STEPAN CO - Quarter Report: 2018 March (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

(MARK ONE)

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2018

FOR THE TRANSITION PERIOD FROM                 TO                

Commission File Number 1-4462

STEPAN COMPANY

(Exact name of registrant as specified in its charter)

Edens and Winnetka Road, Northfield, Illinois 60093

(Address of principal executive offices)

Registrant’s telephone number (847) 446-7500

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company.  See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) Yes   ☐    No  ☒

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Part I FINANCIAL INFORMATION

Item 1 - Financial Statements

STEPAN COMPANY

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

Unaudited

The accompanying Notes to Condensed Consolidated Financial Statements are an integral part of these financial statements.

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STEPAN COMPANY

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

Unaudited

The accompanying Notes to Condensed Consolidated Financial Statements are an integral part of these financial statements.

3

STEPAN COMPANY

CONDENSED CONSOLIDATED BALANCE SHEETS

Unaudited

The accompanying Notes to Condensed Consolidated Financial Statements are an integral part of these financial statements.

4

STEPAN COMPANY

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Unaudited

The accompanying Notes to Condensed Consolidated Financial Statements are an integral part of these financial statements.

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STEPAN COMPANY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2018

Unaudited

The condensed consolidated financial statements included herein have been prepared by Stepan Company (the Company), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) have been condensed or omitted pursuant to such rules and regulations, although management believes that the disclosures are adequate and make the information presented not misleading. In the opinion of management, all adjustments, consisting only of normal recurring accruals, necessary to present fairly the Company’s financial position as of March 31, 2018, and its results of operations and cash flows for the three months ended March 31, 2018 and 2017, have been included.  These financial statements and related footnotes should be read in conjunction with the financial statements and related footnotes included in the Company’s 2017 Annual Report on Form 10-K.

Below are reconciliations of total equity, Company equity and equity attributable to noncontrolling interests for the three months ended March 31, 2018 and 2017:

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The following were the financial instruments held by the Company at March 31, 2018, and December 31, 2017, and the methods and assumptions used to estimate the instruments’ fair values:

Cash and cash equivalents

Carrying value approximated fair value because of the short maturity of the instruments.

Derivative assets and liabilities

Derivative assets and liabilities included the foreign currency exchange contracts discussed in Note 4.  Fair value and carrying value were the same because the contracts were recorded at fair value.  The fair values of the foreign currency contracts were calculated as the difference between the applicable forward foreign exchange rates at the reporting date and the contracted foreign exchange rates multiplied by the contracted notional amounts. See the table that follows the financial instrument descriptions for the reported fair values of derivative assets and liabilities.

Long-term investments

Long-term investments included the mutual fund assets the Company held to fund a portion of its deferred compensation liabilities and all of its non-qualified supplemental executive defined contribution obligations (see the defined contribution plans section of Note 8). Fair value and carrying value were the same because the mutual fund assets were recorded at fair value. Fair values for the mutual funds were calculated using the published market price per unit at the reporting date multiplied by the number of units held at the reporting date.  See the table that follows the financial instrument descriptions for the reported fair value of long-term investments.

Debt obligations

The fair value of debt with original maturities greater than one year comprised the combined present values of scheduled principal and interest payments for each of the various loans, individually discounted at rates equivalent to those which could be obtained by the Company for new debt issues with durations equal to the average life to maturity of each loan.  The fair values of the remaining Company debt obligations approximated their carrying values due to the short-term nature of the debt.  The Company’s fair value measurements for debt fall within level 2 of the fair value hierarchy.

At March 31, 2018, and December 31, 2017, the fair values and related carrying values of debt, including current maturities, were as follows (the fair value and carrying value amounts are presented without regard to unamortized debt issuance costs of $1,113,000 and $987,000  as of March 31, 2018 and December 31, 2017, respectively):

The following tables present financial assets and liabilities measured on a recurring basis at fair value as of March 31, 2018, and December 31, 2017, and the level within the fair value hierarchy in which the fair value measurements fall:

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The Company is exposed to certain risks relating to its ongoing business operations. The primary risk managed by the use of derivative instruments is foreign currency exchange risk.  The Company holds forward foreign currency exchange contracts that are not designated as any type of accounting hedge as defined by GAAP.  The Company uses these contracts to manage its exposure to exchange rate fluctuations on certain Company subsidiary cash, accounts receivable, accounts payable and other obligation balances that are denominated in currencies other than the entities’ functional currencies. The forward foreign exchange contracts are recognized on the balance sheet as either an asset or a liability measured at fair value. Gains and losses arising from recording the foreign exchange contracts at fair value are reported in earnings as offsets to the losses and gains reported in earnings arising from the re-measurement of the asset and liability balances into the applicable functional currencies. At March 31, 2018, and December 31, 2017, the Company had open forward foreign currency exchange contracts, all with durations of one to three months, to buy or sell foreign currencies with U.S. dollar equivalent amounts of $52,718,000 and $41,197,000, respectively.

The fair values of the derivative instruments held by the Company on March 31, 2018, and December 31, 2017, are disclosed in Note 3. Derivative instrument gains and losses for the three-month periods ended March 31, 2018 and 2017, were immaterial.  For amounts reclassified out of accumulated other comprehensive income (loss) (AOCI) into earnings for the three-month periods ended March 31, 2018 and 2017, see Note 10.

On March 31, 2018, the Company had stock options and stock awards outstanding under its 2006 Incentive Compensation Plan and stock options, stock awards and stock appreciation rights (SARs) outstanding under its 2011 Incentive Compensation Plan. SARs granted prior to 2015 are cash-settled, and SARs granted after 2014 are stock-settled.  Stock options and SARs granted prior to 2017 generally cliff vested after two years. Starting in 2017, stock options and SARs have a three-year graded vesting feature, with one-third of the awards vesting each year. The Company has elected the straight-line method of expense attribution for the stock options and SARs with the graded vesting feature.

