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Greetings and welcome to the Q1 2019 earnings call. [Operator Instructions] As a reminder, this conference is being recorded Tuesday, April 30, 2019. I would now like to turn the call over to Mr. Luis Rojo. Please go ahead.
Good morning, and thank you for joining Stepan Company's First 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 foreign operations, global and regional economic conditions and factors detailed in our Securities and Exchange Commission filings. Whether you're joining us online or over the phone, we encourage you to review the investor slide presentation, which we have made available at www.stepan.com under the Investor Relations section of our website. We make these slides available at approximately the same time as when the earnings release is issued, and we hope that you find information and perspectives helpful. Now with that, I would like to turn the call over to Quinn Stepan Jr., our Chairman, President and Chief Executive Officer.
Thank you, Luis. Good morning and thank you all for joining us today. Following a record first quarter last year, Stepan Company had a good start to 2019. Strong volume, particularly within our key strategic end markets, was overshadowed by the negative impact of the sulfonation equipment failure and our recently acquired surfactant facility in Ecatepec, Mexico and unfavorable timing of certain items within our polymer segment. First quarter adjusted net income was $30.6 million or $1.31 per diluted share versus $33.6 million or $1.44 per diluted share in the prior year. Surfactant operating income for the quarter was down primarily due to the equipment failure in Mexico. The plant is scheduled to restart in 2 weeks. Our insurance provider has acknowledged this incident as a covered event, and the company is pursuing insurance recovery for damaged equipment, incremental supply chain expenses and business interruption. Global Surfactant sales volume increased 3% on higher demand within the functional end markets, including agricultural and oilfield chemicals. The polymer business was down versus the prior year, primarily due to the nonrecurrence of a class action settlement received in 2018, unfavorable timing related to the consumption of higher price inventories and a onetime cost related to a planned maintenance shutdown at our site in Germany to debottleneck capacity. Global polyol volume increased 3% on higher rigid polyol demand in North America, Europe and China. Rigid polyol margins were down in North America, but should recover in the second quarter. Our Specialty Products business results were hired due to timing differences within our flavor business. A decision was made to reduce overhead within this segment, which should provide benefits in the second half of the year. Our Board of Directors declared a quarterly cash dividend on Stepan's common stock of [ $0.25 ] per share, payable on June 14, 2019. At this point, I'd like Luis to walk through a few more details about our first quarter results.
Thank you, Quinn. My comments will generally follow the slide presentation. In the first quarter of 2019, the company adopted changes in accounting principles, converting from the last-in first-out inventory method to the first-in first-out inventory method. This change was adopted retrospectively and all reported prior periods have been adjusted. We believe this change align us more compare for industry and provides greater transparency. The net effect of obscuring LIFO from prior year results was $1.2 million of additional income in the first quarter of 2018, and will be $1.6 million of additional expense for the full year 2018, net a minor adjustment to 2018 P&L results. As per our balance sheet, $24 million was added to return earnings. Let's start with the Slide 4 to recap the quarter. Adjusted net income for the first quarter of 2019 was $30.6 million or $1.31 per diluted share, a 9% decrease versus $33.6 million or $1.44 per diluted share in the first 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, adjustment to reported net income this quarter consists of adjustment for deferred compensation expense and restructuring expenses. Adjusted net income for the quarter excludes deferred compensation expense of $5.1 million or $0.22 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 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 this item from our operational discussion. Adjusted net income for the quarter also excludes $500,000 or $0.02 per diluted share of after-tax business restructuring charges, related to the decision to close the Specialty Products office in the Netherlands, and ongoing decommissioning cost related to the Canadian plant closure in 2017. We expect an additional $1 million of after-tax decommission expense at our Canadian and German plants in 2019. Slide 5 shows the total company earnings bridge for the first quarter compared to last year first quarter, and breaks down the decrease in adjusted net income. Because this is net income, these figures noted here are on an after-tax basis. We will cover each segment in more detail, but to summarize Surfactant and polymers were down, while Specialty Products was up versus the prior year. Corporate expenses were lower during the quarter due to lower costs associated with the company first quarter 2018 Ecatepec acquisition. Favorable net interest expense was related to higher interest income in the U.S. after the company cash repatriation in 2018. The company's effective tax rate was 19.5% in the first quarter of 2019 versus 18.7% in the first quarter of 2018, mainly due to country mix. We expect the full year 2019 effective tax rate to be in the range of 21% to 24%.
