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Edited Transcript of SCL earnings conference call or presentation 23-Oct-19 2:00pm GMT

Q3 2019 Stepan Co Earnings Call

NORTHFIELD Oct 26, 2019 (Thomson StreetEvents) -- Edited Transcript of Stepan Co earnings conference call or presentation Wednesday, October 23, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* F. Quinn Stepan

Stepan Company - Chairman, President & CEO

* Luis E. Rojo

Stepan Company - VP & CFO

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Conference Call Participants

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* Jason Andrew Rodgers

Great Lakes Review - VP

* Michael Joseph Harrison

Seaport Global Securities LLC, Research Division - MD & Senior Chemicals Analyst

* Vincent Alwardt Anderson

Stifel, Nicolaus & Company, Incorporated, Research Division - Associate

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Presentation

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Operator [1]

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Greetings, and welcome to the Stepan Company Third Quarter 2019 Earnings Conference Call. (Operator Instructions) As a reminder, today's conference is being recorded, Wednesday, October 23, 2019.

I would now like to turn the conference over to Luis Rojo, Vice President of Finance and Chief Financial Officer. Please go ahead.

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Luis E. Rojo, Stepan Company - VP & CFO [2]

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Good morning, and thank you for joining Stepan Company's Third Quarter 2019 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 reporting operations, global and regional economic conditions and factors detailed in our Securities and Exchange Commission filings. Whether 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 when the earnings release is issued, and we hope that you find the information and perspective helpful.

Now with that, I would like turn the call over to Mr. Quinn Stepan, Jr., our Chairman, President and Chief Executive Officer.

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F. Quinn Stepan, Stepan Company - Chairman, President & CEO [3]

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Thank you, Luis. Good morning, and thank you all for joining us today.

Despite the challenging current environment, the company's quarterly net income and adjusted net income exceeded prior year. And through 9 months, adjusted net income is ahead of last year's record. For the quarter, Surfactant earnings were down due to lower commodity volumes in North America and the slow recovery of our business in Mexico.

The Polymer business had a strong third quarter, driven by Global Rigid Polyol volume growth.

Specialty Products income was down due to customer order patterns, but will deliver significant profit growth for the year.

Third quarter adjusted net income was $27.9 million or $1.20 per diluted share versus $26.4 million or $1.13 per diluted share in the prior year. First 9-month adjusted net income was $93.7 million or $4.02 per diluted share versus $92.2 million or $3.95 per diluted share in 2018.

Surfactant operating income results for the first 9 months have been negatively impacted by the Ecatepec equipment failure, wet weather in the U.S farm belt, weak demand in the global consumer product end market and foreign currency translation.

The Polymer business improved significantly during the quarter and is up for the first 9 months on the strength of volume growth and slight margin improvement.

North American and European Rigid Polyol volumes have grown 11% and 8%, respectively, during the first 9 months versus last year.

Specialty Product operating income was down slightly compared to prior year quarter, primarily due to unfavorable order timing within our pharmaceutical business, largely offset by improved medium-chain triglyceride product margins.

The company increased its quarterly cash dividend in the fourth quarter of 2019 by $0.025 per share or 10%, marking the 52nd consecutive year that the company has increased its cash dividend to stockholders. The quarterly cash dividend on Stepan's common stock is now $0.275 per share payable on December 13, 2019.

At this point, I would like Luis to walk through a few more details about our third quarter results.

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Luis E. Rojo, Stepan Company - VP & CFO [4]

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Thank you, Quinn. My comments will generally follow the slide presentation. Let us start with Slide 4 to recap the quarter.

Adjusted net income for the third quarter of 2019 was $27.9 million, a 6% increase versus $26.4 million in the third quarter of 2018. Because adjusted net income is a non-GAAP measure, we provide full reconciliations to the comparable GAAP measures, and these can be found in Appendix 2 of the presentation and Table 2 of the press release.

Specifically, adjustments to reported net income for this quarter were made for deferred compensation expense and restructuring expenses. Adjusted net income for the quarter exclude deferred compensation expense of $1.7 million or $0.07 per diluted share, compared to deferred compensation expense of $2.6 million or $0.11 per diluted share.

