision relatively soon to decide to extend yourself in this market to try to keep market or capture market share, or is this still a distant decision?

No, I don't think it's a -- as I mentioned last quarter, we were very actively studying it, and I can tell you that the flurry of activity has not abated at all. We're very serious that we still think it's a viable opportunity. The issues we're trying to make sure on now is, as I said, we got into this fairly inexpensively with existing equipment. When we go to a much larger scale operation, we want to make sure we've got the right technology and the right logistical support to take the product away. And when you add modifying or extending rail sidings, now you're starting to add some more significant costs. So we want to make sure we design a plant that is cost-effective. And also, in the meantime, new market opportunities have been brought into consideration, as I said, in the electrical generation and some other markets. So we want to make sure we've got a product for the customer base that we want to go after that will be able to sell out that capacity 12 months of the year.

The timing -- I can't commit to an exact timing of when we will have a decision. We, certainly in the next four to six weeks, hope to be trying to formalize what we want to do the engineering on, and discuss it with the Board of Directors.

In the outlook comments that were in the release today, there was a discussion about increasing your sales prices to affect the increase in crude oil pricing. Exactly -- does that suggest that your price -- your increased pricing is effectively taking into consideration this very recent blip that we had in crude oil, as opposed to, say, the average of the second quarter?

We had a lot of feedstock price increases announced by our suppliers effective for July 1st. And at that point in time, crude was already north of 70 (technical difficulty). (indiscernible) feedstock for the phthalic anhydride and polyol business we were well aware of, and have tried to get that pushed through in July 1 price increases. And then on the surfactant side, the linear alkyl benzene producers raised prices July 1, and we got that out in price increases as well. It's really a continuation of really the last 18 months of just constantly trying to maintain margins or make sure we are recovering our higher raw material costs in the marketplace.

Just a general comment. At the last quarter conference call, there was an implication that earnings were going to be better going forward into the -- for the second quarter. And this basically didn't materialize. What about looking at giving some interim guidance as to company operations, as opposed to waiting until this point to -- at the time of the earnings release when something like that is going on?

The difficulty we have is that a large piece of the volatility was caused by deferred compensation. And unfortunately, with that plan, it's entirely controlled by the marketplace. So giving guidance on deferred compensation expenses is nearly impossible, given the uncertainties of the marketplace. And that's what really caught us this quarter, at least a big piece of the downturn that we weren't -- certainly were not anticipating in the quarter, coupled with the higher legal costs now.

Some of the legal costs we were certainly aware of, but it was larger -- some of them were certainly larger than we anticipated. And then we thought the downturn in the surfactant commodity volume -- initially we thought that might be limited to the first quarter. We had preliminary indications that it was inventory adjustments and other factors. So it really wasn't until the full second quarter was well underway that it looked like the shortfall was going to continue, which we now would say we have reason to believe it will continue throughout the balance of the year.

One question on overall sales in the international area on your expansion programs, such as the fabric softener startup in the Philippines. And then, if you could comment on Brazil, if anything is going on there. And then you mentioned about China getting up into potentially a profit mode in the second half of the year. What kind of sales volumes are we looking at in this Philippines situation, and anything else that you're bringing about in either South America or China?

Let's start -- in South America we're adding a multipurpose reactor, and the sales volumes initially will probably be fairly small. What we're trying to do is penetrate some of the agricultural market, specialty markets. We want to stay with the higher margin opportunities in those countries, and not tie up the reactor or go after commodity-type products in that area.

So initially, today, with the baseload business we have in Brazil, we've got roughly a breakeven operation. And we would hope this would certainly give us a profitable operation. And then we could certainly add reactors thereafter. But the relative contribution to the Company from Brazil would be relatively small, I think, in the near term.

In China, the whole idea was as we penetrate the polyol market, we would be capable of adding reactors down the road. So the initial reactor, I believe, was a 20,000-ton reactor, which we would hope to have sold out within the next 12 to 18 months. But again, it would be fairly modest profitability at that level. And then we would hope to be able to continue to grow with the Chinese market.

These products are -- the strategy here is not an export product, but to penetrate the Chinese and Asian marketplace with polyols going into rigid insulation foams. But initially, the profitability will be fairly small to the total operation of the Company, but with the goal of building a more major market share in China.

And then the Philippines you asked about -- (indiscernible). The market in the Philippines was an interesting dynamic. We got in primarily in commodity sulfonation, and it was based on alcohol feedstocks. They were under pressure from the World Trade Organization to open up the market to linear alkyl benzene feedstocks. And once that happened the market margins and prices plummeted dramatically. So we went from making a nice profit in the Philippines to breaking even or having losses in the last six to eight months.

Fabric softener will be a totally different product line for the Philippines that will -- most of our sulfonation surfactants in the Philippines stayed in the Philippines. This is really going to be an export business that supports Southeast Asia. And we have commitments for the fabric softeners, and we believe we'll be profitable next year in the Philippines with this product line.

