Greetings and welcome to the Q2 2020 earnings conference call. [Operator Instructions]. As a reminder, this conference is being recorded, Wednesday, July 22, 2020. I would now like to turn the conference over to Luis Rojo, Vice President and Chief Financial Officer. Please go ahead.

Good morning, and thank you for joining the Stepan Company's Second Quarter 2020 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 for our foreign operations, global and regional economic conditions and factors detailed in our Securities and Exchange Commission filings. Whether you are 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 made these slides available at approximately the same time as well as the earnings release is issued, and we hope that you find the information and perspective helpful. Now with that, I would like to turn the call over to Mr. Quinn Stepan, our Chairman, President and Chief Executive Officer.

Thank you, Luis. Good morning, and thank you all for joining us. We hope you and your families are safe and healthy. Furthermore, we hope you are cleaning and disinfecting your homes and workspaces often and are washing your hands frequently. At Stepan, we appreciate the passion and commitment our employees have to supply products that contribute to the fight against the coronavirus. Despite the challenges of the pandemic and the impact of the first quarter power outage at our Millsdale facility, Stepan had a solid first half of the year. Second quarter adjusted net income was a record $38.3 million or $1.65 per diluted share versus $35.1 million or $1.50 per diluted share in the prior year. Surfactant income benefited from strong volumes in the global consumer product end market, driven by higher demand for cleaning and disinfection products as a result of COVID-19. Functional Product volumes were down. Mexican operations continue to deliver year-over-year earnings growth. Polymer income was down as COVID-19 construction project delays and cancellations in Europe and North America led to reduced Rigid Polyol volumes, partially offset by strong growth in China. Lower phthalic anhydride volume and higher raw material inventory costs associated -- also contributed to the decline in income. Our Specialty Product business results were lower due to order timing differences within our food and flavor business and lower margins within our medium chain triglyceride product line. Our Board of Directors declared a quarterly cash dividend on Stepan's common stock of $0.275 per share payable on September 15, 2020. At this point, I'd like Luis to walk through a few more details about our second quarter results.

Thank you, Quinn. My comments will generally follow the slide presentation. Let's start with Slide 4 to recap the quarter. Adjusted net income for the second quarter of 2020 was a record $38.3 million or $1.65 per diluted share, a 9% increase versus $35.1 million or $1.50 per diluted share in the second quarter of 2019. Because adjusted net income is a non-GAAP measure, we provide full reconciliations to the comparable GAAP measures, and this can be found in appendix 2 of the presentation and table 2 of the press release. Specifically, adjustment to reported net income this quarter consists of adjustment for deferred compensation and cash-settled SARs and some minor restructuring expenses. Adjusted net income for the quarter exclude deferred compensation expense of $2.4 million or $0.10 per diluted share compared to deferred compensation expense of $1.4 million or $0.06 per diluted share in the same period last year. The deferred compensation numbers represent the net expense related to the company's deferred compensation plan as well as cash-settled stock appreciation rights for our employees. Because these liabilities change with the movement in the stock price, we exclude these items from our operational discussion. Slide 5 shows the total company earnings bridge for the second quarter compared to last year's second quarter and breaks down the increase in adjusted net income. Because this is net income, the figures noted here on an after-tax basis. We will cover each segment in more detail, but to summarize, Surfactant was up significantly, while Polymers and Specialty Products were down versus the prior year. Corporate expenses and all other were higher during the quarter due to acquisition-related expenses, a higher effective tax rate and foreign exchange losses. The company's effective tax rate was 23.9% in the first half of 2020 versus 21.8% in the…