Compensation expense recorded for all stock options, stock awards and SARs was as follows:

The year-over-year increase in stock-based compensation expense was primarily attributable to cash-settled SARs. SARs compensation expense increased due to an increase in the fair values of cash-settled SARs that resulted from a rise in the market value of Company common stock during the first quarter of 2018. The market value of Company common stock decreased during the first quarter of 2017.

Unrecognized compensation costs for stock options, stock awards and SARs were as follows:

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The increases in unrecognized compensation costs for stock options, stock awards and SARs reflected the 2018 grants of:

The unrecognized compensation costs at March 31, 2018, are expected to be recognized over weighted-average periods of 2.4 years, 2.0 years and 2.4 years for stock options, stock awards and SARs, respectively.

The composition of inventories at March 31, 2018, and December 31, 2017, was as follows: 

Inventories are priced primarily using the last-in, first-out inventory valuation method.  If the first-in, first-out inventory valuation method had been used for all inventories, inventory balances would have been approximately $35,145,000 and $33,518,000 higher than reported at March 31, 2018, and December 31, 2017, respectively.

There are a variety of legal proceedings pending or threatened against the Company.  Some of these proceedings may result in fines, penalties, judgments or costs being assessed against the Company at some future time.  The Company’s operations are subject to extensive local, state and federal regulations, including the U.S. Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA) and the Superfund amendments of 1986 (Superfund) as well as similar regulations in other countries where the Company operates.  Over the years, the Company has received requests for information related to or has been named by the government as a potentially responsible party (PRP) at a number of waste disposal sites where cleanup costs have been or may be incurred under CERCLA and similar state statutes.  In addition, damages are being claimed against the Company in general liability actions for alleged personal injury or property damage in the case of some disposal and plant sites.  The Company believes that it has made adequate provisions for the costs it may incur with respect to these sites.

As of March 31, 2018, the Company estimated a range of possible environmental and legal losses of $23.9 million to $45.2 million.  At March 31, 2018, and December 31, 2017, the Company’s accrued liability for such losses, which represented the Company’s best estimate within the estimated range of possible environmental and legal losses, was $23.9 million and $24.2 million, respectively. Cash outlays related to legal and environmental matters approximated $0.2 million and $0.4 million for the three-month periods ended March 31, 2018 and 2017, respectively.  

For certain sites, the Company has responded to information requests made by federal, state or local government agencies but has received no response confirming or denying the Company’s stated positions. As such, estimates of the total costs, or range of possible costs, of remediation, if any, or the Company’s share of such costs, if any, cannot be determined with respect to these sites. Consequently, the Company is unable to predict the effect thereof on the Company’s financial position, cash flows and results of operations. Given the information available, management believes the Company has no liability at these sites. However, in the event of one or more adverse determinations with respect to such sites in any annual or interim period, the effect on the Company’s cash flows and results of operations for those periods could be material.  Based upon the Company’s present knowledge with respect to its involvement at these sites, the possibility of other viable entities’ responsibilities for cleanup, and the extended period over which any costs would be incurred, the Company believes that these matters, individually and in the aggregate, will not have a material effect on the Company’s financial position.  However, in the event of one or more adverse determinations with respect to such sites in any annual or interim period, the effect on the Company’s cash flows and results of operations for those periods could be material.

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Following are summaries of the material contingencies at March 31, 2018:

Maywood, New Jersey Site

The Company’s property in Maywood, New Jersey and property formerly owned by the Company adjacent to its current site and other nearby properties (Maywood site) were listed on the National Priorities List in September 1993 pursuant to the provisions of CERCLA because of certain alleged chemical contamination.  Pursuant to an Administrative Order on Consent entered into between the U.S. Environmental Protection Agency (USEPA) and the Company for property formerly owned by the Company, and the issuance of an order by USEPA to the Company for property currently owned by the Company, the Company has completed various Remedial Investigation Feasibility Studies (RI/FS), and on September 24, 2014, the USEPA issued its Record of Decision (ROD) for chemically-contaminated soil. The USEPA has not yet issued a ROD for chemically-contaminated groundwater for the Maywood site. Based on the most current information available, the Company believes its recorded liability represents its best estimate of the cost of remediation for the Maywood site. The best estimate of the cost of remediation for the Maywood site could change as the Company continues to hold discussions with the USEPA, as the design of the remedial action progresses, if a groundwater ROD is issued or if other PRPs are identified. The ultimate amount for which the Company is liable could differ from the Company’s current recorded liability.

In April 2015, the Company entered into an Administrative Settlement Agreement and Administrative Order on Consent with the USEPA which requires payment of certain costs and performance of certain investigative and design work for chemically-contaminated soil.  Based on the Company’s review and analysis of this order, no changes to the Company’s recorded liability for claims associated with soil remediation of chemical contamination were required.  

In addition, under the terms of a settlement agreement reached on November 12, 2004, the U. S. Department of Justice and the Company agreed to fulfill the terms of a Cooperative Agreement reached in 1985 under which the United States will take title to and responsibility for radioactive waste removal at the Maywood site, including past and future remediation costs incurred by the United States.  As such, the Company recorded no liability related to this settlement agreement.

D’Imperio Property Site

During the mid-1970’s, Jerome Lightman and the Lightman Drum Company disposed of hazardous substances at several sites in New Jersey.  The Company was named as a PRP in a lawsuit in the U.S. District Court for the District of New Jersey that involved the D’Imperio Property Site located in New Jersey.  In 2016, the PRPs were provided with updated remediation cost estimates which were considered in the Company’s determination of its range of estimated possible losses and liability balance.  The changes in range of possible losses and liability balance were immaterial.  Remediation work is continuing at this site.  Based on current information, the Company believes that its recorded liability represents its best estimate of the cost of remediation for the D’Imperio site.  Depending on the ultimate cost of the remediation at this site, the amount for which the Company is liable could differ from the current estimates.