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 this liability change with the movement in our stock price, we exclude this item from our operational discussion.

Adjusted net income for the quarter also excludes $0.3 million or $0.02 per diluted share of after-tax business restructuring charges related to the ongoing decommissioning costs related to the Canadian plant closure in 2017 and the Germany sulfonation shut down in 2018. We expect an additional $0.8 million of after-tax decommissioning expenses in 2019.

Slide 5 shows the total company earnings bridge for the third quarter compared to last year's third quarter and break down the increase in adjusted net income.

Because this is net income, if you [guys] notice here are on an after-tax basis. We will cover each segment in more detail, but to summarize, Surfactant and Specialty Products were down while Polymer was up versus the prior year.

Favorable net interest expense was related to higher interest income in the U.S. after a company cash repatriation in 2018. The company's effective tax rate was 17.3% for the first 9 months of 2019 versus 18.7% for the first 9 months of 2018. This year-over-year decrease was primarily due to higher U.S. R&D tax credits, partially offset by a one-time favorable tax project in 2018. We expect the full year 2019 effective tax rate to be in the range of 18% to 21%.

Slide 6 focuses on Surfactant segment results for the quarter. Surfactant operating income in the quarter decreased $9.2 million versus the prior year, primarily due to lower sales volume, higher inventory-related costs associated with the company internal Asian-U. S. supply chain and the receivable impact of the equipment failure in Ecatepec, Mexico.

Surfactant net sales were $300 million for the quarter, a 14% decrease versus the prior year. Sales volume decreased 8% mostly due to the company exit from the sulfonation business in Germany in 2018, lower agricultural demand due to the wet weather in the U.S. farm belt and lower commodity demand in the U.S. consumer product markets.

Selling prices were down 4%, primarily due to the pass-through of lower raw material costs. A translation impact of a stronger U.S. dollar decreased net sales by 2%.

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.

The North America decrease was primarily driven by lower commodity consumer product volumes, soft agricultural demand due to the wet weather in the United States farm belt and higher inventory costs related to internal Asian-U. S. supply chain systems.

Latin America is down due to the Ecatepec, Mexico sulfonation equipment failure, Brazil effects and one-time benefits in the prior year. The Ecatepec facility is now fully operational and we are gradually regaining the business. The company's insurance provider has acknowledged this incident is a covered event.

European results increased despite FX headwinds and the exit of the low margin sulfonation business in Germany, driven by strong growth in the agricultural market.

Now turning to Polymers on Slide 7.

Polymer operating income increased $4 million versus the prior year, primarily due to higher sales volume and a more favorable product mix. Polymer net sales were $135 million for the quarter, down 5% versus the prior year. Total sales volume increased 3%.

Global Rigid Polymer growth of 6% was partially offset by lower PA and Specialty Polyol volumes. Selling prices declined 6%, and the translation impact of a stronger U.S. dollar negatively impacted net sales by 2%.

Global polyol volumes increased 3% due to Rigid Polyol growth of 6%, driven by North America and Asia. Strong market demand in Rigid Polyol was driven by increased insulation standards and growth in construction.

North America polyol results increased due to strong volume growth and slight margin improvements. European results increased due to slight margin improvement. China results improved on 54% volume growth, driven by increased demand in cold storage insulation. Finally, PA results decreased due to lower volumes.

Specialty Product operating income decreased $0.4 million versus the prior year, primarily due to unfavorable order timing differences within our pharmaceutical business, partially offset by improved margins with our MCT product line. Specialty Products net sales were $17 million for the quarter, a 14% decrease versus the prior year. Sales volume declined 2% for the quarter.

Turning to Slide 8. Our balance sheet remains strong as we continue to have no net debt. During the first 9 months of 2019, the company paid $16.9 million of dividends and repurchased $13.2 million of company stock.

Beginning on Slide 9, we will now update you on our strategic priorities and plans to increase shareholder value.

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F. Quinn Stepan, Stepan Company - Chairman, President & CEO [5]

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Thank you, Luis.