Thank you, Luis. 2020 will continue to be a difficult year for our world, our country and our industry. We believe Stepan's business remains better positioned to perform than most, as we demonstrated in the second quarter. We continue to prioritize the safety and health of our employees as we deliver products that contribute to the fight against COVID-19. We believe our Surfactant volume in the consumer product end markets should remain strong as a result of changing consumer habits and increased use of disinfection, cleaning and personal wash products. Our core product lines drove Surfactant volume growth of 10% in the second quarter. Tier 2 and tier 3 customers continue to be the center of our strategy. We had strong double-digit growth in this space as we added 443 new customers around the world. Our diversification strategy into Functional Products continues to be a key priority for Stepan. Our agricultural business grew 6% despite a decrease in North America due to high inventory carryover from last year. We have introduced many new products in this end market, and we continue investing in more capacity and new capabilities. Oilfield volume was down due to the collapse of oil prices during the quarter. We remain optimistic about future opportunities in this segment as we continue to expand our portfolio. Polymers is having a challenging year, given the availability of labor on construction projects and the need for social distancing. However, the long-term prospects for our Polymer business remain attractive as energy conservation efforts and more stringent building codes should increase demand. We will have higher raw material costs due to the Illinois River lock closure during the second half of 2020. We continue to work with our insurance carrier to recover costs associated with the first quarter power outage at our…

[Operator Instructions]. Our first question comes from the line of Vincent Anderson with Stifel.

Really nice job on the quarter, everyone, and agriculture in particular. I wanted to ask, maybe it's a bit early, but are you hearing any shifts with regards to order patterns from some of your Surfactants customers where maybe end users of commercial and industrial cleaning supplies are looking to secure larger or maybe longer-dated volume commitments related to just structurally higher demand for cleaning and disinfection going forward?

I would say the market is tight. The global market is tight for disinfectant products, particularly into the industrial and institutional space. There may be some small amount of inventory building or hoarding, if you will. But there's, quite frankly, not enough material available on the marketplace to really do much of that today.

Interesting. And then just quickly, I was hoping to get a little bit more background on the Clariant acquisition. It sounded like this plant or plants are maybe being absorbed into your more backwards-integrated operations in Mexico? And if so, is that going to provide an immediate margin uplift? Or do you plan to carry some of the fixed costs at those assets for the purpose of maybe transitioning it to other product lines?

So the first thing I would say is we have not closed on the acquisition yet, so I'm not going to share a lot of details about it. But our intent is not to continue to run that site, it's to buy the business and the equipment at the site, and both of those things will be moving to our Ecatepec, Mexico, facility. So we'll be increasing capacity utilization at our Ecatepec site and serving our customers well from that 1 location.

That's helpful. And if I can sneak one more in, and I'll give everyone else a chance. On Rigid Polyol growth in China, were you able to gauge just how much of this demand increase is coming from the build-out of factory farms and cold storage versus maybe a more general trend in construction demand or shift on the building efficiency standards?

Virtually all our business and all of our growth is being driven by cold storage and livestock activity. We do not have a position in the traditional construction market due to Chinese regulations today.

And Vincent, this is Luis. What I will add is between cold storage and livestock, what we're seeing is roughly the growth is 50-50 between those 2 end markets.

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

Nice quarter. I was wondering, Quinn, if you can talk a little bit about the margin strength that you saw in Surfactants. And maybe help us understand how much of that maybe is mix benefit from higher margins associated with products for disinfection versus how much maybe is related to plant utilization. I assume that your plants are running about as flat out as they have in some time right now.

Yes. And what I would say is when we look at the performance of our Surfactant business overall, volume is driving a significant part of the benefit, both from just additional sales but also in higher plant utilization. But we are benefiting from an improved product mix. So if we look at our -- kind of our -- sulfonation being our core business. But if we look at our -- kind of our next 4 product lines that we sell into that marketplace, including kind of amphoterics, which would include amine oxides and betaines, and then in addition to biocidal clothes and ethoxylates kind of all of those product lines, including sulfonation, are up significantly. But the other ones that have -- typically have a higher margin than our sulfonation business, those product lines up -- on average, are up about 22%. So we are benefiting significantly from an improved product mix and more volume of those products that we're selling in the marketplace. And some of that improvement is actually being driven by an improved customer mix with our 2, 3 -- 2 tier -- our tier 2, tier 3 strategy. So if we look at that business, growth in that segment of customers is also up strong double digits as well. So we feel pretty good about kind of the customer mix and product mix going forward, and that's really where the margin improvement is coming from.