Wilmington Site

The Company is currently contractually obligated to contribute to the response costs associated with the Company’s formerly-owned site in Wilmington, Massachusetts.  Remediation at this site is being managed by its current owner, to whom the Company sold the property in 1980.  Under the agreement, once total site remediation costs exceed certain levels, the Company is obligated to contribute up to five percent of future response costs associated with this site with no limitation on the ultimate amount of contributions. The Company has paid the current owner $2.6 million for the Company’s portion of environmental response costs through March 31, 2018. The Company has recorded a liability for its portion of the estimated remediation costs for the site.  Depending on the ultimate cost of the remediation at this site, the amount for which the Company is liable could differ from the current estimates.

The Company and other prior owners also entered into an agreement in April 2004 waiving certain statute of limitations defenses for claims which may be filed by the Town of Wilmington, Massachusetts, in connection with this site.  While the Company has denied any liability for any such claims, the Company agreed to this waiver while the parties continue to discuss the resolution of any potential claim which may be filed.

Other U.S. Sites

Through the regular environmental monitoring of its plant production sites, the Company discovered levels of chemical contamination that were above thresholds allowed by law at two of its U.S plants. The Company voluntarily reported its results to the applicable state environmental agencies. As a result, the Company is required to perform self-remediation of the affected areas. In the fourth quarter of 2016, the Company recognized a charge for the estimated cost of remediating the sites. Based on

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current information, the Company believes that its recorded liability for the remediation is adequate. However, actual costs could differ from current estimates.  

Defined Benefit Pension Plans

The Company sponsors various funded qualified and unfunded non-qualified defined benefit pension plans, the most significant of which cover employees in the U.S. and U.K. locations.  The U.S. and U.K. defined benefit pension plans are frozen and service benefits are no longer being accrued.

Components of Net Periodic Benefit Cost

In the first quarter of 2018, the Company implemented ASU No. 2017-07, Compensation-Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost, which amended the guidance for the presentation of the components of net periodic cost in the income statement.  The guidance requires the service cost component of net periodic benefit cost to be included in employee compensation costs in the income statement and all other components elsewhere in the income statement outside of income from operations.  The Company does not have a service component of the net periodic benefit cost because the defined benefit plans (both U.S. and U.K. locations) are frozen.  The other components of net periodic benefit cost such as interest cost, amortization of net actuarial loss and expected return on plan assets are included in the line item Other, net within Other Income (Expense) section of the Income statement. See Note 14 for more details.

Employer Contributions

U.S. Plans

As a result of pension funding relief provisions included in the Highway and Transportation Funding Act of 2014, the Company is not required to make contributions to the funded U.S. qualified defined benefit plans. Approximately $312,000 is expected to be paid related to the unfunded non-qualified plans in 2018.  Of such amount, $143,000 had been paid related to the non-qualified plans as of March 31, 2018.

U.K. Plan

The Company’s U.K. subsidiary expects to contribute approximately $500,000 to its defined benefit pension plan in 2018.  Of such amount, $138,000 had been contributed to the plan as of March 31, 2018.

Defined Contribution Plans

The Company sponsors retirement savings defined contribution plans that cover eligible U.S. and U.K. employees. The Company’s U.S. retirement plans include two qualified plans, one of which is a 401(k) plan and one of which is an employee stock ownership plan, and one non-qualified supplemental executive plan.  Historically, the Company has made profit sharing contributions into the qualified retirement plans for its U.S. employees.  Profit sharing contributions were determined each year using a formula that was applied to Company earnings.  The contributions, which were made partly in cash paid to the 401(k) plan and partly in Company common stock, are allocated to participant accounts on the basis of participant base earnings.

Defined contribution plan expenses for the Company’s retirement savings and profit sharing plans were as follows:

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The Company has a rabbi trust to fund the obligations of its non-qualified supplemental executive defined contribution plans (supplemental plans). The trust comprises various mutual fund investments selected by the participants of the supplemental plans. In accordance with the accounting guidance for rabbi trust arrangements, the assets of the trust and the obligations of the supplemental plans are reported on the Company’s consolidated balance sheets.  The Company elected the fair value option for the mutual fund investment assets so that offsetting changes in the mutual fund values and defined contribution plan obligations would be recorded in earnings in the same period. Therefore, the mutual funds are reported at fair value with any subsequent changes in fair value recorded in the consolidated statements of income. The liabilities related to the supplemental plans increase (i.e., supplemental plan expense is recognized) when the value of the trust assets appreciates and decrease when the value of the trust assets declines (i.e., supplemental plan income is recognized). At March 31, 2018, the balance of the trust assets was $1,641,000, which equaled the balance of the supplemental plan liabilities (see the long-term investments section in Note 3 for further information regarding the Company’s mutual fund assets).

Below are the computations of basic and diluted earnings per share for the three months ended March 31, 2018 and 2017:

⁽¹⁾ Options/SARs to acquire 2,807 and 74,521 shares of Company common stock were excluded from the computations of diluted earnings per share for the three months ended March 31, 2018 and March 31, 2017, because the effect of including the instruments would have been antidilutive.

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Below is the change in the Company’s AOCI balance by component (net of income taxes) for the three months ended March 31, 2018 and 2017:

Information regarding the reclassifications out of AOCI for the three month periods ended March 31, 2018 and 2017, is displayed below:

The Company has three reportable segments: Surfactants, Polymers and Specialty Products.  Net sales by segment for the three months ended March 31, 2018 and 2017, were as follows:

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Segment operating income and reconciliations of segment operating income to consolidated income before income taxes for the three months ended March 31, 2018 and 2017, are summarized below:

⁽²⁾  The 2017 data has been immaterially changed from the amounts originally reported as a result of the Company’s first quarter 2018 adoption of ASU No. 2017-7, Compensation-Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost.