Slide 6 focus on Surfactant segment results for the quarter. Surfactant net sales were $350 million, down 3% from the same quarter a year ago, primarily driven by unfavorable foreign exchange translation impact of 3 points. Volume increased 3% due to higher functional product demand, partially offset by lower volume through our distribution channel. The segment operating income decreased $4.3 million or 10% versus the prior year. The base business was in line with our expectation. The base business excluding the Ecatepec sulfonation equipment failure and the exit of the sulfonation business in Germany. 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 mix impact, due to lower volumes through our distribution channel, partially offset by a strong demand for functional products, especially in agriculture and oilfield chemicals. Latin American results were down primarily due to negative impact of the sulfonation equipment failure at our Ecatepec, Mexico plant in January 2019, as communicated during the last earnings conference call. We're working diligently to fix the issue with an expectation to be operational by the middle of the second quarter. As such, we expect the second quarter results to be negatively impacted as well. Our insurance provider has acknowledged this incident is a covered event, and the company is pursuing insurance recovery for damaged equipment, incremental supply chain expenses and business interruption. Therefore, we believe the majority of this impact is just a timing issue with recovery in future quarters. The European results improved on favorable mix on sales through our distribution channel, growth in agricultural chemicals and some inventory build due to Brexit. The favorable results were partially offset by lower volumes related to the sulfonation shutdown in Germany in 2018. Now turning to polymers on Slide 7. Net sales for the quarter were $120 million, down 1% from the prior year period, primarily driven by unfavorable foreign exchange translation of 4 points. Organic sales were up 3%. This organic sales growth were driven by a 3% increase in global polymers volume. The driver of this increase was a strong rigid polyol volume growth of 9%, with an increase across all regions, due to strong market demand driven by increased insulation standards, European PIR insulation recovery from the 2017 MDI challenges and growth in construction. This growth was partially offset by lower PA volume during the quarter. Polymer operating income decreased $5.2 million versus the prior year, despite the strong Global Rigid Polyol volume growth. In North America, polyol results decreased to the nonrecurrence of $2.1 million class action settlement received in 2018, and lower Rigid Polyol margin. The European results were negatively impacted by higher costs related to our planned maintenance shutdown on our site, in general, through the bottleneck capacity, despite a 9% increase in volume. PA results decreased due to lower volume and unfavorable timing related to the consumption of higher price inventory.
Finally, China results improved on higher volume driven by growth in cold storage insulation
Specialty Products operating income increased $3.5 million versus the prior year, due to order timing differences within our flavor business. As mentioned previously, the decision to close the office in the Netherlands should provide benefits in the second half of the year. Turning to Slide 8, our balance sheet remains strong as we continue having no net debt. Also shareholders' equity has grown at a compound annual growth rate of 10% over the past 4 years. Higher working capital requirements are typical for the company in the first quarter. We'll return $6 million to our shareholders via dividend in the first quarter of 2019. In 2018, we also increased our cash dividend for the 51st consecutive year, placing us in a very select group of companies. Beginning on Slide 9, Quinn will now update you on our plans to increase shareholder value.
Thank you, Luis. Looking forward, we believe our Surfactant business will continue to benefit from our diversification efforts into functional products, new technologies, improved internal efficiencies and expanded sales into our broad customer base globally. We believe our polymer business will benefit from the growing market for insulation materials, and we are optimistic that the business will deliver both full year volume growth and incremental margin improvement versus 2018. We believe our Specialty Products segment will deliver better margins and combined with our restructuring efforts will increase our operating income in 2019. Overall, we remain optimistic about the balance of the year. Turning to Slide 9. After a good start to the year, we are well positioned to continue our momentum by focusing on our strategic priorities, market diversification, customer intimacy, innovation, operational excellence and M&A. Our core values, which are ingrained throughout the entire organization serve as the foundation for the company's execution of this strategy. Turning to Slide 10. We've made good progress on our market diversification efforts, which continues to be a key component of our strategy. Volume to the functional product end markets including agricultural and oilfield chemicals, increased 10% during the quarter. We are also aggressively pursuing opportunities to expand our presence in specialty alkoxylates with new dedicated technical resources. Next, our focus on customer intimacy helped us to deliver growth within our Tier 2 and Tier 3 Surfactant customer base and to maintain our market leadership position in several of our key businesses. Tier 2 and Tier 3 Surfactant customer volume increased 3% during the quarter. Global polyol volume increased 9% during the quarter. We remain optimistic about the continued growth of the Rigid Polyol market due to increased insulation standards, energy conservation efforts and growth in the construction globally. Innovation is also a key aspect of our strategy. As a leader in the rigid polyester polyol market, we continue to work on developing the next generation of value-added technologies for our customer base, and are excited about advances in our research pipeline. Our agricultural