All right. And then I saw that the Surfactant pricing was up by about 1% in the second quarter. I think you mentioned that, that was mostly mix driven. But just given the tight supply-and-demand dynamics that you're seeing, should we see -- or expect to see some additional price come into the Surfactants business in Q3?

I think as we look at the performance of the business overall, price, customer mix and product mix, between the 3 of those, there may be some limited upside potential. But the product mix was generally pretty healthy in Q2 and that's much more important than pricing at this point in time.

Yes. And Mike, I will add also, raw material dynamics, right? In some cases where raw materials are up, we will need to pass that through, et cetera. So that's another component of the whole strategy. But the driver of the mix is product and customer mix.

All right. Well, that actually gets to my next question, which is just understanding these raw material dynamics. I think you mentioned, particularly in the Polymers business, that you saw higher raws flowing through the P&L during the second quarter. Have we burned through that high-cost inventory at this point? Or is there still some additional high costs? Just trying to understand maybe how much sequential tailwind we could see as those raw material costs normalize.

The vast majority of that raw material bubble, if you will, has been moved through the system. I would anticipate that we've got maybe another $1 million to kind of work its way through the system. But we've significantly reduced that vulnerability in the second quarter.

All right. And then last question for me is on the Illinois river block maintenance project. I think now that that's getting closer, I don't know if it started yet or not, can you maybe...

It has started, and the river is supposed to be closed for a period of 3 months. Last week, the Army Corps of Engineers announced that they're 2 weeks behind schedule. We've anticipated that it'll be down 6 months. We're hoping that'll be closer to the 3.5 to 4 months as we go forward.

And I will add, Mike, that the previous estimates that we have shared continues to be the same with -- pegged around a $3 million increase in cost because of this activity. And again, we hope that it stays in the 3.5 to 4 months. If it is longer, the cost could be a little bit higher.

So the $3 million in higher costs is based on the current assumption of 3.5 to 4 months of closure?

Yes. So the $3 million that we have -- Mike, the $3 million that we have shared is based on our plan of 6 months, yes. But again, that $3 million is an estimate, and that can fluctuate a little bit. We will provide more clarity when we close Q3, what we are seeing.

Our next question comes from the line of David Silver with CL King.

So I guess, I wanted to maybe just start out -- you have addressed this in part, but I was just hoping for a more comprehensive view. But I was looking at the deltas in the Surfactants area. In terms of revenue, it was about $19 million higher year-over-year, and operating income was up more than $16 million. So you did cite improved customer mix. I was just wondering, to what extent did operating efficiency or the lack of disruptions at either Millsdale or Ecatepec or maybe other facilities -- in other words, what kind of a role did just pure operational efficiency inside the plant gate play in boosting year-over-year operating income?

I don't have the number in Ecatepec, but Ecatepec was down in last year's second quarter. So there is a -- and we were spending expense dollars during that period to remediate and fix the site. You'll recall, in Q4, we received an insurance settlement. So there is a timing difference in terms of our performance in Mexico. Overall, our business in Mexico is up significantly. We're kind of back on track with our business case plans from 2018 when we purchased the site. So we feel good about where we're going in Mexico and at that facility.

And yes, and that's why we made the comment that $5 million -- out of the $16 million in Surfactant, $5 million is coming from Mexico, and it's because you are comparing versus a very low, low base because we were not operating at that time. That's one of the drivers of the $16 million up. And of course, then product and customer mix in North America and the other regions.

Yes. And last year's Q2 relative to our Millsdale site and other sites that we have around the world. We didn't have any significant operational issues. So the performance for the balance of the increase is a function of the volume growth -- primarily the volume growth that we have.

Okay. Great. I was hoping to, again, hone in on your Surfactants business a little bit -- with a little bit finer view. But certainly, you had 10% volume growth, and I'm kind of scratching my head. I mean I'm just wondering how that compares to maybe overall industry growth. And you did provide a little bit of detail with the sulfonation growth versus the nonsulfonation areas. But I'm just wondering in terms of ability to meet ongoing demand increases, with the assets you have in place now, I mean, you mentioned tight supply, is Stepan close to running full out? Or maybe, I don't know, in the amphoterics, which you've indicated are more of a batch process, is there potentially significant capability with the assets in place to kind of ramp up production in response to continued growth, let's say, in the handwashing kind of disinfection demand?