12.    REVENUE FROM CONTRACTS WITH CUSTOMERS

In the majority of instances the Company deems a contract with a customer to exist when a purchase order is received from a customer for a specified quantity of product or products and the Company acknowledges receipt of such purchase order.  In some instances the Company has entered into manufacturing supply agreements with customers but these agreements typically do not bind a customer to any purchase volume requirements and thus an obligation is not created until the customer submits a purchase order to the Company.  The Company’s contracts typically have a single performance obligation that is satisfied at the time product is shipped.  For a small portion of the business, performance obligations are deemed satisfied when product is delivered to a customer location.  Revenue is recognized when performance obligations under terms of a contract with a customer have been satisfied, which is predominantly at a point in time.  With the 2018 adoption of ASU 2014-09, revenue is currently recognized when a customer obtains control of a product as compared to the “risk and rewards” criteria used in prior years.  However, the adoption of ASU 2014-09 did not have a material impact on the Company’s financial position or results of operations during the first quarter of 2018.

Payment terms on sales of product typically range from 30 to 60 days and ordinarily do not exceed 75 days.  As a result, the Company has concluded it does not provide any significant benefits of financing to its customers.

The Company has elected to account for shipping and handling as activities to fulfill a promise to transfer the good.  As such, shipping and handling fees billed to customers in a sales transaction are recorded in Net Sales and shipping and handling costs incurred are recorded in Cost of Sales.  The Company has elected to exclude from Net Sales any value added, sales and other taxes that it collects concurrently with revenue producing activities.  These accounting policy elections are consistent with the manner in which the Company has historically recorded shipping and handling fees and taxes.

In some instances, a customer may qualify for a rebate based on the volume of purchases made over a specified period of time, typically a quarterly or annual period.  The Company estimates the expected volume of total purchases using actual volumes, customer projections and historical order patterns and accrues for these rebates based on the best available information at the time.  These estimated rebates are treated as a reduction to Net Sales with the offset being recognized within Current Liabilities.  This methodology is consistent with the manner in which the Company has historically estimated and recorded volume based rebates.  In other instances, discounts for early payments are offered to certain customers.  These discounts are principally accrued for based on a customer’s historical use of discounts.  These estimated early payment discounts are accounted for similarly to volume rebates.  These forms of variable consideration are considered part of the transaction price.  

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The Company warrants its products from defects.  The Company has concluded that these represent assurance-type warranties as opposed to service-type warranties.  Product defects are rare in occurrence.  As a result, the Company does not maintain any warranty accruals until such time as it is probable a product defect exists.    

As of March 31, 2018, the Company did not have any contract assets or contract liabilities.  A contract liability would typically arise when an advance or deposit is received from a customer before the Company recognizes revenue.  In practice, this is extremely rare as it would require a customer to make a payment prior to a performance obligation being satisfied.  If such a situation did arise the Company would maintain a deferred revenue liability until the time a performance obligation has been satisfied.  The Company did not recognize any revenue in the current period from any pre-existing contract liability balance.

The tables below provides a geographic disaggregation of net sales for the three months ended March 31, 2018 and 2017.  The Company’s business segmentation by geographic region most effectively captures the nature and economic characteristics of the Company’s revenue streams impacted by economic factors.  This regional data is the predominant information used by senior management to assess the financial performance of operating segments and make resource allocation decisions.   

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At March 31, 2018, and December 31, 2017, debt comprised the following: 

On January 30, 2018, the Company entered into a five year committed $350 million multi-currency revolving credit facility that matures on January 30, 2023 with a syndicate of banks.  This credit facility replaced the Company’s prior $125 million credit agreement. The Company’s outstanding Note Purchase Agreements were amended effective January 30, 2018 to make certain covenants consistent with those included in the credit agreement. The Company maintains standby letters of credit under its workers’ compensation insurance agreements and for other purposes, as needed from time to time, which are issued under the revolving credit agreement. As of March 31, 2018, the Company had outstanding letters of credit totaling $4,927,000 and no outstanding debt under this agreement. There was $345,073,000 available under the revolving credit agreement as of March 31, 2018.    

The Company’s loan agreements contain provisions which, among others, require maintenance of certain financial ratios and place limitations on additional debt, investments and payment of dividends. Based on the loan agreement provisions that place limitations on dividend payments, unrestricted retained earnings (i.e., retained earnings available for dividend distribution) were $136,167,000 and $190,495,000 at March 31, 2018 and December 31, 2017, respectively.

Other, net in the consolidated statements of income included the following:

            Based on requirements of ASU No. 2017-07, Compensation-Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost, the Company reclassified Net periodic benefit cost outside of income from operations. See Note 8 for more details for the components of Net periodic benefit cost.

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In May 2016, the Company announced plans to shut down its Longford Mills, Ontario, Canada (Longford Mills) manufacturing facility, a part of the Surfactant reportable segment, by December 31, 2016. The shutdown plan was developed as an effort to improve the Company’s asset utilization in North America and to reduce the Company’s fixed cost base. Manufacturing operations of the Longford Mills plant ceased by the end of 2016, and production of goods manufactured at the facility was transferred to other Company North American production sites. Decommissioning of the assets is expected to continue throughout 2018. As of March 31, 2018, $5,197,000 of aggregate restructuring expense has been recognized, reflecting $1,594,000 of termination benefits for approximately 30 employees and $3,603,000 for other expenses, principally asset decommissioning costs. 