Looking forward, we believe our Surfactant strategy will deliver value for our shareholders despite the current headwinds. Our continued focus on end-market diversification, Tier 2 and Tier 3 customers as well as our cost-out activities should improve future margins. We remain optimistic the Polymer business will deliver full year volume growth and incremental margin improvement versus 2018, given our strong Rigid Polyol growth in the first 9 months.

We believe full year Specialty Product results will improve versus 2018 on the strength of its 9-month earnings.

Overall, despite the current-year challenges, we have an opportunity to deliver another year of adjusted net income growth.

Turning to Slide 10. We've made good progress on our market diversification efforts, which continues to be a key component of our strategy. Although volume to the functional end markets decreased during the quarter and lower demand for agricultural products in North America due to the wet weather, our agricultural volume in Latin America increased 35%.

During the first 9 months, our global agricultural volume is up versus last year. We are expanding our presence in specialty alkoxylates with new dedicated technical resources and have introduced 13 new products over the past 18 months.

Next, our focus on customer intimacy continues to be a priority in order to deliver growth within our Tier 2 and Tier 3 surfactant customer base and to maintain our leadership position in several of our key businesses. However, Tier 2 and Tier 3 surfactant customer volumes decreased 7% during the quarter, primarily due to competitive pressure in North America and our exit from the sulfonation business in Germany.

Global Rigid Polyol volumes increased 6% during the quarter due to strong market demand, driven by increased insulation standards and growth in construction. We remain optimistic about continued growth of the Rigid Polyol market due to global energy conservation efforts.

Innovation is a key part of our strategy. As the leader in the Rigid Polyester Polyol market, we continue to work on developing the next generation of value-added technologies for our customer base.

The launch of STEPANQUAT Helia is well underway. North American personal-care customers are responding positively to this new haircare conditioner ingredient that is mild and safer for the environment.

During the quarter, we continue to sell STEPANQUAT Helia in North America, and we now also have introduced the product in Latin America, Brazil and India.

Next, operational excellence is an integral part of our strategy. We believe that the application of sulfonation best practices, network synergies and dry cost-saving opportunities will create long-term value from our Ecatepec acquisition.

We are also delivering savings on the shutdown of our surfactant operations at the Wesseling, Germany plant. We will continue to examine our asset base for opportunities to further optimize and improve capacity utilization and to more efficiently serve our customers around the world.

Operational excellence can be delivered from all groups within our company. During this calendar year, we have significantly improved the contributions from our finance team. We have reduced interest net expenses, delivered an efficient, effective tax rate and reduced pass-through receivables, all of which have improved our bottom line and cash position.

Finally, M&A represents an extremely important tool as a means to deliver meaningful EPS and EBITDA growth over the next few years. Given the strength of our balance sheet, we will continue to pursue M&A opportunities to fill gaps in our product portfolio and add new platform chemistries.

Our core values: customer focus, people first, continuous improvement, integrity, growth and innovation and sustainability describe how we will accomplish our plan. The market provides opportunities and challenges. We feel we are well positioned to capture opportunities for you, our shareholders.

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

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from the line of Jason Rodgers with Great Lakes Review.

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Jason Andrew Rodgers, Great Lakes Review - VP [2]

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Would you be able to quantify the one-time inventory costs related to the Asian-U. S. supply chain?

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Luis E. Rojo, Stepan Company - VP & CFO [3]

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Yes. It's roughly around $2 million when you include everything in.

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Jason Andrew Rodgers, Great Lakes Review - VP [4]

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All right. And then in regards to the comments around the smaller customers in North America that you're targeting for surfactants, you mentioned some competitive pressure, is that -- was that a new phenomenon? Is that getting worse as far as the competitive environment why that was called out?

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F. Quinn Stepan, Stepan Company - Chairman, President & CEO [5]

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I think we're seeing a slight increased material being shipped in from offshore into the United States, and it's having an impact on some of the commodity margins in that space.

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Jason Andrew Rodgers, Great Lakes Review - VP [6]

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All right. And then any rebound in the agricultural business in North America so far in the current quarter after the wet weather?

