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Edited Transcript of SXT earnings conference call or presentation 18-Oct-19 1:30pm GMT

Q3 2019 Sensient Technologies Corp Earnings Call

MILWAUKEE Oct 21, 2019 (Thomson StreetEvents) -- Edited Transcript of Sensient Technologies Corp earnings conference call or presentation Friday, October 18, 2019 at 1:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Paul Manning

Sensient Technologies Corporation - Chairman, CEO & President

* Stephen J. Rolfs

Sensient Technologies Corporation - Senior VP & CFO

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Conference Call Participants

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* Brett Michael Hundley

Seaport Global Securities LLC, Research Division - Research Analyst

* Heidi Maria Vesterinen

Exane BNP Paribas, Research Division - Financial Analyst

* Lalishwar Mitra Ramgopal

Sidoti & Company, LLC - Healthcare Sell Side Analyst

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Presentation

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Operator [1]

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Good morning, and welcome to the Sensient Technologies Corporation 2019 Third Quarter Earnings Conference Call. (Operator Instructions) Please note, this event is being recorded.

I would now like to turn the conference over to Steve Rolfs. Please go ahead, sir.

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Stephen J. Rolfs, Sensient Technologies Corporation - Senior VP & CFO [2]

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Good morning. I'm Steve Rolfs, Senior Vice President and Chief Financial Officer of Sensient Technologies Corporation. I would like to welcome all of you to Sensient's conference call to discuss 2019 third quarter financial results.

I'm joined this morning by Paul Manning, Sensient's Chairman, President and Chief Executive Officer. This morning, we released our 2019 third quarter financial results. A copy of the release is now available on our website at sensient.com.

During our call today, we will reference certain non-GAAP financial measures, which we believe provide investors with additional information to evaluate the company's performance and improve the comparability of results between reporting periods. These non-GAAP financial measures remove the impact of currency movements, depreciation and amortization, noncash stock-based compensation, the impact of the 2017 U.S. tax legislation and other items as noted in the company's filings.

Non-GAAP financial results should not be considered in isolation from or as a substitute for financial information calculated in accordance with GAAP. A reconciliation of non-GAAP financial measures to the most directly comparable GAAP financial measures is available on the Investor Information section of our website at sensient.com and in our press release. We encourage investors to review these reconciliations in connection with the comments we make this morning.

I would also like to remind everyone that comments made this morning, including responses to your questions, may include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Our statements may be affected by certain factors, including risks and uncertainties, which are discussed in detail in the company's filings with the Securities and Exchange Commission. We urge you to read Sensient's filings for a description of these factors. Please bear these factors in mind when you analyze our comments today.

Now we'll hear from Paul Manning.

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Paul Manning, Sensient Technologies Corporation - Chairman, CEO & President [3]

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Thank you, Steve. Good morning. This morning, we released our third quarter results, and they were below my expectations. Before I provide an update on our businesses, I would like to comment on what we are seeing in the market and how that is impacting our results.

The first market dynamic I'll comment on is the overall softness in a handful of product lines. The overall market in North America and Europe for food and beverages, which includes a broad array of product categories from pet food to soup, has been down for the trailing 12 months. We have been directly impacted by the slowness, particularly in our flavor ingredient product lines, which has a significant presence in soup and yogurt as well as other categories.

Despite the slowdown, we are experiencing successes in a number of areas, such as ice cream, natural colors and pharmaceuticals. In addition, our North American Savory business is turning around and is well positioned for next year.

Turning to cosmetics. The cosmetic makeup market remained soft. The rebound continues but is about a quarter or 2 slower than originally anticipated. That said, we have seen promising signs in our order patterns and a full rebound in certain geographic locations and customer segments. We expect the cosmetic business to be back on track in 2020.

Another market dynamic has been the challenges caused by economic, political and trade uncertainty. The impact of tariffs has resulted in higher cost for certain raw materials from China and has caused other suppliers to raise their prices as well. In most situations it has been difficult to pass on the full impact of the tariffs through pricing. Tariffs have also impacted revenue as they have created conditions in certain regions, which have led to deferred product launches, de-stocking and general uncertainty.