Below is a reconciliation of the December 31, 2017 and the March 31, 2018 restructuring liabilities:

2018 Acquisition

On March 26, 2018, the Company through a subsidiary in Mexico closed on a previously announced agreement with BASF Mexicana, S.A.DE C.V.to acquire their surfactants production facility in Ecatepec, Mexico and a portion of their associated surfactants business.  The facility is located close to Mexico City and has over 50,000 metric tons of capacity, 124,000 square footage of warehouse space, a large laboratory and office space.  The acquired assets and business are included in the Company’s Surfactants segment. The purchase price of the acquisition was $21,475,000 and was paid with cash on hand.  The primary assets acquired were land, buildings, machinery and equipment and inventory.  The acquisition was accounted for as a business combination, and, accordingly, the assets acquired were measured and recorded at their estimated fair values.   The purchase price allocations are preliminary as of March 31, 2018 because the valuations necessary to assess the fair values of net assets acquired are still in process.

The acquired business is expected to have minimal impact on the Company’s 2018 financial results.  Pro forma financial information for the first quarter 2017 and 2018 has not been included because revenues and earnings of the Company would not have been significantly different than reported had the acquisition date been January 1, 2017.

17.     INCOME TAXES

On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (Tax Act).  The Tax Act made broad and complex changes to the U.S. tax code.  For various reasons that are discussed more fully below, we have not completed our accounting for the income tax effects of certain elements of the Tax Act.  If we were able to make reasonable estimates of the effects of elements for which our analysis is not yet complete, we recorded provisional adjustments.  If we were not yet able to make reasonable estimates of the impact of certain elements, we have not recorded any adjustments related to those elements and have continued accounting for them in accordance with ASC 740 on the basis of the tax laws in effect before the Tax Act.

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Our accounting for the Tax Act is incomplete.  As noted at year-end, we were able to reasonably estimate certain effects and, therefore, recorded the provisional adjustments related to the following:

Reduction of U.S. federal corporate tax rate: The Tax Act reduced the corporate tax rate to 21 percent, effective January 1, 2018.  We recorded a provisional adjustment for certain of our deferred tax assets and liabilities associated with the tax rate reduction for the year ended December 31, 2017.  

We have not made any additional measurement-period adjustments in the quarter because such adjustments may be affected by other analyses related to the Tax Act, including, but not limited to, our calculation of deemed repatriation of deferred foreign income and the state tax effect of adjustments made to federal temporary differences.  However, we are continuing to gather additional information to complete our accounting for this item and expect to complete our accounting within the prescribed measurement period.

Deemed Repatriation Transition Tax: The Transition Tax is a tax on previously untaxed accumulated and current earnings and profits of certain of our foreign subsidiaries.   We recorded a provisional Transition Tax obligation for the year ended December 31, 2017.  

We have not made any additional measurement-period adjustments in the quarter because we are continuing to gather additional information to more precisely compute the amount of the Transition Tax.  However, we expect to complete our accounting within the prescribed measurement period.

Our accounting for the Tax Act is incomplete.  As noted at year-end, we were not yet able to reasonably estimate the effects for the following items:  Therefore, no provisional adjustments were recorded:

Global intangible low taxed income (GILTI): The Tax Act requires the Company to include certain income (GILTI) of its foreign subsidiaries in gross income.  The amount of this inclusion is determined under complex rules, and depends, in part, on the character of income earned by the foreign subsidiaries, the tax bases of those subsidiaries’ assets and the amount of certain interest expenses.

Under U.S. GAAP, we are allowed to make an accounting policy choice of either (1) treating taxes due on future income inclusions related to GILTI as a current-period expense when incurred (the period cost method) or (2) accounting for such amounts in measuring deferred taxes (the deferred method).  Our selection of an accounting policy with respect to the new GILTI tax rules will depend, in part, on analyzing our global income to determine whether we expect to have future income inclusions related to GILTI and, if so, what the impact is expected to be.  These determinations depend not only on our current structure and estimated future results of global operations but also our intent and ability to modify our structure and/or our business.  Therefore, we have not made any adjustments or estimates related to any potential deferred tax liabilities related to GILTI in our financial statements and have not made a policy decision regarding whether to record deferred tax liabilities related to GILTI.

Deductibility of Executive Compensation: The Tax Act amended certain aspects of Section 162(m) of the Internal Revenue Code (Section 162(m)), which generally disallows a tax deduction for annual compensation paid to “covered employees” in excess of $1 million, including eliminating an exception to the deduction limit for “qualified performance-based compensation,” effective for tax years beginning after December 31, 2017.  The Tax Act provides for a grandfather provision, pursuant to which remuneration that is provided pursuant to a written binding contract in effect on November 2, 2017, and which has not been modified in any material respect on or after that date, will not be subject to the amendments made to Section 162(m) by the Tax Act and will remain eligible for deduction as qualified performance-based compensation. To the extent available, we intend to continue to treat “qualified performance-based compensation” that is grandfathered under the Tax Act as deductible compensation. We have not yet completed our evaluation of our existing compensation arrangements to determine whether any amounts payable to our Section 162(m) covered employees may continue to constitute qualified performance-based compensation under Section 162(m) and qualify under the grandfather provision. Therefore, we have not made any adjustments or estimates related to any potential tax liabilities in our financial statements related to the amendments to Section 162(m).

Cost recovery: We have not yet completed all of the computations necessary or completed an inventory of our 2017 expenditures that qualify for immediate expensing.  Therefore, we have not made any adjustments or estimates related to any potential tax liabilities in our financial statements related to immediate expensing.

Valuation allowances: The Company must assess whether valuation allowances assessments are affected by various aspects of the Tax Act (e.g., GILTI inclusions and new categories of foreign tax credits).  Because, as discussed herein, the Company

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has recorded no amounts related to certain portions of the Tax Act, any corresponding determination of the need for or change in a valuation allowance has not been completed and no changes to valuation allowances as a result of the Tax Act have been recorded.

