SCL

Business Context and Reporting Period

Company: Stepan Company
Filing Type: Form 10-Q (Unaudited)
Reporting Period: Quarter and six months ended June 30, 2009
Business Overview: Stepan produces intermediate chemicals used in consumer and industrial applications. Operations are divided into three segments: Surfactants (78% of H1 2009 sales), Polymers (19%), and Specialty Products (3%). The company operates manufacturing sites in North America, Europe, and Latin America.

Key Financial Metrics

Note: Free Cash Flow calculated as Operating Cash Flow less Capital Expenditures ($23,355 for H1 2009).

Material Changes vs. Prior Period

• Profitability Surge: Net income for Q2 2009 increased 101% year-over-year, and H1 2009 net income increased 88%. This was driven by a 31% increase in Q2 gross profit and a 66% increase in H1 operating income.
• Revenue Decline: Net sales decreased 24% in Q2 and 20% in H1 compared to the prior year. This was attributed to an 11% drop in sales volume due to the global recession and lower average selling prices reflecting reduced raw material costs.
• Margin Expansion: Despite lower sales, gross margins expanded significantly (from 11.9% to 20.4% in Q2) as lower raw material costs (crude oil derivatives) outpaced price reductions passed to customers.
• Segment Performance:
  • Surfactants: Sales down 23% (Q2), but operating income up 88% due to cost efficiencies and lower freight/raw material costs.
  • Polymers: Sales down 31% (Q2) due to weak construction demand; operating income rose slightly (6%) due to cost containment.
  • Specialty Products: Sales up 25% (Q2) with operating income up 136%.
• Balance Sheet Strength: Cash and cash equivalents increased from $8.3 million to $55.8 million. Total debt decreased by $21.4 million to $121.5 million. Net debt (debt minus cash) dropped from $126.3 million to $65.7 million.

Outlook, Risks, and Management Commentary

• Outlook: Management expects to deliver record profits from operations for the full year 2009. While polymer and functional surfactant volumes remain negatively impacted by the economy, laundry and personal care surfactant volumes are expected to remain recession-resistant.
• Price Increases: Due to rising crude oil costs near the end of Q2, the company announced price increases for some surfactant products effective July 1, 2009.
• Deferred Compensation Volatility: Q2 expenses included a $2.9 million increase in deferred compensation expense due to a rise in the company's stock price. However, for the full six months, deferred compensation was a net benefit compared to the prior year.
• Environmental Contingencies: The company faces potential liabilities at 23 waste disposal sites. The estimated range of possible losses is $7.5 million to $31.4 million, with an accrued liability of $16.5 million. Management believes these will not have a material effect on financial position.
• Liquidity: The company maintains $58.4 million in available credit under a $60 million revolving agreement. Management believes cash from operations and credit facilities are sufficient to fund capital expenditures and dividends.

Investor Verification Checklist

• Raw Material Cost Sensitivity: Verify the sustainability of gross margin expansion if crude oil prices continue to rise, as the company has already implemented price increases.
• Deferred Compensation Impact: Monitor the volatility of deferred compensation expenses, which are tied to the company's stock price and can cause significant period-to-period earnings fluctuations.
• Environmental Reserves: Review the specific status of the Maywood, New Jersey, and Lightman Drum Company Superfund sites, as actual remediation costs could differ from current estimates.
• Debt Covenants: Confirm continued compliance with debt covenants, specifically the minimum interest coverage ratio (2.0 to 1.0) and net worth requirements ($113.7 million).
• Volume Recovery: Assess the timeline for volume recovery in the Polymers segment, which is heavily dependent on the construction and automotive industries.