Shifting to Europe. Brexit continues to drag on, impacting our customers' order patterns and overall cautiousness on purchasing decisions. Furthermore, recent discussions on U.S. imposing European tariffs have also contributed to this uncertainty. During the third quarter, our U.K. business was down substantially. We experienced lower demand in Europe for flavor, color and cosmetics.

Another market dynamic relates to changing consumer trends and the impact on our customers. Many of the largest multinational customers are struggling to address rapidly changing consumer preferences. They are under pressure to find ways to grow. Many are focused on raw material cost reductions and are also rationalizing their product lines. We have felt the impact of the cost focus and these rationalization efforts.

For smaller- and mid-sized companies, what we call B and C customers, there's a continued focus on introducing new products. This is good news, but these launches are smaller and the success rates have been uneven.

Now let me outline what are we doing to address these market conditions: first, we're focusing on key markets, food colors, finished flavors, and extracts, cosmetics, pharmaceuticals and Natural Ingredients; second, we are divesting certain business lines; third, we are continuing to reduce our cost structure; and lastly, we are focusing on our free cash flow.

Going forward, we will exclusively concentrate on our key strategic markets: food colors, finished flavors and extracts, cosmetics, pharmaceuticals and Natural Ingredients. Within the Color Group, we continue to see strong demand for natural colors and pharmaceuticals. The pharmaceutical product line is up double digits for the year and natural colors are up nearly double digits for the year. We expect this strong growth to continue into 2020 and beyond for both businesses.

Our cosmetic business continued to deliver strong margins. And as the market normalizes, we should return to year-over-year growth in this business. I, therefore, expect growth in 2020 and beyond. Food colors, cosmetics and pharmaceuticals will constitute the core strategic focus areas for the Color Group going forward.

In the flavor segment, we continue to deliver solid sales growth in finished flavors and extracts, which are up mid-single digits for the year. We are also seeing positive momentum in our North American Savory, sweet flavors and Latin America flavor businesses, which are all winning many new projects. Finished flavors, extracts, taste modulation technologies and Natural Ingredients will continue to -- will constitute our core strategic focus for the Flavor Group going forward.

To further solidify our strategic focus, we are divesting the inks, fruit prep and fragrance business lines. We do not enjoy the scale in these markets to effectively compete in these business lines any longer. These business lines have been significant headwinds for the company for several years. We believe we can refocus and maximize our investments in our core businesses and improve our overall product portfolio and growth prospects. I anticipate that our ability to deliver consistent results will be greatly improved without the headwinds and distractions of these business lines.

In the short term, we will use the proceeds to reduce debt, and thereafter, we will use the proceeds to acquire businesses in our core focus areas. Another way we'll overcome these market challenges is to continue to reduce our cost structure in both flavors and colors. We have made progress in reducing our production and SG&A cost in both groups. The reduction of these costs better align our organization to our key strategic areas and will improve -- and will provide an improved profit picture for both groups moving forward.

We also continue to focus on our free cash flow, starting with inventory. Coming out of restructuring, we built our inventory to improve our customer service commitments. Having reestablished excellent customer service levels, we are now focused on reducing our inventory levels, which have come down by $20 million since December. We have also reduced our capital expenditures consistent with our smaller post-restructuring production footprint.

Taken together, the reduction in the inventory and capital expenditures has contributed to an increase in our free cash by $35 million, more than 50% this year. With this cash flow, we have reduced debt by $129 million over the last 12 months. We've experienced some exceptionally challenging market dynamics this year. Our actions to continue to focus the company, divest nonstrategic business lines, reduce costs and focus on free cash flow will provide better results going forward.

Steve will now provide you with the additional details on the third quarter.

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Stephen J. Rolfs, Sensient Technologies Corporation - Senior VP & CFO [4]

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Thank you, Paul. Sensient's revenue was $317.7 million in the quarter compared to $342.7 million in last year's third quarter. Operating income was $38.8 million compared to $50.3 million in the comparable period last year.

Local currency adjusted EBITDA was down approximately 15% during the current quarter. Foreign currency translation reduced both revenue and operating income by approximately 1% in the quarter.

Diluted earnings per share were $0.75 in the quarter. During last year's third quarter, we finalized our estimate of the impact of the 2017 tax legislation. The diluted earnings per share in last year's third quarter of $1.12 includes $0.17 of tax benefit related to finalizing our estimate of the U.S. tax law change. The adjusted results for 2018 removed the impact of the tax legislation accounting and were $0.95 in last year's third quarter.