In May 2014, the Financial Accounting Standards Board (FASB) issued ASU No. 2014-9, Revenue from Contracts with Customers (Topic 606). The new update was later amended by ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date. The standard outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers. In addition, the ASU requires expanded disclosures about revenue recognition that enable the users of the financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. ASU No. 2014-09 supersedes most of the previous revenue recognition guidance. For public entities, the new guidance, as amended, is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. On January, 1, 2018, the Company adopted ASU No. 2014-9, which did not have a material effect on the Company’s financial position, results of operations or cash flows.  The Company has added Note 12 – Revenue from Contracts with Customers to comply with the expanded disclosure requirements of ASU No. 2014-9.  

In February 2016, the FASB issued ASU No. 2016-2, Leases (Topic 842). This guidance requires a dual approach for lessee accounting whereby a lessee will account for lease arrangements with terms greater than 12 months as either finance leases or operating leases. Both finance leases and operating leases will be recognized on the lessee’s balance sheet as right-of-use assets and corresponding lease liabilities, with differing methodologies for income statement recognition. In addition, the ASU requires expanded qualitative and quantitative disclosures about the Company’s lease arrangements. This guidance is effective for public business entities for fiscal years, and interim periods within those years, beginning after December 15, 2018. Early adoption is permitted. A modified retrospective approach is required for all leases existing or entered into after the beginning of the earliest comparative period in the consolidated financial statements. Most of the Company’s operating leases will be required to be placed on the balance sheet. The Company is assessing the quantitative impact that adoption of ASU No. 2016-2 will have on its financial position, results of operations and cash flows.

In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, which adds or clarifies guidance on the classification of eight specific types of cash flows. The update is intended to reduce the existing diversity in practice with respect to the specific cash flow items. The amendments in ASU No. 2016-15 are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted. On January 1, 2018, the Company adopted ASU No. 2016-15, which had an immaterial impact on the cash flow presentation and did not impact the Company’s financial position or results of operations.  

In October 2016, the FASB issued ASU No. 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory. The update requires an entity to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. Current accounting guidance prohibits the recognition of current and deferred income taxes for an intra-entity asset transfer until the asset has been sold to an outside party. The amendments in ASU No. 2016-16 are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted for all entities as of the beginning of an annual reporting period for which financial statements (interim or annual) have not been issued or made available for issuance. That is, earlier adoption should be in the first interim period if an entity issues interim financial statements. The amendments in this update should be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. On January 1, 2018, the Company adopted ASU No. 2016-16, which did not have a material effect on the Company’s financial position or results of operations and cash flows.

In January 2017, the FASB issued ASU No. 2017-4, Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment, which eliminates Step 2 from the goodwill impairment test. When an indication of impairment was identified after performing the first step of the goodwill impairment test, Step 2 required that an entity determine the fair value at the impairment testing date of its assets and liabilities (including unrecognized assets and liabilities) using the same procedure that would be required in determining the fair value of assets acquired and liabilities assumed in a business combination. Under the amendments in ASU No. 2017-4, an entity would perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying value. An entity would recognize an impairment charge for the amount by which the carrying value exceeds the reporting unit’s fair value. In addition, an entity must consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable. A public business entity that is a SEC filer should adopt the amendments in ASU No. 2017-4 for its annual, or any interim, goodwill impairment tests in fiscal years beginning after December 15, 2019. It is not expected that the adoption of the guidance in ASU No. 2017-4 will have a material effect on the Company’s financial position, results of operations or cash flows.

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In January 2017, the FASB issued ASU No.2017-1, Business Combination (Topic 805): Clarifying the Definition of a Business, with the objective of adding guidance to assist with evaluating whether transactions should be accounted for as an acquisition (or disposal) of assets or a business.  This Update provides criteria to help determine when a set of assets and activities comprise a business as opposed to an acquisition of assets.  This guidance is effective for annual periods beginning after December 15, 2017, including interim periods within those periods.  On January 1, 2018, the Company adopted ASU No. 2017-1, which did not have a material effect on the Company’s financial position, results of operations or cash flows.

In March 2017, the FASB issued ASU No. 2017-7, Compensation – Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost, which amends existing guidance for the income statement presentation of the components of net periodic benefit cost for an entity’s sponsored defined benefit pension and other postretirement plans. The amended guidance requires entities to include the current service component of net periodic benefit cost in employee compensation costs in the income statement and to include all other components elsewhere in the income statement outside of income from operations. In addition, only the service cost component of net benefit cost is eligible for capitalization. For the Company, ASU No. 2017-7 is effective for interim and annual periods beginning after December 31, 2017, with early adoption permitted as of the beginning of any annual period for which an entity’s financial statements have not been issued. The requirements for the separate presentation of the service cost component and the other components of net periodic benefit cost must be adopted on a retrospective basis. The requirement to capitalize only the service component of net periodic benefit cost must be adopted on a prospective basis. On January 1, 2018, the Company adopted ASU No. 2017-7, which did not have a material effect on the Company’s financial position or cash flows but affected the presentation of the Company’s results of operations.  For amounts reclassified on the Company’s statements of the results of operations, see Note 8 and Note 14.

      In August 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, which amends previous guidance regarding hedge accounting recognition and presentation requirements. The updated guidance alters the hedge accounting model to make achieving hedge accounting easier for an entity and to have such accounting better reflect an entity’s risk management activities. ASU No. 2017-12 also adds new, and amends previous, disclosure requirements. For the Company, ASU No. 2017-12 is effective for interim and annual periods beginning after December 15, 2018. Early adoption is permitted. Entities must apply a modified retrospective approach to existing hedging relationships as of the adoption date. At present, because the Company has not entered into any transactions designated as accounting hedges, adoption of ASU No. 2017-12 is not expected to have a material effect on the Company’s financial position, results of operations and cash flows.

