Participants

Luis E. Rojo; VP & CFO; Stepan Company

Scott R. Behrens; CEO, COO, President & Director; Stepan Company

David Cyrus Silver; Senior MD & Director of Equity Research; CL King & Associates, Inc., Research Division

David Joseph Storms; Research Analyst; Stonegate Capital Markets, Inc., Research Division

Michael Joseph Harrison; MD & Senior Chemicals Analyst; Seaport Research Partners

Vincent Alwardt Anderson; Associate; Stifel, Nicolaus & Company, Incorporated, Research Division

Presentation

Operator

Good day, and thank you for standing by. Welcome to the Stepan Fourth Quarter and Full Year Earnings Conference Call. (Operator Instructions) Please be advised that today's conference call is being recorded. I would now like to turn the conference over to your speaker today, Luis Rojo, Vice President and Chief Financial Officer. Please go ahead.

Luis E. Rojo

Good morning and thank you for joining Stepan Company's fourth quarter and full year 2022 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 process for our foreign operations, global and regional economic conditions and factors detailed in our Securities and Exchange Commission filings.

Scott R. Behrens

Good morning and thank you all for joining us today to discuss our fourth quarter and full year results. To begin, I will share our fourth quarter and full year highlights and strategy outlook, while Luis will provide additional details on our financial results. Despite significant external supply chain challenges in a difficult macro environment, the business was able to deliver another record year. Significant inflation in raw materials, logistics and other expenses were fully offset with pricing actions, mix improvements and productivity efforts.

Luis E. Rojo

Thank you, Scott. My comments will generally follow the slide presentation. Let's start with slide 5 to recap the quarter. Adjusted net income was $13.5 million or $0.59 per diluted share versus $22.5 million or $0.97 per diluted share for the fourth quarter of 2021. Because adjusted net income is a non-GAAP measure, we provide full reconciliations to the comparable GAAP measures, and this can be found in Appendix 2 of the presentation and Table 2 of the press release. Specifically, the adjusted net income for the fourth quarter exclude deferred compensation expense of $2.2 million compared to last year's expense of $2.4 million.

Scott R. Behrens

Thank you, Luis. In addition to delivering another record year of earnings, we made good progress on advancing our strategic priorities in 2022. The following slides capture our strategic priorities and a vision for a cleaner, healthier and more energy-efficient world with our customers' preferences in mind. Our diversification strategy in the functional products, including agricultural and oilfield chemicals continues to be a key priority for Stepan. Our global agricultural volumes increased double digits in 2022, supported by high commodity prices for corn, soybean and wheat, which incentivize growers to utilize the full breadth of crop protection options.

Question and Answer Session

Operator

(Operator Instructions) Our first question will be coming from Mike Harrison of Seaport.

Michael Joseph Harrison

I was hoping that you could discuss some of the factors that drove the 17% volume decline that you saw in Q4? Maybe help us understand how those split out between destocking, underlying market weakness and other factors? And were there any key differences in the volume impacts, particularly from destocking as you look between the Surfactants business and the Polymers business.

Luis E. Rojo

Thank you, Mike. Look, as you rightly said, so when you think about the minus 17%, you need to think about those three buckets, right? One is demand, one is destocking and the other is the transition to low 1,4 dioxane product, which we clearly communicated in October that we lost a Tier 1 customer, and there are other impacts on the volume side related to the transition. So if you think about those three big buckets and you think about the minus 17%, roughly, each bucket is one-third. So think about 5%, 6% is the impact of each of them. And of course, when you think about polymers, you don't have the low 1,4 dioxane transition, so you can see more than a half and half situation between the other two buckets. But that's how we'll summarize the three big buckets that we saw in the minus 17% in Q4.

Michael Joseph Harrison

All right. And I guess in terms of destocking, that can't go on forever from your customers. Are you starting to see signs that order patterns are normalizing at some point here in Q1? Maybe talk about what you're hearing from your customers in surfactants as well as in polymers.