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F. Quinn Stepan, Stepan Company - Chairman, President & CEO [7]

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We are anticipating the fourth quarter to be up sequentially from kind of the third quarter, but generally, there's a seasonality associated with the business. And we typically expect a higher performance in the fourth quarter anyway, but we are seeing -- on a global basis, we are anticipating the ag business to be up in the fourth quarter.

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Operator [8]

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

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Michael Joseph Harrison, Seaport Global Securities LLC, Research Division - MD & Senior Chemicals Analyst [9]

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The surfactant performance, I think, particularly in North America and Latin America, seems like it's depressed just if we look at the volume trends as well as some of the unusual costs that you've mentioned, both the inventory costs or supply chain costs as well as the Ecatepec outage. Can you talk a little bit about what the time line for volume and operating income recovery should look like? Is that something that's going to remain depressed into Q4 and Q1? Or is it something that could come back sooner than that?

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F. Quinn Stepan, Stepan Company - Chairman, President & CEO [10]

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As we look at our business today, I would tell you that we anticipate that the volumes will be up in Q4 versus Q3. We've had some customer implementations of new SKUs that were delayed into the quarter, but I don't see significant growth in the commodity space into Q4 2019 or into 2020 at this point in time.

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Michael Joseph Harrison, Seaport Global Securities LLC, Research Division - MD & Senior Chemicals Analyst [11]

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All right. Maybe a question on the commodity side of the Surfactants business. To some extent, is this part of your diversification strategy, that this idea that maybe we try to work down our reliance on commodity volumes and increase the specialty side of the business? And maybe tied into that, can you comment on where capacity utilization sits today within your surfactants or your sulfonation business?

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F. Quinn Stepan, Stepan Company - Chairman, President & CEO [12]

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Yes, it's certainly a key part of our strategy going forward to continue to grow in the more functional markets of surfactants, and we have a significant part of our R&D and marketing efforts skewed toward growth in the functional markets. And so that is a priority for our company. It's also a priority to continue to grow in the smaller regional accounts, the Tier 2, Tier 3 customers. And we have increased resources on a regional basis dedicated to those smaller customers that we can leverage our 90 -- almost 90-year history in that space and help them grow in their local markets. So that is a fundamental part of our strategy.

With regard to kind of deemphasizing the commodity business, we continue to work with the larger customers to sell those products, and we'll do so when it's economically attractive to us, but there are some global pressures in that segment. From a capacity utilization, on a North American basis, we still have some excess capacity within our network. We're probably operating at 75% to 80% of capacity utilization today, I would say.

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Michael Joseph Harrison, Seaport Global Securities LLC, Research Division - MD & Senior Chemicals Analyst [13]

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All right. And then a question on the Polymers business. You mentioned better mix as something that was helping your Polymers margin, but it sounds like, in terms of volumes, Rigid Polyols were up while Specialty Polyols were down and PA was down. So can you just help us understand maybe some of the margin differences between some of these product lines? Or maybe there are regional differences and maybe provide some additional detail on what was stronger or weaker to generate that mix improvement that you saw in Q3.

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F. Quinn Stepan, Stepan Company - Chairman, President & CEO [14]

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Generally, when we talk about an improved mix in Polymers, we're talking about less phthalic anhydride and more Rigid Polyols, not the driver, Mike.

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Michael Joseph Harrison, Seaport Global Securities LLC, Research Division - MD & Senior Chemicals Analyst [15]

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All right. And then last question for me is just on the tax rate. It looks like Q3 tax rate was very low. I know you mentioned the R&D credits that came in, but in terms of that Q4 number, that 18% to 21% full year guidance kind of gives us a really wide range for Q4 tax rate. So just wondering if you can help us understand the puts and takes around what might get you to the higher or lower end of that range.

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Luis E. Rojo, Stepan Company - VP & CFO [16]

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Yes. As you know, we always provide a wide range on the tax rate, given the volatility of potential new projects or mix within the countries. For example, if we get any type of insurance in Mexico at 30% tax rate, of course, it can change the mix significantly. So I will say, if you look at the range, the midpoint is kind of what we're forecasting right now. And that will give you a rate for Q4 that is consistent with what we have talked before about the -- our ongoing tax rate in the 23%, 24% range.