      In January 2018, the FASB issued ASU No. 2018-01, Leases (Topic 842): Land Easement Practical Expedient for Transition to Topic 842, which permits an entity to select an optional transition practical expedient to not evaluate under Topic 842 existing or expired land easements that were not previously accounted for as leases under the current leases guidance in Topic 840. An entity that elects this practical expedient should apply the practical expedient consistently to all of its existing or expired land easements that were not previously accounted for as leases under Topic 840. Once an entity adopts Topic 842, it should apply that Topic prospectively to all new (or modified) land easements to determine whether the arrangement should be accounted for as a lease. An entity that does not elect this practical expedient should evaluate all existing or expired land easements in connection with the adoption of the new lease requirements in Topic 842 to assess whether they meet the definition of a lease. An entity should continue to apply its current accounting policy for accounting for land easements that existed before the entity’s adoption of Topic 842. This update is effective for public business entities for fiscal years, and interim periods within those years, beginning after December 15, 2018. Early adoption is permitted. The Company is assessing the quantitative impact that adoption of ASU No. 2018-01 will have on its financial position, results of operations and cash flows.

In February 2018, the FASB issued ASU No. 2018-02, Income Statement-Reporting Comprehensive Income (Topic 220):  Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income, which permits a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act.  Consequently, the Update eliminates the stranded tax effects resulting from the Tax Cuts and Jobs Act and will improve the usefulness of information reported to financial statement users.  However, because the amendments only relate to the reclassification of the income tax effects of the Tax Cuts and Jobs Acts, the underlying guidance that requires that the effects of the change in tax laws or rates be included in income from continuing operations is not affected.  The amendments in this update also require certain disclosures about stranded tax effects.  This update is effective for public business entities for fiscal years, and interim periods within those years, beginning after December 15, 2018.  Early adoption is permitted. The Company is assessing the quantitative impact that adoption of ASU No. 2018-02 will have on its financial position, results of operations and cash flows.

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Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following is management’s discussion and analysis (MD&A) of certain significant factors that have affected the Company’s financial condition and results of operations during the interim periods included in the accompanying condensed consolidated financial statements.

Certain statements in this Quarterly Report on Form 10-Q, other than purely historical information, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act). These statements include statements about Stepan Company’s and its subsidiaries’ (the Company) plans, objectives, strategies, financial performance and outlook, trends, the amount and timing of future cash distributions, prospects or future events and involve known and unknown risks that are difficult to predict. As a result, the Company’s actual financial results, performance, achievements or prospects may differ materially from those expressed or implied by these forward-looking statements. In some cases, forward-looking statements can be identified by the use of words such as “may,” “could,” “expect,” “intend,” “plan,” “seek,” “anticipate,” “believe,” “estimate,” “guidance,” “predict,” “potential,” “continue,” “likely,” “will,” “would,” “illustrative” and variations of these terms and similar expressions, or the negative of these terms or similar expressions. Such forward-looking statements are necessarily based upon estimates and assumptions that, while considered reasonable by the Company and its management based on their knowledge and understanding of the business and industry, are inherently uncertain. These statements are not guarantees of future performance, and stockholders should not place undue reliance on forward-looking statements. There are a number of risks, uncertainties and other important factors, many of which are beyond the Company’s control, that could cause the Company’s actual results to differ materially from the forward-looking statements contained in this Quarterly Report on Form 10-Q.

Such risks, uncertainties and other important factors, include, among others, the risks, uncertainties and factors set forth under “Part I-Item IA. Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 inclusive of: (a) the risks and uncertainties related to accidents, unplanned production shutdowns or disruptions in any of the Company’s manufacturing facilities; (b) global competition and the Company’s ability to successfully compete; (c) volatility of raw material, natural gas and electricity costs as well as any disruption in their supply; (d) disruptions in transportation or significant changes in transportation costs; (e) reduced demand for Company products due to customer product reformulations or new technologies; (f) the Company’s ability to make acquisitions of suitable candidates and successfully integrate acquisitions; (g) the Company’s ability to keep and protect its intellectual property rights; (h) international business risks, including fluctuations in currency exchange rates, legal restrictions and taxes; (i) potentially adverse tax consequences due to the international scope of the Company’s operations; (j) the impact of changes in the tax code as a result of recent U.S. federal tax legislation and uncertainty as to how some of those changes may be applied; (k) compliance with anti-corruption, environmental, health and safety and product registration laws; (l) the Company’s inability to accurately estimate and maintain appropriate levels of recorded liabilities for existing and future contingencies; (m) the Company’s ability to operate within the limitations of its debt covenants; (n) downgrades to the Company’s credit ratings or disruptions to the Company’s ability to access well-functioning capital markets; (o) downturns in certain industries and general economic downturns; (p) conflicts, military actions, terrorist attacks and general instability, particularly in certain energy-producing nations, along with increased security regulations; (q) cost overruns, delays and miscalculations in capacity needs with respect to the Company’s expansion or other capital projects; (r) interruption of, damage to or compromise of the Company’s IT systems and failure to maintain the integrity of customer, colleague or Company data; (s) unfavorable resolution of litigation against the Company; (t) and the Company’s ability to retain its executive management and other key personnel.

These factors are not necessarily all of the important factors that could cause the Company’s actual financial results, performance, achievements or prospects to differ materially from those expressed in or implied by any of its forward-looking statements. Other unknown or unpredictable factors also could harm the Company’s results. All forward-looking statements attributable to the Company or persons acting on the Company’s behalf are expressly qualified in their entirety by the cautionary statements set forth above. Forward-looking statements speak only as of the date they are made, and the Company does not undertake or assume any obligation to update publicly any of these forward-looking statements to reflect actual results, new information or future events, changes in assumptions or changes in other factors affecting forward-looking statements, except to the extent required by applicable laws. If the Company updates one or more forward-looking statements, no inference should be drawn that the Company will make additional updates with respect to those or other forward-looking statements. The “Company,” “we,” “our” or “us” means Stepan Company and one or more of its subsidiaries only.