Scott R. Behrens

Yes, Mike, I would say that it can't go on forever as well. But I would say, incrementally, we may be seeing a little uptick versus what the pattern we saw in Q4, but I don't think we're done with destocking activities at this point. As you compare surfactants versus polymers, obviously, two different channels to the retail end use. I would say on the polymer side, it's -- once you get past the manufacture of the rigid insulation panels that our Polyols goes into, it's a highly fragmented market of distributors and contractors across the country.

Luis E. Rojo

So Mike, and I would summarize it as simple as in Q1 versus what we are seeing already 6 weeks into it, we expect a similar demand condition versus what we saw in Q4. But everybody is expecting a pick up in the second half, right? That's kind of the general theme and consensus that we're hearing from customers and suppliers, people stay at of Q1 or first half of the year and then picking up in the second half.

Michael Joseph Harrison

All right. Very helpful. And then I wanted to ask about the Pasadena start-up process. It sounds like there's going to be some P&L impact associated with expenses that you're taking on before you officially start commercial sales. And it does also look like the startup or commercial sales timing was pushed out a little bit. I believe you said previously, early 2024 now first half of '24. So maybe just help us out with the timing and how we should think about modeling the impact of that start-up.

Luis E. Rojo

Sure. I will let Scott later to comment on the small -- on the very small delay that we're seeing on the construction phase. What I will tell you, look, we have -- you have -- on the expense side you have three big buckets as well, right? I mean you have the Pasadena pre start-up investments, right? I mean if we're going to produce full -- we're going to have a full production capacity in 2024, we need to hire. We need to train our people. This is a chemical plant, and we take this very seriously our training, EH&S and everything.

Scott R. Behrens

Yes. So Mike, as it relates to the construction and start-up schedule, we have slipped maybe a month, maybe two max -- we're about 20% complete with the construction. So it's in full swing. We had some raw material delays related to getting the civil construction done on the site. So nothing from just normal raw material constraints that were associated with the civil portion of the site project. So we should be mechanically complete and up and running before midyear.

Luis E. Rojo

And for example, we have all the major equipment already on site. I mean when you think about the reactors and all the major equipment that we need they're all on site already.

Operator

The next question will be coming from Vincent Anderson of Stifel.

Vincent Alwardt Anderson

I just wanted to ask, given your existing alkoxylate portfolio and the PerformanX acquisition last quarter, how quickly do you think you can ramp and then fill the order book for the Pasadena facility once it's up and running?

Scott R. Behrens

Yes. Good morning Vincent, from an alkoxylation perspective, we have two existing alkoxylation facilities here in the U.S. today. Pasadena will be our third. We also utilize a broad network of third-party toll manufacturers today that we have been using as capacity to continue to grow the product line, which has been doing very well, exceeding our expectations. So upon startup at Pasadena, we will have a very good opportunity to get that utilization up in balance with how we want to manage our external tolling network. So we have, I think, the ultimate flexibility to ensure the proper utilization of our internal assets and allow us to continue to grow using tollers as needed.

Vincent Alwardt Anderson

Perfect. And I'm not going to ask you to predict the future on raw materials and all of that. But if we continue along this slow demand environment through at least the first half of the year, is there any reason that we wouldn't see a little bit of positive timing impact between price and raws like we've seen in past down cycles.

Scott R. Behrens

It's hard to say, Vince. I would say that raw materials kind of plateaued in Q4. So it's pretty stable right now. And whether it's going up or down from here, it's hard to predict. There's too many factors that play into that. Our focus is really we will continue our pricing actions to cover our continuing any cost inflation that we have within the business and operations. So I think it's wait and see, but we expect that we'll continue with our pricing strategy as needed.

Vincent Alwardt Anderson

Okay. Fair enough. And then I had a quick one on taxes of all things. The 2023 effective tax rate guidance is maybe a little bit higher than the last couple of years. But more importantly, maybe with all this capital spending, do either the low 1,4 dioxane projects or the Pasadena project qualify for bonus depreciation? And if so, how should we think about that impact in cash taxes over the next couple of years?

Luis E. Rojo

Yeah. Great question, Vincent. Look, the guidance is kind of similar. Remember, for example, UK is moving to a 25% tax rate in April. So that's a key impact. And then you have country mix as well baked into that. So our normal tax rate, if you go back to 2021 -- or 2020, 2021, we had a lot of tax projects. But in 2020, you see our tax rate always in the 25%, 26%. So that's the guidance that we have right now.