Foreign currency translation reduced EPS by approximately $0.01 in the quarter compared to last year's adjusted EPS. The company's consolidated tax rate was 5.9% in the quarter compared to an adjusted tax rate of 10.5% in last year's third quarter. This year's third quarter rate includes approximately $0.15 of benefit related to a tax planning strategy. Last year's third quarter adjusted tax rate benefited $0.13 related to tax planning actions taken in response to the tax law changes.

The company's year-to-date consolidated tax rate is 17.5% compared to last year's adjusted rate of 17.1%. As reported, cash flow from operations for the third quarter of 2019 was $51.4 million. Capital expenditures in the third quarter of 2019 were $9.5 million compared to $10.1 million in the third quarter of 2018.

Cash flow from operations for the first 9 months of 2019 is $127.6 million compared to the adjusted results of $100 million for the first 9 months of 2018, an increase of 28%. Our free cash flow in the first 9 months of 2019 was $101.5 million compared to adjusted free cash flow of $65.9 million in the first 9 months of 2018.

We continue to focus on reducing our working capital, particularly inventory, and we're seeing positive results. The company's total debt decreased $40 million during the quarter and $129 million since September of 2018 to its current level of $637 million.

The company now anticipates that our full year EPS will be in the range of $2.90 to $3 per share. We continue to expect our full year local currency adjusted EBITDA to be below last year's results.

Thank you for your time this morning. We will now open the call for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Brett Hundley with Seaport Global.

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Brett Michael Hundley, Seaport Global Securities LLC, Research Division - Research Analyst [2]

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Paul, one of the questions that I'm getting a fair amount this morning from clients is as you guys decide to explore strategic alternatives for certain product lines, why not sit down and review the entire business as a whole?

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Paul Manning, Sensient Technologies Corporation - Chairman, CEO & President [3]

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Well so, we -- I always look at the entire business, and the pieces that we are selling are those that are most obviously better resting in the hands of another market participant. These are businesses that -- I think scale is very important. Market position is very important. In some cases, these are very much legacy businesses of Sensient.

And so these are quite different from the businesses that we talk about from a core focus of food colors and flavors and pharma, et cetera. So 2 different worlds, and I think that based on where the company is right now, these have been the biggest headwinds to us, and it makes the most sense to take these pieces, to sell them, again, to a buyer with a much stronger position in the market where they can take advantage of their scale and their ability to cover a wide range of customers and to maintain a good position.

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Brett Michael Hundley, Seaport Global Securities LLC, Research Division - Research Analyst [4]

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And to follow on, I mean, what type of market do you think exists for these business lines at a high level?

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Paul Manning, Sensient Technologies Corporation - Chairman, CEO & President [5]

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For the 3 that we're selling, these are obviously, markets where scale is very important. And as we describe our business, we are a specialty company. We're making specialty ingredients that are based on far greater degree of customization. They're not necessarily built on large capital volume-driven plants. And so, again, I would speak to these as being very much legacy businesses for the company.

At one point, these are very different markets than they are today. So as markets mature and develop, there's a natural progression of the product line, and certainly, we're no different. But the remaining businesses that we focus on, it's a very different situation for Sensient, right?

You saw our Food Color's results. You see that Sensient is a indisputable market leader in food colors, and we outgrow the market in just about every one of our geographies. You look at our cosmetic business, where we have a top market position. We're in a situation right now with makeup that I think, certainly, we cycle through that one in the short term, and we're back where we were, a very strong, technically driven, compelling market position business.

Ditto for -- as you think about the rest of the focus areas that I've discussed, SNI, our business -- our agricultural business, we are a top market participant. So it's a lot easier to grow businesses where you have that type of leadership position, where you have that type of influence. It's much more difficult to do that in the market where you're one of many, where perhaps scale is more relevant economic factor in your success.

So I think the divestitures make a great deal of sense for us, and quite frankly, they make a great deal of sense for the buyer too. So I think this is a very good outcome for both parties. And I think, this will -- as you heard me say in the prepared comments, this removes a lot of the headwinds and the distractions that we've faced in these business lines for the last several years. So I think this is a real high positive for the company to rethink the portfolio how we -- as we have.