Overview

The Company produces and sells intermediate chemicals that are used in a wide variety of applications worldwide. The overall business comprises three reportable segments:

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2018 Acquisition

On March 26, 2018, the Company’s subsidiary in Mexico closed on its previously announced agreement with BASF Mexicana, S.A. DE C.V. (BASF) to acquire BASF’s production facility in Ecatepec, Mexico, and a portion of its related surfactants business.  The facility, which is near Mexico City, has over 50,000 metric tons of capacity, 124,000 square feet of warehouse space, a laboratory and office space.  The acquisition supports the Company’s growth strategy in Latin America.  The Company believes that this acquisition should enhance its market position and supply capabilities for surfactants in Mexico and position the Company to grow in both the consumer and functional surfactants markets.  See Note 16 for additional details.   

Deferred Compensation Plans

The accounting for the Company’s deferred compensation plans can cause period-to-period fluctuations in Company expenses and profits. Compensation expense results when the values of Company common stock and mutual fund investment assets held for the plans increase, and compensation income results when the values of Company common stock and mutual fund investment assets decline. The pretax effect of all deferred compensation-related activities (including realized and unrealized gains and losses on the mutual fund assets held to fund the deferred compensation obligations) and the income statement line items in which the effects of the activities were recorded are displayed in the following table:

Effects of Foreign Currency Translation

The Company’s foreign subsidiaries transact business and report financial results in their respective local currencies. As a result, foreign subsidiary income statements are translated into U.S. dollars at average foreign exchange rates appropriate for the reporting period. Because foreign exchange rates fluctuate against the U.S. dollar over time, foreign currency translation affects period-to-period comparisons of financial statement items (i.e., because foreign exchange rates fluctuate, similar period-to-period local currency results for a foreign subsidiary may translate into different U.S. dollar results). The following table presents the effects that foreign currency

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translation had on the period-over-period changes in consolidated net sales and various income line items for the three months ended March 31, 2018 and 2017:

RESULTS OF OPERATIONS

Three Months Ended March 31, 2018 and 2017

Summary

Net income attributable to the Company for the first quarter of 2018 decreased four percent to $30.7 million, or $1.31 per diluted share, from $31.9 million, or $1.37 per diluted share, for the first quarter of 2017. Adjusted net income increased one percent to $32.0 million, or $1.37 per diluted share, from $31.7 million, or $1.36 per diluted share in 2017 (see the “Reconciliation of Non-GAAP Adjusted Net Income and Diluted Earnings per Share” section of this MD&A for a reconciliation between reported net income attributable to the Company and related earnings per diluted share and non-GAAP adjusted net income and related earnings per diluted share). Below is a summary discussion of the major factors leading to the quarter-over-quarter changes in net sales, profits and expenses.  A detailed discussion of segment operating performance for the first quarter of 2018 compared to the first quarter of 2017 follows the summary.

Consolidated net sales increased $31.0 million, or seven percent, between quarters. Higher average selling prices favorably impacted the quarter-over-quarter change in net sales by $9.4 million. The increase in average selling prices was mostly attributable to the pass through of higher raw material costs within the Surfactants segment.  Consolidated sales volume increased one percent, which had a $4.0 million favorable impact on the quarter-over-quarter change in net sales.  Sales volume increased four percent and two percent for the Surfactants and Specialty Products segments, respectively.  Sales volume declined nine percent for the Polymers segment.  Foreign currency translation positively affected the quarter-over-quarter net sales change by $17.6 million.  The favorable foreign currency translation effect reflected a weaker U.S. dollar against the majority of currencies for countries where the Company has foreign operations.  Unit margins improved for Surfactants and declined for Polymers and Specialty Products.

Operating income for the first quarter of 2018 decreased $6.5 million, or 14 percent, compared to operating income reported for the first quarter of 2017.  Most of this decrease was related to higher 2018 deferred compensation expense and lower Polymers operating income, which increased by $1.2 million and declined by $4.5 million, respectively.  The Polymers segment operating income decline was primarily due to lower sales volume and unit margins in North America and Europe.  

Operating expenses (including deferred compensation expense and business restructuring expenses) increased $4.0 million, or nine percent, between quarters. Changes in the individual income statement line items that comprise the Company’s operating expenses were as follows:

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Net interest expense for the first quarter of 2018 increased $0.2 million, or five percent, from net interest expense for the same quarter of last year primarily due to lower non-U.S. interest income.

Other, net was $1.2 million of income for the first quarter of 2018 compared to $1.1 million of income for the same period of 2017. The Company posted $0.2 million of investment income (including realized and unrealized gains and losses) for the Company’s deferred compensation and supplemental defined contribution mutual fund assets in the first quarter of 2018 compared to $1.7 million of income in last year’s first quarter. In addition, the Company reported foreign exchange gains of $1.1 million in the first quarter of 2018 compared to $0.5 million of losses in the first quarter of 2017.   The Company also reported $0.1 million of net periodic pension cost in the first quarter of 2018 versus $0.2 million of expense in 2017.

The Company’s effective tax rate was 18.4 percent for the first quarter of 2018 compared to 28.0 percent for the first quarter of 2017.  The decrease was primarily attributable to the following items: 1) a lower U.S. statutory tax rate of 21 percent in the first quarter of 2018 versus 35 percent in the first quarter of 2017, and 2) higher excess tax benefits derived from stock based compensation awards exercised or distributed in the first quarter of 2018 versus the first quarter of 2017.   The effective tax rate for 2018 was negatively impacted as a result of income earned outside of the U.S. being taxed, on average, at a relatively similar effective tax rate as the U.S. earnings compared to 2017 when the U.S. effective tax rate was higher due to the higher statutory tax rate of 35 percent.

Segment Results