Is there a measure that you can give us of what your volume might be in terms of tonnage or poundage or whatever?

For the fabric softener (multiple speakers)? I don't remember. Let me get back to you on that, because I don't remember the exact size of the reactor.

(indiscernible), [Shaker Investments].

Thank you. Could you comment on the 20 basis point improvement in gross margin during the quarter?

Probably the major driver (multiple speakers) -- pardon me?

Sequential improvement.

The major driver was the polymer group had two improvements there, and their volumes started to improve over the first quarter. And their profitability or margins have been a recovery mode of margin as they pass along higher raw material costs. So that certainly helped. And then surfactants has had -- the biodiesel contribution was minimal in the first quarter compared to the second quarter. And that would probably be the biggest second factor, is the biodiesel volume contributions. And really, our broader surfactant business has had a solid improvement in volume in the second quarter. It was the lower margin commodity volume that declined. So the mix within surfactants has moved to a much more healthy mix.

Do you kind of expect more similar sized improvements going forward, in the gross margin (multiple speakers)

I wouldn't expect the margin to improve significantly from this point. I think they would stay at this level based on this mix. We expect the commodity business to continue to be a little weak, but be made up by the improved mix (multiple speakers)

Let me ask the question this way. Based on your natural gas hedging that you have in place now, what kind of impact would that have on your margins if pricing, etcetera -- if nothing else changed?

We would be slightly better. We'd be a little -- we'll see some slight improvement.

Can you give an order of magnitude? Is it like a 20 basis point number?

At the most. It probably wouldn't even be that large of a number.

You mentioned that you're pretty close to presenting your board with some engineering materials on your biodiesel expansion plans. Can you -- is it too early to give us a glimpse of either the magnitude of the investment you're considering, and/or the timing that it would take to realize such an investment?

The construction time for something like this would typically be at least a 12-month leadtime from the time we get the green light to go. In terms of the (indiscernible), I guess I can share with you that most biodiesel facilities built by other parties are anywhere from 20 to $50 million. We certainly would hope to do something for less than that kind of money, but we're certainly looking at alternatives that include fairly sizable dollars.

One other question. The expenses that you referred to due to the deferred compensation expenses that were tied to your share price, what expense line item does that fall in, or does it get spread?

It's in the administrative expense line.

It's all in administrative expense?

Yes.

Okay.

In the press release we broke it out separately. We split admin, just so that everybody could see what the composition was.

John Roberts, Buckingham.

You were optimistic about volume in the second half of the polymers business. Are you optimistic about North America and Europe?

Are you speaking to polymers or surfactants now?

Polymers.

In polymers, yes; the volume in polymers we're feeling pretty good about for the second half of this year.

What gives you optimism in North America and Europe?

Just the feedback from our customers. Again, not being tied to residential construction but being primarily in commercial, there seems to be a pent-up demand for roof replacements and the improved energy efficiency of thicker insulation on the top of the flat roofs.

Secondly, in the surfactants business in North America, do you know how much extra capacity the customers still have to take business back? Are they near full up, or could this go on for quite a while?

We don't think there's significant excess capacity. There's capacity in the industry, but in the customers themselves, it's probably not where most of the excess capacity is. It's probably out in the merchant producer market.

The business that's been taken back by customers recently -- at least you pointed to some in-sourcing back into captive production -- what's driving that? Their costs of raw materials shouldn't be substantially different than yours.

If they've got -- if they do -- assuming they do have excess capacity, it's an incremental decision to them. Obviously, they're only going to incur the variable costs and not incur the toll fee they incur with us. So it would be just a cash savings opportunity then to maximize the production in their own internal manufacturing facilities.

But they could have done that last year. Is it just because they're under more pressure overall?

I can't speak to that, because I don't know if it's -- if they've -- where their constraints were in their production facilities.

George Gaspar, Robert W. Baird.

Just back on the earnings outlook guidance, and maybe you've touched on this. Are there any particular reductions in cost structure compared to what incurred in the second quarter that you could cite for us?

We don't anticipate as much of a legal expense cost to continue in the second half. The pension plan changes we implemented -- I would just remind you we froze our pension plan June 30th -- incurred significant legal consulting costs to complete that process.

The upside to that, though, is that longer-term we won't see any near-term significant savings in pension costs because we replaced it with a defined contribution plan. But the volatility of that cost should smooth out and over time decline. But yes, we don't expect to incur the repeat legal consulting costs that we had in the first half, and we continue to look for cost savings opportunities throughout the system.

Anything on the environmental side that can positively impact or negatively impact in the coming quarter?

We don't have any significant new developments in any of our environmental sites. No, I can't identify anything specific that would give us upside or a downside in the second half.

(OPERATOR INSTRUCTIONS). We seem to have no further questions at this moment. I'll turn the call back to you, sir.

I just wish to thank everybody for participating in our call today. Thank you. Bye bye.

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