Yes. So let me start by saying from a sulfonation perspective in North America, we have sufficient capacity to support the market needs. As we look at our sulfonation assets on a global basis, we do have some excess capacity in Mexico that will allow us to absorb the Clariant acquisition. But if we look at our other assets -- sulfonation assets in the U.K., in Brazil and others, we're -- I'd say we're relatively full or approaching relatively full. So we feel kind of good about that from a capacity utilization perspective. You mentioned amphoterics. Amphoterics is a batch process. And I would say on amphoterics globally, we are tight. We are looking at debottlenecking efforts and have -- and are producing more today than we have in the past. We will add and replace an existing reactor in Fieldsboro -- an idled reactor in our Fieldsboro facility and add new capabilities in North America. We will also add additional amphoteric, and specifically amine oxide capabilities, by taking advantage of an idle reactor in our Mexican Ecatepec facility. And so we're looking at our asset utilization on a global basis. Because they are batch processes, we do have some flexibility, particularly to make more amine oxides. Betaines require special metallurgy, and so we're looking at that as well. From a biocidal quaternary, which is a disinfectant product, we have plans in place to add additional reactor capabilities to our Matamoros, Mexico, facility, and that will provide additional capacity to support the North American and Mexican, Latin American markets. That reactor will be up late Q4 of this year. So we are taking steps to support our profitable product lines, as appropriate, around our global network.

And just to clarify, but in that current CapEx budget unchanged, $100 million to $120 million, that does include the growth CapEx you just cited for Matamoros. Is that -- do I understand that correctly?

Yes. That's correct.

That's not incremental?

It is. Correct.

Yes. And then I did have one big-picture question on, I guess, your policies with regards to FX. So I'm going to be pulling -- I'll warn you in advance, this might seem a little scattershot, I'm pulling some data points from a couple of different areas. You mentioned that FX reduced your reported EPS by, I believe, $0.11 a share here in what was a record quarter. So in my opinion, that was pretty significant. And then you also mentioned, I believe it was 443 new customers, which sounds like a lot to me, and I'm assuming most of those are offshore. So I'm just kind of scratching my head. And from a global perspective, from a business planning perspective, does the growth in the market tilted towards offshore and the relatively high exposure you have currently to the current mix of currencies that you deal in, I guess, Latin America in particular, most recently. I mean what is the right approach? Or are you taking a harder look at implementing maybe a more sophisticated, more global approach with a different emphasis on certain currencies as you move forward in this post-pandemic environment? Sorry for the disjointed comments, but that was kind of my question. How does pot your policy towards managing your FX exposures change with the evolving business outlook and especially post pandemic?

Yes. David, this is Luis. What I will say is that the majority of the FX impact that you saw in the quarter on the operating side, on the operating income side, the majority of the impact was in Latin America, as you rightly mentioned. The biggest actually was Brazil. And that's why we were extremely happy to deliver another record quarter in Brazil despite the significant FX headwinds that we had in that market. As you know, the reals went up from $4 -- BRL 4 per dollar, all the way to BRL 6. It went back down, now it's around BRL 5.30, BRL 5.40. But that was the biggest impact in the quarter. And the second one was Mexico. If you remember, I mean, the Mexican pesos went all the way to MXN 25, MXN 26 and now settled back in the MXN 22, MXN 23 range. And we delivered a record quarter in Mexico as well despite the FX volatility. We manage our business. We are a U.S.-based company, and we will continue looking at dollars despite operating in different countries. And we want to make the dollars, and we will manage our pricing and our cost structure accordingly, right? The other thing that I will say is that when you think about FX exposure on the balance sheet, we have a good hedging program around the world. And actually, that was a small help in Q2. We had a small help in our hedging program that we have instituted in many of our markets. So we manage this on a day-to-day basis, on a weekly basis. And again, we want to make sure that we deliver the margins and the dollars that we are targeting in all our operations outside the U.S.

