STEPAN CO quarterly report, Q3 FY2011

Business context and reporting period

Stepan Company filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2011. The company makes intermediate chemicals for consumer and industrial applications. Its reportable segments are surfactants, polymers and specialty products; surfactants generated 74% of nine-month sales.

Financial performance

• Q3 sales rose 36%; management attributed the increase primarily to higher selling prices, alongside 4% volume growth and favorable foreign currency translation. Nine-month sales rose 31%, reflecting higher prices, currency translation and 3% volume growth.
• Approximate gross margin was 12.8% in Q3 versus 15.9% a year earlier, and 14.0% for nine months versus 17.3%. Approximate operating margin was 6.7% in Q3 versus 8.5%, and 7.0% for nine months versus 8.8%.
• Q3 diluted EPS decreased 2%; nine-month diluted EPS increased 2%. Lower Q3 income before tax was partly offset by a lower effective tax rate: 31.9% versus 38.5%. Nine-month rates were 31.9% versus 36.2%.
• Segment results: Q3 operating income increased in surfactants to $23.2 million and polymers to $12.2 million, but specialty products declined to $3.6 million. For nine months, surfactants operating income fell to $76.0 million from $77.3 million; polymers increased to $33.6 million from $27.7 million; specialty products fell to $10.3 million from $12.2 million.
• Operating cash flow was $12.6 million for nine months, down from $46.2 million. Capital expenditures were $61.0 million; operating cash flow less capital expenditures was negative $48.5 million.

Balance sheet, liquidity and debt

At September 30, 2011, cash was $32.4 million, down from $111.2 million at December 31, 2010. Total debt was $186.6 million, compared with $191.6 million; net debt increased to $154.2 million from $80.4 million. Current assets were $489.1 million and current liabilities $249.3 million. The company had $47.4 million available under its $60 million U.S. revolving credit facility after borrowings and letters of credit. It reported compliance with all loan agreements and expected to remain compliant through 2011.

Working capital consumed $41.0 million more cash year over year, with receivables and inventory increases reflecting higher sales and raw-material costs, as well as planned inventory to support customer service. Management said liquidity was sufficient for anticipated working-capital needs and expected cash, operations and committed facilities to fund planned requirements.

Material changes, outlook and risks

• Raw-material inflation drove price increases and higher working-capital needs. Despite higher sales, margin percentages contracted. Q3 other expense also swung unfavorably, including investment and foreign-exchange losses.
• In June, Stepan acquired Lipid Nutrition product lines for $13.6 million cash; post-acquisition results were insignificant in the period. The acquisition expands specialty food and health products.
• Management said growth initiatives remained on track to deliver increased earnings in 2012 and that 2011 could be the company’s fourth consecutive record-income year. It expected surfactants earnings to improve in 2011, with functional surfactants and enhanced-oil-recovery demand offsetting weaker consumer volumes; lower commodity prices were expected to help Q4 margins. Management also cited global polyol demand and anticipated lower European supply-chain costs in 2012. No numerical earnings or revenue guidance was provided.
• Management forecast 2011 capital spending of $85–$90 million, including Singapore capacity expansion. Commercial methyl-esters production in Singapore was expected in Q2 2012.
• A fire-damaged German polyol reactor raised costs of supplying Europe; repairs were expected to finish in November, with property insurance expected to cover repairs. No business-interruption recovery was recognized pending settlement.
• Environmental and legal loss exposure was estimated at $9.4–$29.2 million, with $15.2 million accrued. The company warned actual costs could differ and adverse determinations could materially affect cash flows and results in a period, while stating it did not expect a material effect on financial position.
• Other risks include raw-material price and working-capital volatility, currency movements, weaker consumer demand, execution and costs of international growth investments, and legal and environmental obligations. Management reported no material changes to previously disclosed risk factors.

Investor verification priorities

1. Check whether pricing and sales volumes sustain growth while margins recover from the period’s contraction.
2. Track receivables, inventory, operating cash flow and net debt as raw-material costs and working-capital requirements change.
3. Verify delivery, costs and expected returns from the Singapore expansion and other growth investments, including the Lipid Nutrition product lines.
4. Monitor German reactor repairs, insurance recoveries and the company’s environmental and legal reserves against actual outcomes.
5. Assess whether weaker consumer demand, foreign-exchange swings and input-cost changes affect segment earnings and management’s stated outlook.