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Brett Michael Hundley, Seaport Global Securities LLC, Research Division - Research Analyst [6]

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And how easily can these business lines be separated? I guess 2-part question. How easily can these business lines be separated? And then I need to go back to my old initiation to add everything up, but I'm getting to around 20%, 25% plus of your combined revenue line that could be under review "relative" to the businesses that you mentioned. Am I in the right ballpark there?

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Paul Manning, Sensient Technologies Corporation - Chairman, CEO & President [7]

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So for the first part, I think these are -- you could almost describe them as mutually exclusive from the other parts of the business, right? They operate in different production-type environments. In some cases, they have very different customers. Clearly, in the case of inks that's the case. So the ability to separate them is -- I think it's a pretty clean evolution. It's not easy, but it's a fairly clean separation that I think can be readily done.

If you're thinking of kind of magnitude, think in terms of about 10% of the revenue, not 25%. 25% would be -- we would be at very high estimate. It's more like about 10%.

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Brett Michael Hundley, Seaport Global Securities LLC, Research Division - Research Analyst [8]

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Perfect. And then just one more for me. At the outset here, you talked about a number of the things that have contributed to softer-than-anticipated results this year. A couple of them we've been aware of. They've been ongoing. For Q3 specifically, it sounds like cosmetics just didn't progress as you thought it would. And then it also sounds like some of your ingredients just haven't progressed as expected. You also mentioned the U.K. as well, but is there something that really stands out insofar as the shortfall in Q3?

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Paul Manning, Sensient Technologies Corporation - Chairman, CEO & President [9]

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Okay. So what really stands out in Q3 as contributing to the shortfall of the 2 you mentioned, these flavor ingredients and the cosmetic market. So let me take the cosmetic piece first.

When we first observed the slowdown in demand for cosmetic makeup products, it was very much focused on makeup. It excluded skin. And it was more of a mass market-type outcome. This did not really affect the high-end makeup products. Those tend to be resistant to really any economic changes in the markets. As we saw that happening, we had anticipated, and if you go back about a year, that these businesses, these geographies would sort of resume normal demand in sort of this orderly fashion, beginning with the U.S. and Europe and then eventually, flowing through to Latin America.

In reality, what happened here, it was kind of reversed. We had determined that or we've seen that Latin America is very much back on track. They had a very strong outcome in Q3 and in Q4 here as we're sitting here in late October. Where the recovery has been a little bit slower than we had anticipated is in the U.S. and in Europe. Asia was really principally impacted by the U.S.-China tariff, which had a profound impact on many of the customers that we sell to in China who export to the U.S. and other markets.

So when you look at this market, you'd say we are a market leader. You would say that this downturn in our businesses is not the result of some competitive action that's taken our business. This is not the result of some technological innovation that Sensient missed the boat on. So it's still fundamentally a very good market. It's still fundamentally a market that we are a leader in. And so what's frustrating here is the recovery has not been as fast as I had anticipated, but I think this is still a very strong market.

I mentioned we've already seen some of them come back. I think we can expect Asia to get very, very close to resuming things here in -- even in Q4. But I think as you look at 2020, we would anticipate that the rest of the geographies are back in place.

With respect to the second one that I mentioned, flavor ingredients, yes, that was an enormous headwind to us. Absolutely. Because you look at -- our natural colors were up. Our flavor sales were up mid-single digits. Our pharma business was up. And where we really felt the brunt of the revenue declines were in these flavor ingredients. And this is why I go back to the point of having that market position, that market share, that volume, that scale that perhaps others do is not something that we have. And so we have to respond to that in a thoughtful way. And in my opinion, the best way that we do that is we pursue a sale of those product lines.

So removing that significant headwind. Again, flavors. Where we have been focused? Finished flavors' sales is a part of the portfolio that is up. It is growing. We are winning. And I think I feel very good about that in the future, and I feel even better when that type of success is not being concealed by the headwinds that are, we feel, routinely in this flavor ingredient space. So I guess that's all I have to say about that.

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Operator [10]

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The next question comes from Heidi Vesterinen with Exane BNP Paribas.