Okay. And if you don't mind, just one last question. This would be related to your businesses in country in Mexico, Matamoros, Ecatepec; and, I guess, Brazil. Those two countries have suffered from the pandemic to a pretty severe extent, and there has been some disruption to workforces and whatnot. Can you just give us a quick review of the status of your workforces in Mexico and Brazil, and whether we should expect any disruptions or any difficulty in maintaining full operations, let's say, over the next quarter or two?

So let me let me first kind of give you an overview of what Stepan is doing in terms of COVID-19. And we've established a set of principles, and I won't go through all of those here today. But first and most importantly, what we've said is that the health and safety of our employees is number one. Number two, what we've said is the supply of products that can help contribute to the solution of COVID-19, which are cleaning products, our disinfection products and our personal wash products, we will prioritize the sale and -- the manufacture and sale of those versus others. The next priority that we've established is that we want to continue to keep our employees employed, and we want to continue to provide health benefits to them and position them -- position us and them for the post-pandemic world. So I'm pleased to say that generally speaking, we've been able to keep our employees very healthy. I believe the current number is we've had 32 employees affected on a global basis. The answer to your -- and 24 of those 32 are back at work, no problem. Within the past week, we've had 4 people at our Matamoros, Mexico, facility be diagnosed with COVID, and we've had no impact to the operations as a result of that. We have a disciplined process as it relates to quarantining and tracing the activity of the employees, and so -- if we do have an incident. Today in Brazil, I believe we have 1 employee that has been diagnosed and currently self-quarantined. We've had a couple of other instances in Brazil over the last 3 months. All of those employees are back and healthy and at work. Most of our admin employees around the world are still working from home. Our plants, all 18 of them, are up and running. And that's the biggest vulnerability that we have as an organization is -- and it's just -- if we have a significant outbreak at one of our sites and have to close down, it's a big deal. And it's a big deal for employees, it's a big deal for us as an organization. And so far, we've been able -- with everybody contributing and everybody kind of watching out for themselves and for each other, we've been able to keep everybody safe. And we feel good about the policies and practices that we have ongoing throughout the company.

David, the only thing that I will add is, as Quinn mentioned, and that's the biggest risk in the whole supply chain, and not only in this industry, but of course, across all industry because it's not only Stepan. You can have issues with a supplier, you can have an issue with a customer manufacturing site. So that's the biggest vulnerability in the whole supply chain, and we are just one piece of it.

Our next question comes from the line of Vincent Anderson with Stifel.

Yes. Could we go back to your comments on pricing upside in Surfactants? It seems like I can interpret that as maybe you're more focused on using this opportunity to improve your longer-term customer mix via market share gains instead of taking price. Or am I thinking about that wrong?

I think the bigger benefit for the company is to supply a more diverse, robust, value-added product mix rather than pricing at this point in time. That's not to say that we're ignoring pricing. Pricing is an important component of it. But in today's world, we want to be able to help our customers solve problems out in the marketplace. We want to help them facilitate their delivery of solutions to consumers around the world. And that's the most important thing that we're concentrating on at this point in time.

That makes sense. And then just quickly, you mentioned that you grew in Specialty Polyols. What exactly drove that, especially in the 2Q environment that we had? And how repeatable do you expect that to be going forward?

Well, specifically, we grew our Specialty Polyol business in Europe. And our business in Europe is more tied to adhesives. And so there was significant adhesive growth in the marketplace as a result of food packaging. So as people were not going out to eat as often and buying a little more processed food or packaged food, the adhesive component of our Specialty Polyol business grew. In addition to that, we have a new application in China, which is helping that business in the sense that we're supplying some Specialty Polyols into the facemask market in China.

That's helpful. And I promise just one more. Just can you remind us if you plan to hold the manufacturing of the KMCO portfolio for now? And this 2020 launch that you have planned, given the oil price environment, is it safe for me to assume that you've had good customer feedback, or even some contracts in place, to ensure demand that soon?

