STEPAN CO quarterly report, Q2 FY2015

Business context and reporting period

Stepan Company’s unaudited Form 10-Q covers the quarter and six months ended June 30, 2015, compared with the same 2014 periods. The company produces intermediate chemicals through Surfactants, Polymers and Specialty Products. Amounts below are in millions of dollars except per-share data and percentages.

Financial performance

Cash flow and liquidity: First-half operating cash flow was $78.3 million, versus $15.0 million in 2014; capital expenditures were $54.0 million, versus $39.1 million. Investing activities used $57.6 million and financing activities used $19.7 million. Cash declined $2.9 million to $82.4 million. At June 30, total debt was $260.5 million and net debt was $178.1 million; total debt was down $13.4 million from year-end 2014. The $125 million revolving facility had $110.0 million available after $10.0 million of borrowings and $5.0 million of letters of credit. Management said liquidity and expected funding sources were sufficient for foreseeable needs.

Margins and balance sheet: Gross margin improved in both comparison periods, but Q2 operating margin and earnings fell as corporate expenses rose. Current assets were $564.4 million and current liabilities $234.0 million at June 30. Debt-to-debt-plus-equity was 32.1%, compared with 33.8% at December 31, 2014.

Material changes versus prior periods

• Q2 sales fell 10% and first-half sales fell 7%. Management attributed the declines primarily to currency translation and lower selling prices, largely reflecting lower raw-material costs; sales volume rose 1% in Q2 and 2% in the first half.
• Q2 operating income declined 23% and attributable net income declined 31%. First-half operating income increased 7% and net income increased 2%.
• Q2 segment operating income increased 26% in Surfactants and 27% in Polymers, but fell 57% in Specialty Products. First-half segment operating income increased 54% in Surfactants and 31% in Polymers, and decreased 50% in Specialty Products.
• Corporate expenses increased $16.3 million in Q2 and $21.2 million in the first half. A major driver was stock-price-linked deferred compensation: expense was $6.6 million in Q2 2015 versus $5.5 million of income in Q2 2014, and $8.2 million expense in the first half versus $5.7 million income.
• Foreign currency translation reduced Q2 sales by $33.6 million and first-half sales by $63.2 million. It also weighed on operating results. The Q2 effective tax rate was 29.8%, versus 26.6%; the first-half rate was 30.1%, versus 27.1%, including an unfavorable foreign tax audit charge in 2015 and a favorable transfer-pricing adjustment in 2014.

Outlook, management commentary and notable items

• Management said the company remained on track to re-establish earnings momentum for full-year 2015; it did not provide a numerical earnings forecast. It expected second-half Surfactants results to benefit from new laundry volumes in North and Latin America, European diversification, improved operations and efficiency initiatives. It expected continued Polymer income growth, supported by higher polyol volumes for rigid insulation and metal panels.
• Management estimated 2015 capital expenditures of $120 million to $140 million, including capacity expansions in the United States, China and Brazil. The China and Poland polyol projects were progressing, with production expected to start in 2016.
• In June, Stepan acquired P&G Brazil’s Bahia surfactant facility for $5.1 million cash; the facility has 30,000 metric tons of capacity. Initial post-acquisition results were insignificant, and purchase accounting remained under evaluation.
• In July, the company completed a $100 million unsecured private placement loan at a fixed 3.95% rate, with annual principal payments beginning in 2021 and final maturity in 2027. Also in July, it signed a long-term North American laundry surfactant supply agreement with The Sun Products Corporation, expected to begin in Q3 2015 and materially improve North American capacity utilization. A separate agreement to buy selected assets at SUN’s Pasadena, Texas site was expected to close in Q3, subject to customary conditions; Stepan also had a two-month option to buy the property.
• Environmental and legal losses were estimated at $20.7 million to $41.1 million; the recorded liability was $20.7 million. Management said some sites could not be reliably estimated and adverse determinations could materially affect cash flows and results for a period, though it did not expect the matters overall to materially affect financial position. The Maywood remediation estimate may change as work and discussions progress. An unclaimed-property examination remained ongoing for accounts-receivable credits.
• Other items affecting comparability included a $2.9 million pretax gain on the sale of a specialty polyurethane systems product line in Q1 2015 and favorable resolution of a previously recorded customer claim contributing to Q2 Surfactants gross profit. The 2015 Q2 results also included higher expenses for consulting, talent acquisition and incentive compensation.

Important facts for investors to verify

• Whether second-half volume gains and operating improvements offset currency pressure, lower selling prices and volatile raw-material costs.
• How recurring earnings compare with reported results after considering deferred-compensation volatility, the product-line sale gain, customer-claim settlement and non-recurring tax items.
• Progress, cost and expected utilization from the Bahia acquisition, China and Poland capacity projects, and the SUN supply and asset agreements.
• Actual capital spending versus the $120 million to $140 million estimate, and the effect on debt, cash and covenant headroom following the new $100 million loan.
• Developments in environmental, legal, customer and tax matters, including the range of possible losses and the continuing unclaimed-property examination.