chemicals business had developed and commercialized 10 new products over the last year, which are helping customers around the world improve their performance and environmental profile of pesticide formulations. Our patent-pending technology for fracking including flowback modifiers and friction reducer boosters are helping oilfield customers maintain or increase production at lower cost. Current oil prices should accelerate adoption. The use of biocides is growing in the fracturing market due to regulations that restrict the use of freshwater, which should provide opportunities for our biocidal quaternary products. The launch of STEPANQUAT Helia is well under way. North American personal care customers are responding positively to a new haircare conditioner ingredient that is mild and safer for the environment. We will introduce STEPANQUAT Helia to our Latin American customer base in the second quarter. Next, operational excellence is an integral part of our strategy. We believe that the application of sulfonation best practices, network synergies and drive cost savings opportunities will create long term value from our Ecatepec acquisition. Also, as I mentioned previously, a decision was made to plan -- to close the Specialty Products office in the Netherlands and absorb the site supply chain QA and R&D functions into other Stepan locations. We will continue to examine our asset base for opportunities to further optimize and improve the capacity utilization, and to more efficiently serve our customers around the world. Finally, M&A is an important tool as a means to deliver EPS growth. Given the strength of our balance sheet, we will continue to prudently access M&A opportunities to fill gaps in our product portfolio and to add new platform chemistries. Our core values: customer focus, people first, continuous improvement, integrity, growth in innovation and sustainability describe how we will accomplish our plan. The market provides challenges and opportunities. We feel we are well positioned to capture opportunities for you, our shareholders. This concludes our prepared remarks. At this time, we'd like to turn the call over for questions. Calandra, please review the instructions for the question portion of today's call.
[Operator Instructions] Our first question comes from the line of Vincent Anderson from Stifel.
I just want to -- with regards to your functional products, particularly the newer ones, are the assets producing these products running at fairly low utilization rates implying some degree of operating leverage as sales grow? Or these products largely going to replace output of lower margin business?
Yes. The answer is somewhat dependent on where you are in the world. But I would say, generally for the most part, we have -- we're relatively full in those assets across the world and we're trading up in terms of our commodity range up into higher value opportunities.
Great. And then just more recently, have you seen any shift in oilfield customer inventories with the recent rise in oil prices?
Not that we can see. We are seeing increased experimentation with some of our new technologies because of the higher oil price. I think people are looking to increase our production, but we haven't seen an increase in inventories per se.
If I could sneak one more in here. I believe we'll see a decent amount of ethylene oxide capacity coming online over the next year or 2 in North America. Would you expect to be passing through really all of your lower raw material prices to your customers? Or do your Tier 2 and Tier 3 customers allow for better margin retention in the declining feedstock environment?
Well we see a significant increase in ethylene production being added to the U.S., North American market. Ethylene oxide itself remains relatively tight today. There are a couple of announcements for ethylene oxide expansions that are somewhat a little further off. So ethylene oxide as a raw material for Stepan, will be relatively tight or snug. I think the market is in pretty good balance today. We may see some excess capacity over a period of time, kind of 2020, 2021. Stepan specifically is looking at expanding its alkoxylation footprint and we will by buying FeO and propylene oxide and continuing to try to grow our solution based business for our customers in the agricultural and the oilfield market with those derivatives.
Our next question comes from the line of Mike Harrison from Seaport Global SEC.
I was wondering if you can give us a little bit of an update on what's going on in Ecatepec with the outage that you had there. Are you back up and running at this point? And you noted the operating income impact. But can you talk at all about the volume impact and if there were some specific applications or markets within the Surfactant's business that were affected due to the outage?
Okay. Good morning, Mike. Yes, good question. Relative to Ecatepec, let me first say that we are not back up running yet. We anticipate being up in the next 2 weeks. So we're still experiencing the outage. The piece equipment that had failed was part of the sulfur burner which is the first step of the sulfonation process. And so at the -- and so we are just beginning the start-up phases of that or preparing for the start-up phases and we will starting up in the next 2 weeks or so. So we are very excited when we bought the plant. The market respond favorably to us. We increased our volume about 30% within the first 5, 6 months of operation. So we felt good about where we were in the marketplace. Obviously, as we're being down we lean towards our facility in Matamoros, Mexico, initially to help us respond to the outage. And we also leaned on some of our facilities in North America. Our 2 plants specifically in Winder, Georgia and Millsdale, Illinois, to help us respond and support some of the customer base. So we were able to keep just less than 60% of the Mexican volume during that period. And we anticipate that we'll be able to recapture some of that business as we restart the facility over the next -- the second, third and fourth quarter. So we don't anticipate we're going to get all the business back up. So -- but we have some work to do in terms of winning that business back.