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Heidi Maria Vesterinen, Exane BNP Paribas, Research Division - Financial Analyst [11]

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So the first question is on the exits. Would you be able to tell us how the core businesses have been growing? So excluding the bits you want to exit. And so how have we been growing in the past few years? And what will the exit mean in terms of profitability, please? That's my first question.

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Paul Manning, Sensient Technologies Corporation - Chairman, CEO & President [12]

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Okay. So the businesses ex these flavor ingredients and in inks, right? So let's take -- I mentioned natural colors is up -- was up in the quarter mid-single digits for the year, nearly double digits. And that other than Europe, actually all the regions are doing quite well on the natural colors front.

I mentioned that for flavors we were up mid-single digits in the quarter as well as the year. Pharma has been double digits essentially for the year. Cosmetics, as a result of the market downturns I've referenced, was down about mid-single digits. So if you do the math, you'd conclude that these flavor ingredients and inks tell a very different tale. And so I don't how that math plays out, but ultimately, these were the single biggest headwind in terms of the results.

Now there's another factor too that I'd like to speak to, and it doesn't often get a lot of attention, but the level of attrition that we are observing in the market is also quite significant. Some of this is product rationalization, but some of this is just the failure rate of new product launches. And so our new product launches, which we review or I should say sales that not only include new products, but also sales to existing customers, continues to be quite good. We are winning new projects. But a part of the headwind that we also see, and particularly, in the U.S. market, is a lot of product attrition. The failure rate of new products is considerably high. And so you can be winning a lot, but things are falling off the wagon so to speak, that makes for a bit of a headwind.

So we've seen throughout 2019 a significant rise in attrition rate. Now attrition is different from you lost it to a competitor. My definition of attrition is customer A has a product and he discontinues that product, or customer A launches a product and he only launches it for 6 months as a limited-time offering, when in fact he thought it was going to be a permanent fixture on his -- in his business.

So that is a dimension of the market that we are seeing right now that is much higher than what we've seen in previous years. I think some of this is a result of the uncertainty in certain markets. I think some of this is the result of, again, larger customers, in particular, rationalizing their portfolio perhaps not unlike how we're proposing to rationalize our portfolio. So that's how I would kind of break that up.

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Heidi Maria Vesterinen, Exane BNP Paribas, Research Division - Financial Analyst [13]

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And then in terms of profitability, will it be positive if you succeed with these exits?

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Paul Manning, Sensient Technologies Corporation - Chairman, CEO & President [14]

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Let's just say we're going to take the proceeds. We're going to reallocate that capital for acquisitions. And I don't have to buy anything nearly as large as what I'm divesting to make up for that profit.

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Heidi Maria Vesterinen, Exane BNP Paribas, Research Division - Financial Analyst [15]

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And the next question on the exit is so how far you've progressed with this? Is this a new process that you're starting now? Or how should we think about the timing of the sale?

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Paul Manning, Sensient Technologies Corporation - Chairman, CEO & President [16]

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Yes. I don't want to get into the specific puts and takes on transactions, simply because they're governed by NDAs, if they were to exist or not exist. So I think it's probably easier for us to just say that at this point, it's about 10% of the revenue. It's not as profitable, obviously, as the broad-based businesses, whether color or flavors. And as we progress and as we eventually culminate these transactions and the signing and the closing, we would make the results of that publicly available to all our folks.

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Heidi Maria Vesterinen, Exane BNP Paribas, Research Division - Financial Analyst [17]

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And then lastly, I guess going back to the earlier question, the first question. So are you really set on just divesting the 10% of sales? If somebody were to come with an offer for the whole business, do you just say no? Or would you be open to a discussion?

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Paul Manning, Sensient Technologies Corporation - Chairman, CEO & President [18]

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Heidi, I'm here to drive value. And as you look at the business, we had a tough quarter. So I suppose, most pragmatically speaking, this would be the absolute worst time to think about something like that. I think what we want to do is take care of these pieces, and then as we always do around here, continue to look at the portfolio. Markets change, markets mature, and then we respond accordingly. As I mentioned, we have, in mind, some inorganic approaches to the business that I think we could potentially discuss here in the future. So I think that's where we're focused. I think that's what's going to turn the ship around, so to speak.