I think the first step is to make sure that we can replicate the product line and supply and meet the customers' needs from a product perspective. And so right now, we're working -- our target is to have 5 products that are qualified throughout this year and introduce those back to the marketplace. So our intent is to introduce five products in 2021. We're not anticipating significant contribution from that business until 2022.

The only thing that I will add, Vincent, is that we have had very good feedback from the customer side. So we will continue replicating our processes and making sure that we have the supply chain ready for the future. But on the customer side, very positive engagements already.

Our next question comes from the line of Mike Harrison, Seaport Global Securities.

Just a couple more for me. On the Rigid Polyol business, you mentioned the project delays that were going on in North America and Europe. Can you comment in a little more detail on how those volumes trended maybe in the May to June to July time frame? And then kind of a separate question. If we're seeing delays now and because this is more of a maintenance and reroofing type of application, does that mean that we potentially have some pent-up demand either later this year or going into 2021?

So what I would say is that we anticipate our polyol volume to be down in Q3 about the same order of magnitude that it was down in Q2, maybe down a little bit less. We think Europe is going to perform better than North America because we had some pent-up demand. As I mentioned earlier, some of the -- well, some of the school business was pulled forward in the United States in Q2 -- I'm sorry, in Q1 versus Q2 because as the schools started to shut down, they continued to do their roofing project. Most of our customers are kind of saying 2020, kind of put that year aside, and we -- and they're anticipating kind of going back to a 2019 base load and then start to look at 3%, 4% growth from a 2019 perspective. And we're hearing that from a number of customers around the world. So that's kind of what we're putting in our planning documents.

All right. And then the other thing I wanted to ask about is you mentioned bringing in some third-party supply chain consultants. Can you just talk about what the opportunity could be from improving supply chain efficiency from both a P&L or margin perspective as well as maybe a working capital perspective?

Yes. I would say kind of from an expense perspective, we're looking at trying to generate an additional $10 million of operating income in 2021. And then kind of we'll look for additional opportunities beyond that as we go forward and begin to extend that program on a global basis. We're early on in the process.

We are very early on, Mike, and...

But we would not have started the process if we didn't think we could add at least $10 million of operating income, yes.

And the only thing that -- as you said, it's going to be P&L and it's going to be also cash because we will try to improve our inventories as well.

We do now have a follow-up question from David Silver, CL King.

I take it personally if I don't get the last question. I'm just kidding. I had a quick -- I had just a follow-up question on the 443 new customers and your 10% volume growth in Surfactants. So just in general, I'm wondering if it was the case where you continued to meet full contract requirements for your existing customer base and then added the new customers, 443 or whatever. Or is this the case -- my understanding is most supply contracts, you have some flexibility, a minimum required volume shift and a maximum to which the specified contract terms apply. And I'm just wondering, was the second quarter a quarter where you were supplying your existing customer base a little bit less than the max in order to free up volumes for the new customers? Or is this one where, with the capacity you have now, you were able to meet all customer commitments in full? So I'm just trying to wonder what type of adjustments you made kind of in real-time in response to the net new demand that you're trying to service.

So relative to the 443 new customers, what we've said is that, that is part of our tier 2, tier 3 acquisition of new customers. So those are smaller customers on a global basis that buy relatively small volumes on a global basis. So that is not a barrier to us servicing our tier 1 customers on a global basis. In the vast majority of our product lines, we were able to sell the full volumes that we needed to, to our customers on a global basis. We did have -- in one of our amphoteric product lines, we did need to place some customers on allocation where we were shipping at 85% allocation to our customers due to some raw material availability issues. We are trying to work with our supplier base and with our customers, looking at, in some cases, some reformulation to more readily available products that can be substituted. In addition to that, we're also working on, with our supplier base, to try to get additional quantities made. There are some expansion for some of those product lines that are in tight supply today, from our supplier base, that will become available in Q1 of 2021. So we've got some issues in a limited part of our portfolio that we're working through with our customers.

There are no further questions at this time.

Okay. Thank you very much for joining us on today's call. We appreciate your interest and ownership in Stepan Company. We look forward to reporting to you on our third quarter 2020 call. Have a great, safe, healthy day. Thank you.

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