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Operator [17]

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(Operator Instructions) Our next question comes from the line of Vincent Anderson with Stifel.

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Vincent Alwardt Anderson, Stifel, Nicolaus & Company, Incorporated, Research Division - Associate [18]

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Nice job on polyols this quarter. I was hoping we could dig a little bit more into the surfactants margins. If you're able and willing, how much of that was due to sort of the direct or indirect expenses related to the plant closure in Germany? How much of it was the lower functional product mix and all leading up to when we can expect those margins to normalize?

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Luis E. Rojo, Stepan Company - VP & CFO [19]

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Vincent, what I would say is that if you look at the margins on a year-to-date basis for surfactants and you exclude the LIFO change on the base, we are in the ballpark similar to last year. And then you need to take into account that we have significant losses year-to-date in the first 3 quarters due to Mexico. So if you reverse that out, our margins are on a healthy position when you look at the global surfactant business.

Last year, we closed at $9.9 million margins, but if you exclude the LIFO, it's more like $9.6 million. So again, if you exclude the Mexico piece, we are in -- our margins are healthy and stable to growing. So again, Q3 was particularly impacted by a few cost items as well as with sales growth in -- 14% in surfactants, of course, you have all the fixed cost of SG&A and overhead impacting your margins. And that's why -- I mean, you saw the $6.6 million in Q3. But I would encourage you to look at the numbers more on a long-term basis.

And we are in a decent position in surfactants. We're growing slightly our margins in Polymers. And in Polymers, what I would say is, also in China is a nice delta of almost a point of margins. So a slight margin improvement in North America and Europe, but then a big jump because of China to the overall Polymers margins at 14% instead of 12% last year. And Specialty Products is also growing significantly from the 15% last year to 20% this year. So we feel good about our margin situation.

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Vincent Alwardt Anderson, Stifel, Nicolaus & Company, Incorporated, Research Division - Associate [20]

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Okay. And just to be clear, so it's not as if there were significant one-time or short-term expense related to the sulfonation plant closure that would roll off either next quarter or into 2020?

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Luis E. Rojo, Stepan Company - VP & CFO [21]

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No.

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Vincent Alwardt Anderson, Stifel, Nicolaus & Company, Incorporated, Research Division - Associate [22]

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Okay. And then so if I look at the agricultural demand, obviously, the U.S. was tough, but you posted some nice growth outside the U.S. Are you able to quantify roughly how much of that growth came from your recently introduced products?

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Luis E. Rojo, Stepan Company - VP & CFO [23]

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I don't have the number here with me. Yes, I don't have it in here. We can work that offline.

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Vincent Alwardt Anderson, Stifel, Nicolaus & Company, Incorporated, Research Division - Associate [24]

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Okay. And then just a bit more broadly on the strategy, I was curious about your current ability to service private label personal care producers, whether that's a customer that you feel is maybe underrepresented in your current portfolio and what your strategy is for servicing the private label market going forward.

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F. Quinn Stepan, Stepan Company - Chairman, President & CEO [25]

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Stepan has and historically has had a fairly large presence in the personal -- or the private label segment with some key core relationships, primarily in North America. I would say that, today, we are underrepresented in that marketplace in Europe today, particularly with the closure of our German asset. But we have a presence with many of the leading players in North America. We don't have a presence with all of them. There recently was a share shift within that segment, and one of our key core customers lost some share to someone that we are not supplying in the personal care space.

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Vincent Alwardt Anderson, Stifel, Nicolaus & Company, Incorporated, Research Division - Associate [26]

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Okay. Right, right. And actually, if I can sneak one more in. I would just be interested to know, with regards to the competitive imports on your more commoditized products, just generally where those are coming from, and which product specifically are seeing the largest impact.