Operator

(Operator Instructions) And our next question will be coming from David Storm of Stonegate.

David Joseph Storms

Perfect. Just curious about some of the pace in which relates to the expenses for 1,4 dioxane project and the Pasadena project.

Scott R. Behrens

David, could you repeat that question? We broke up on us.

David Joseph Storms

No. Sorry about that. Just curious about the pacing for the expenses. You've mentioned some of the expenses to 1,4 dioxane projects and the Pasadena projects. And just curious how we should think about the pacing with that through 2023 and beyond?

Luis E. Rojo

Yes. No. What I would say is probably it's more half and half year. The first half is heavily loaded. It's more loaded into low 1,4 dioxane. The back half is going to be more loaded with Pasadena.

David Joseph Storms

Perfect. The other thing, I know you guys don't give explicit guidance. But after companies like Exxon and Procter & Gamble released their earnings, we saw a lot of analysts raised their estimates for revenue and EBITDA. Do you think that's kind of directionally correct for the market going forward or?

Scott R. Behrens

Can't comment on that, David. I don't know what's driving Exxon and their expectations.

Operator

(Operator Instructions) Our next question will be coming from David Silver of CL King.

David Cyrus Silver

This is kind of a qualitative question, but you did discuss the outlook for 2023 in some detail overall. I was wondering if you could maybe just highlight some thoughts regionally. In other words, of Europe, let's say, North America and South America. I mean, would North America, in your opinion, and in your build up to an overall 2023 outlook, is North America the strongest region or are there some regional issues that we should kind of keep in mind as we think about the overall 2023 outlook? And of course, I'm thinking maybe geopolitical concerns in Europe or some broader regional issues in Latin America. But how does the regional outlook shake out in your opinion at this point for 2023?

Scott R. Behrens

All right. Great question, David. And let me take a shot at first, talking about kind of destocking and where the underlying demand is. I think everyone saw an earlier kind of slowdown in Europe starting in maybe Q3 last year, whereas in North America, at least in our business, we didn't see the slowdown really to start until Q4. So I think Europe is a little bit ahead in their demand pattern than North America. And I think I said earlier, I think it's still a little uncertain right now 6 weeks into the year as to where the North American destocking will end and a really good demand profile going forward will be able to be established.

David Cyrus Silver

That's great color, I appreciate it. My next question would be kind of about new products. And in particular, I think I've asked this question some time ago, but does Stepan track, I guess, or calculate internally a vitality index? In other words, percentage of revenues from products that have been developed in the last three years, the last five years, something like that. And if not, I was just wondering if you could call out from a revenue or from a margin impact, however you look at it internally.

Scott R. Behrens

Yes. So I'd first start with where we are focused on strategic end market growth. And that's within the agricultural chemicals space as well as specialty alkoxylates. So in agricultural chemicals, we're part of that development pipeline for new active pesticides. And that pipeline is anywhere from 5 to 10 years long for new products to come to market. So we're deeply embedded in those development pipelines with the large pesticide producers out there, which is a really great place to be, and we have new products being launched in multiple regions (inaudible). The other big focus for us is in specialty alkoxylates.

Luis E. Rojo

What I would add, David, is we are investing and we are making good progress as Scott mentioned in the remark spray foam also. So we are working with new products there. If you think -- we also talk about [Chemco] we are relaunching that product line. And actually, when you think about low 1,4 dioxane, right, that's kind of at the end, a significant investment that we're making to have a totally new ether sulfate portfolio that meets the new regulation, but that's at the end, there's a lot of new volume that is going to be in a new product versus the past.

David Cyrus Silver

Yes. No. And I'll just pick up, Luis, on your last comment. I think that was the direction I was heading. But the last couple of years of your business last couple of years, your business has been affected pretty significantly by COVID and pandemic and some other issues that change the way people thought about cleaning and disinfection and things like that. Two parts. First of all, what, in your opinion, will persist once the COVID -- the direct COVID issues kind of fade in importance or maybe move to the background.