But I think removing these ingredients and removing these other lines, where, again, we are not the market leaders, I think will give you and others a very different feel and look for what's happening in the business. And there are very positive things that are happening in these core strategic areas. But again, my easiest answer there is I'm always looking to maximize shareholder value. And I think as I see it right now, the best way for us to do that is to divest these 3, pay down debt, acquire selectively, and continue to focus in these core areas that I described of food color, flavor extracts, cosmetics.

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Operator [19]

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(Operator Instructions) The next question comes from Mitra Ramgopal with Sidoti.

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Lalishwar Mitra Ramgopal, Sidoti & Company, LLC - Healthcare Sell Side Analyst [20]

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Just wanted to follow up, again, on the last question regarding the divestitures. Obviously, a few years ago, you did a restructuring initiative. You divested some noncore businesses. You have identified 3 more today. And I'm just wondering if it's fair to assume, after this process couple years or a few years out, you're pretty much set now in terms of the portfolio you have?

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Paul Manning, Sensient Technologies Corporation - Chairman, CEO & President [21]

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Yes. I mean I think the pieces that I describe where we have market-leading positions are areas that I think we can be quite successful in. Where we're quite profitable; they're very technically driven; they're very defensible, sticky businesses; very different from some of the other pieces that we've had over the years. So yes. As I sit here today on October the 18, I think that the residual components look pretty good to me.

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Lalishwar Mitra Ramgopal, Sidoti & Company, LLC - Healthcare Sell Side Analyst [22]

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Okay. No, that's fair. And on the Color Group, I know you -- one of the things you highlighted in terms of softness in the quarter, in terms of profitability was the higher input costs. And I was wondering if you could add some more detail there in terms of what you're seeing and any potential ways of easing that pressure.

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Paul Manning, Sensient Technologies Corporation - Chairman, CEO & President [23]

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Yes. Where we see the inflation on raw materials is principally on the synthetic food colors, inks, within the Color Group anyway. Those are the areas that we have the most inflation. A lot of that was driven by the tariff. We can measure the explicit impact of the tariff on those raw materials, but what you also have is a dynamic where we're the only country at war with China in the tariff. And so our competitors who are not U.S.-based are not at war with China and then imposing tariffs. And so therefore, they're not subject to that raw material inflation. Many of them can take different pricing strategies with their products to further take advantage of that situation. And so you have kind of a double whammy. You get the raw material inflation and you struggle to pass along the pricing because the passing of the pricing is only by U.S.-based firms. And so that's been a bit of a profit drag for us in color.

I'm not going to opine as to the remediation of that tariff war. All I'll say is that we will work our way through it. And I think as you think about our business over time, it's one where we can ultimately either formulate out certain raw materials or we can convert folks to natural colors. We can do a lot of things to remediate this if this were to lag on and on and on. But we've established new suppliers. Unfortunately, many of those new suppliers are fairly aware of the tariff impact, and they can cost their raw materials at parity with the Chinese plus tariff factor. So the raw material inflation, it goes well beyond just things coming out of China because of the entire market response to that dynamic as well.

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Lalishwar Mitra Ramgopal, Sidoti & Company, LLC - Healthcare Sell Side Analyst [24]

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And then finally on the guidance. Steve, I was just wondering what I should be looking at in terms of potential tax rate for the fourth quarter in light of this year as you have seen earlier?

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Stephen J. Rolfs, Sensient Technologies Corporation - Senior VP & CFO [25]

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Sure. So coming into this year, I had expected tax to be a headwind. We had some significant planning opportunities last year in connection with the new tax law. There have been some new regs that recently came out that did provide some opportunity for additional planning. We essentially -- we're fortunate to have a significant amount of credit carryforwards. And so we'll continue to look for ways to use those to reduce our future taxes. And so in the fourth quarter, again, where as we originally assumed tax to be a headwind, I would say for the year now, we'll probably be at or a couple points below last year's full year tax rate.

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Operator [26]

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This concludes our question-and-answer session. I will turn the conference back to the company for any closing remarks.

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Stephen J. Rolfs, Sensient Technologies Corporation - Senior VP & CFO [27]

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Thank you, everyone, for participating in the call today. That will conclude our call.

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Operator [28]

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The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.