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F. Quinn Stepan, Stepan Company - Chairman, President & CEO [27]

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I would say the commodity adding on, it's either sulfates and sulfonic acids typically coming in from China, Korea. Some of those are coming in from Israel. And I would say there are relatively limited presence in the smaller customers in -- particularly in the East and West Coast United States.

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Operator [28]

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(Operator Instructions) And we are showing -- I apologize. We do have a question. Our question is a follow-up question from the line of Mike Harrison with Seaport Global Securities.

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Michael Joseph Harrison, Seaport Global Securities LLC, Research Division - MD & Senior Chemicals Analyst [29]

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Just a couple more on Polymers. First of all, I heard you reference, Luis, the -- that you're heading toward a 14% operating margin number for Polymers. I think on the last call, you kind of referenced more of a 13% to 13.5%. So is it fair to say that your margin is tracking a little bit better than what you had anticipated 3 months ago in Polymers?

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Luis E. Rojo, Stepan Company - VP & CFO [30]

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I would say it is better mainly because of the China situation.

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Michael Joseph Harrison, Seaport Global Securities LLC, Research Division - MD & Senior Chemicals Analyst [31]

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Got it, okay. So with regard to that China situation and this cold storage opportunity, we've talked about that a little bit in the past, but I'm just wondering if you can help frame up the 54% volume growth number. How big is the cold storage market? And kind of where do you guys sit within that market right now? Just wondering how we should think about 50-plus percent volume growth in the context of that longer-term opportunity in cold storage insulation.

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F. Quinn Stepan, Stepan Company - Chairman, President & CEO [32]

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Yes. So Mike, that's a good question. That's a question that I've been pushing back on our China team to try to understand if that growth is sustainable and what we should anticipate. And what I've been told and what we believe is that the penetration of cold storage or the presence of cold storage is still in its infancy in China. And if we compare it to the U.S., we would take a look at China maybe at a 20% adoption rate in China, and the United States is kind of 90%, 95%. So we do believe there is significant opportunities to grow in cold storage, and it is sustainable over a period of time. Now we've been growing from a relatively small base, so the 54% is meaningful. And we're swinging that operation from a loss to a small or to a decent-sized gain, kind of a $4 million swing year-over-year in terms of operating income. So nice growth in that space, and we believe it's sustainable into 2020 and '21 certainly.

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Michael Joseph Harrison, Seaport Global Securities LLC, Research Division - MD & Senior Chemicals Analyst [33]

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Okay. And then within Polymers, you mentioned that phthalic anhydride volumes were lower. Can you comment on what you're seeing in PA pricing?

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F. Quinn Stepan, Stepan Company - Chairman, President & CEO [34]

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PA pricing has been somewhat stable, I would say. But what we are seeing, and I do think PA is kind of a forward indicator of where the economy could go, that in our Tier 2 and Tier 3 customer base. And so we do see some slowdown in those 2 market segments from an overall demand perspective, and that has us a little bit concerned for growth in those 2 areas in 2020.

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Michael Joseph Harrison, Seaport Global Securities LLC, Research Division - MD & Senior Chemicals Analyst [35]

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Interesting, okay. And then last question is just around corporate expense that was on an adjusted basis that was lower year-on-year. I know that that's been a focus of some of your efforts, but can you maybe provide some guidance for Q4 corporate expense? And any thoughts -- I know it's a little bit early, but any thoughts on what the 2020 corporate expense number could look like?

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Luis E. Rojo, Stepan Company - VP & CFO [36]

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Look, we expect the Q4 to be similar to the trends that you have seen in the first 3 quarters. And as we are in the middle of our budgeting process right now for 2020, what I will say is that we will continue balancing delivering the bottom line with the investments that we need to make in the business to continue growing and to continue creating the capabilities that we need in several areas for our future growth and for our future platform. So we are, as always, contemplating a portfolio of investment opportunities, IT, et cetera, so we will make sure that we have a robust 2020 budget that is balanced.

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Operator [37]

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We have no further questions on the audio lines at this time.

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F. Quinn Stepan, Stepan Company - Chairman, President & CEO [38]

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Good. 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 fourth quarter 2019 call. Thank you very much.

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Operator [39]

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