Okay. And then the -- in terms of the insurance recovery, should we expect that to basically mirror the operating loss that you guys quantified there? Or is there going to be some additional because of the lost business, the business disruption aspect of that?
We believe the insurance will -- we have a $1 million deductible for our policy, but the insurance should cover some business interruption. And we'll be working with our insurance company specifically to find those customers and those volumes and profitability associated with that. So we would anticipate that we would get the majority of the loss back that you saw in Q1, and we will have ongoing losses in Q2 and a potentially into Q3 as well.
Okay. And then last question I had, and then I'll turn it back, is just helping us understand some of the differences in the polymers business. The differences in performance between what you saw in Rigid Polyols, which seems to be doing better and then specialty polymers, which appear to be seeing volume decline. Can you -- is that something that is explained by just market differences right now? Or what's going on between those 2 portions of the polymers business?
Thank you, Mike. This is Luis. Yes. As you mentioned, we had a strong quarter in Rigid Polyol and we're happy to see Europe coming back to growth rate and getting out of the NBI challenge that we had last year. Specialty had a very strong quarter in Europe, was up 25%, 30%. So the business is responding very well in Europe, and we have some challenges in North America. So like you see in Q1 is the -- is the reduction seen in volumes and a little bit of margin, not a lot, but mostly volume in North America and we're working with our customers to get that business back.
But we do feel that from a volume perspective, we're on pretty good -- track both in Europe and in the United States. And as I mentioned in the script, we believe our margins will incrementally improve. And quite frankly, we've seen that already in each successive month this year, and was -- we are seeing it in April as well. So we feel better about the trajectory of our margins in that space as well.
Our next question comes from the line of Christopher Hillary from Roubaix Capital.
Can you -- you've made good progress on improving your mix. Just -- could you share with us today any thought you might have on the cadence of improvement that you would anticipate over the next 2 to 3 years? Your ability just to move your mix up to higher value add sales?
This is Luis. Look, so we are expecting -- we have mentioned our strategy is to continue growing the top line and improving margins gradually year-on-year, through a combination of mix and through a combination of operational excellence, okay? So we believe we will continue moving our margins up, not in a dramatic way in any particular quarter or year, but our strategy of growing in functional products, growing in Tier 2, Tier 3 customers and growing in the Rigid Polyol business, and improving margins in Specialty will give both that ability to improve margin year-on-year with some fluctuation by quarter because of seasonality and one-timers and things like that. But on a year basis, we will continue improving our margins gradually.
Okay and then maybe a quick one. It can always be a little bit difficult from the outside to understand some of the new products that you might be working on, but is there anything that you'd share product-wise or application-wise you are particularly enthusiastic about?
Yes. I think the 2 things in the personal care specialties market that we've talked about over the last 6 months is one product called NINOL CAA which is a multi-functional product that used in shampoos, body wash and hand soaps that allows our customers to reformulate and provide a mild benefit, but also allows our customers to reduce their formulation costs. We're very excited about that. That product is mostly bio-based and is out in the marketplace trialing products today with a number of customers, we're excited about that.
And the recently, first quarter introduced, the STEPANQUAT Helia is a new ingredient for conditioning shampoos, a market that Stepan historically has not been in, that again is bio-based and has a much better biodegradation profile than the current product that people are using. We're excited about that. No sales yet, but we have 170 different companies that have requested samples in the United States and all. So we're excited about that.
So -- and then we continue to work on specialty non-ionics as a key growth platform for Stepan. We've traditionally been somewhat underrepresented in the non-ionic space, and that's the reaction of ethylene oxide and propylene oxide with various hydrophobes. And we make a disproportionate share of our profitability selling those specialty solutions into the agricultural market and the oilfield market and the specialty HI&I market, and we're looking to extend our product line and participation in that segment with those -- with new products. Those are the 3, I think.
[Operator Instructions] Mr. Quinn Stepan, there are no further questions at this time. I will now turn the call back to you. Please continue with your presentation or closing remarks.
How about closing remarks? 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 second quarter 2019 call. Thank you very much. Have a great day.
That does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your line.