Scott R. Behrens

Yes. Okay, David. As it relates to the COVID pandemic, I think if you look at North America, we've been pretty much open for about the last, what, 12 to 18 months here in the U.S. So we did see the spike while in the height of the pandemic around hand soaps and disinfectants, right, hard service disinfection. And I think we reported back in 2021, the significant spike we saw in 2020, but felt that, that was going to come back down not to pre-COVID levels but to levels above where pre-COVID levels were. That is continuing today, okay?

David Cyrus Silver

Okay. Great. And I should have mentioned 1,4 dioxane, of course. Last question, and this would be on your marketing, and it has to do with your strategy for Tier 2, Tier 3 customer development. But you did mention, I think, a net addition customer base of about 550 for 2022. And I'm just wondering if we should think about a particular target for next year? And more to the point, do you think you've kind of, I don't know, cherry-picked or high-graded the opportunities out there on the Tier 2, Tier 3 base of customers?

Scott R. Behrens

Yeah. No, David, great question. We've been, I think, pretty clear that growing this Tier 2, Tier 3 segment is a major portion of our company's growth strategy. And we continue to invest in sales, marketing and R&D to support our continued growth with this segment on a global basis. We've identified that target for a prospective customer list in Tier 2, Tier 3 around the world in the tens of thousands. And becoming more efficient in reaching and securing orders from these customers around the world is our focus. And the $550 million is a good number. We're proud of that, and that leads to improved profitability for our company. And that's kind of our expectation going forward is our teams are going to continue to execute and deliver those new customers on a net basis in that hundreds per year.

Operator

(Operator Instructions) Our follow-up question will be coming from Mike Harrison of Seaport.

Michael Joseph Harrison

Just a couple more from me. In terms of the Surfactants business, I'm curious if you're seeing any trading down happening within the laundry portions of the business or personal care. And if you are seeing that, is it something that's happening in all regions or is it maybe more as you called out Latin America, maybe the consumers are under a little bit more pressure because of inflation? And I guess are you seeing this trend around trading down? Is it getting worse as you look at Q1 or is it pretty stable?

Scott R. Behrens

Yes. Great question, Mike. I would -- from my opinion, trading down in high inflationary environment is a universal trend. It's not geographic specific. And yes, so consumers will trade down from premium to mid-tier to economy tiers. And the economy tiers and mid-tiers also include private label. So I do think there's been that trend -- we've seen that trend from our lens with sales to customers in multiple regions. Is it getting worse? Or I don't know if I can comment on whether it's getting worse or not. It's just -- it's an uncertain view right now with destocking and everything in terms of what the trend is. But it definitely happened in Q4.

Michael Joseph Harrison

All right. And then just looking at the working capital numbers that you guys provided, it looks like working capital improved a little bit compared to Q3. It does look like your net debt went up, though. What was cash from operations in the fourth quarter or the full year? Whatever you can disclose on cash flow would be very helpful.

Luis E. Rojo

Great question, Mike. So what we're seeing is we saw the peak of working capital kind of in Q3, and now we are kind of stable versus that peak level. But yes, this has been roughly a $200 million increase versus the base period versus 2020 we have seen a significant increase because of the -- of inflation on raw material and everything. So as we delivered $161 million in the equation, we're happy with our cash flow. And as you know, we're very efficient on our working capital. We have less than 20% of our sales in working capital when the industry average is more 24%, 25%.

Michael Joseph Harrison

All right. And I guess just maybe another cash flow-related question. Where did the depreciation and amortization end up for the full year? I'm guessing it was around (inaudible), where should that D&A number go? I assume it goes up substantially as you start to bring on some of the new assets that you've discussed.

Luis E. Rojo

You're 100% right, $95 million, we're estimating at least $112 million to $114 million next year, so an increase between $17 million to $20 million. That, of course, will depend on timing on when -- the start of depreciation of some of these assets, but roughly around $17 million.

Operator

That concludes our Q&A session for today. And I would like to turn the call over to Scott Behrens for closing remarks. Please go ahead.

Scott R. Behrens

Thank you very much for joining us on today's call. We appreciate your interest and ownership in Stepan Company, and have a great day.

Operator

This concludes today's conference call. Thank you all for joining, and enjoy the rest of your day.