UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(MARK ONE)

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003MARCH 31, 2004

FOR THE TRANSITION PERIOD FROM            TO            

1-4462

Commission File Number

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  x    No  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)    Yes  x    No  ¨

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

Item 1 - Financial Statements

STEPAN COMPANY

CONDENSED CONSOLIDATED BALANCE SHEETSSTATEMENTS OF INCOME

September 30,For the Three Months Ended March 31, 2004 and 2003 and December 31, 2002

Unaudited

(Dollars in thousands)

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 INCOMEBALANCE SHEETS

For the ThreeMarch 31, 2004 and Nine Months Ended September 30,December 31, 2003 and 2002

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 CASH FLOWS

For the NineThree Months Ended September 30,March 31, 2004 and 2003 and 2002

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

September 30, 2003March 31, 2004

Unaudited

The condensed consolidated financial statements included herein have been prepared by the 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 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 normal recurring adjustments necessary to present fairly the condensed consolidated financial position of the Company as of September 30, 2003,March 31, 2004, and the condensed consolidated results of operations for the three and nine months then ended and cash flows for the ninethree months then ended have been included.

Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, no stock-based employee compensation cost is reflected in net income, as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisionprovisions of SFAS No. 123.

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Inventories consist of following amounts:comprised the following:

Inventories priced at LIFOlast-in, first-out (LIFO) as of September 30, 2003March 31, 2004 and December 31, 2002,2003, amounted to 8279 and 8578 percent of total inventories, respectively. If the first-in, first-out (FIFO) inventory valuation method had been used for all inventories, inventory balances would have been approximately $7.1$9.4 million and $5.3$8.6 million higher than reported at September 30, 2003,March 31, 2004, and December 31, 2002,2003, 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 federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA) and the Superfund amendments of 1986 (“Superfund”). The Company and othershas been named by the government as a potential responsible party at 18 waste disposal sites where clean up costs have been named as potentially responsible parties at affected geographicor 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. The

After partial remediation payments at certain sites, the Company has estimated a range of possible environmental and legal losses from $9.5$8.6 million to $40.4$40.6 million at September 30, 2003.March 31, 2004. At September 30, 2003 and DecemberMarch 31, 2002,2004, the Company’s best estimate of the reserve for such losses was $20.0$18.8 million and $17.6 million, respectively, for legal and environmental matters.matters compared to $19.6 million at December 31, 2003, the reduction being the result of a payment during the quarter.

For certain sites, estimates cannot be made of the total costs of compliance, or the Company’s share of such costs; accordingly, the Company is unable to predict the effect thereof on future results of operations. In the event of one or more adverse determinations in any annual or interim period, the impact on the Company’s financial position, cash flows and results of operations or cash flows for those periods could be material. However, based upon the Company’s present belief as to its relative involvement at these sites, other viable entities’ responsibilities for cleanup, and the extended period over which any costs would be incurred, the Company believes that these matters will not have a material effect on the Company’s financial position, results of operations or cash flows. position.

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Following are summaries of the environmental proceedings related to the major environmental sites where the Company has responsibility for participating in remediation efforts:

Maywood, New Jersey, Site

The Company’s site in Maywood, New Jersey and property formerly owned by the Company adjacent to its current site, were listed on the National Priorities List in September 1993 pursuant to the provisions of the CERCLA because of certain alleged chemical contamination. Pursuant to an Administrative Order on Consent entered into between the United States Environmental

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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 completed a Remedial Investigation Feasibility Study (RI/FS) in 1994. The Company submitted the Draft Final FS for Soil and Source Areas (Operable Unit 1) in September 2002. In addition, the Company submitted the Draft Final FS for Groundwater (Operable Unit 2) in June 2003. Discussions between USEPA and the Company are continuing. The Company is awaiting the issuance of a Record of Decision (ROD) from USEPA relating to the currently owned and formerly owned Company property and the proposed chemical contamination remediation. The final ROD will be issued sometime after a public comment period.

In 1985, the Company entered into a Cooperative Agreement with the United States of America represented by the Department of Energy (Agreement). Pursuant to this Agreement, the Department of Energy (DOE) took title to radiological contaminated materials and was to remediate, at its expense, all radiological waste on the Company’s property in Maywood, New Jersey. The Maywood property (and portions of the surrounding area) were remediated by the DOE under the Formerly Utilized Sites Remedial Action Program, a federal program under which the U.S. Government undertook to remediate properties which were used to process radiological material for the U.S. Government. In 1997, responsibility for this clean-up was transferred to the United States Army Corps of Engineers (USACE). On January 29, 1999, the Company received a copy of a USACE Report to Congress dated January 1998 in which the USACE expressed their intention to evaluate, with the USEPA, whether the Company and/or other parties might be responsible for cost recovery or contribution claims related to the Maywood site. Subsequent to the issuance of that report, the USACE advised the Company that it had requested legal advice from the Department of Justice as to the impact of the Agreement.

By letter dated July 28, 2000, the Department of Justice advised the Company that the USACE and USEPA had referred to the Justice Department claims against the Company for response costs incurred or to be incurred by the USACE, USEPA and the DOE in connection with the Maywood site and the Justice Department stated that the United States is entitled to recovery of its response costs from the Company under CERCLA. The letter referred to both radiological and non-radiological hazardous waste at the Maywood site and stated that the United States has incurred unreimbursed response costs to date of $138 million. Costs associated with radiological waste at the Maywood site, which the Company believes represent all but a small portion of the amount referred

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to in the Justice Department letter, could be expected to aggregate substantially in excess of that amount. In the letter, the Justice Department invited the Company to discuss settlement of the matter in order to avoid the need for litigation. The Company believes

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that its liability, if any, for such costs has been resolved by the aforesaid Agreement. Despite the fact that the Company continues to believe that it has no liability to the United States for such costs, discussions with the Justice Department are currently ongoing to attempt to resolve this matter.

The Company believes it has adequate reserves for claims associated with the Maywood site.site, and has recorded a liability for the estimated probable costs it expects to incur at the site related to remediation of chemical contamination. However, depending on the results of the ongoing discussions regarding the Maywood site, particularly, radiological remediation, the final cost of the remediation could differ from the current estimates.

Ewan and D’Imperio Sites

The Company has been named as a potentially responsible party (PRP) in the caseUSEPA v. Jerome Lightman (92 CV 4710 D. N. J.), which involves the Ewan and D’Imperio Superfund Sites located in New Jersey. Trial on the issue of the Company’s liability at these sites was completed in March 2000. The Company is awaiting a decision from the court. If the Company is found liable at either site, a second trial as to the Company’s allocated share of clean-up costs at these sites will be held. The Company believes it has adequate defenses to the issue of liability. In the event of an unfavorable outcome related to the issue of liability, the Company believes it has adequate reserves. On a related matter, the Company has filed an appeal to the United States Third Circuit Court of Appeals objecting to the lodging of a partial consent decree in favor of the United States Government in this action. Under the partial consent decree, the government recovered past costs at the site from all PRPs including the Company. The Company paid its assessed share but by objecting to the partial consent decree, the Company is seeking to recover back the sums it paid.

Regarding the D’Imperio Superfund Site, USEPA haspreviously indicated it willwould seek penalty claims against the Company based on the Company’s alleged noncompliance with the modified Unilateral Administrative Order.Order (Order). The Company is currently negotiatingrecently entered into a Consent Decree with USEPA, to settle its proposed penaltywhich resolves all claims asserted against the Company but doesfor the alleged noncompliance with the Order. Following the requisite notice and comment period, the Company expects the Consent Decree to be entered by the court in 2004. The $65,000 payment due under the Consent Decree will not believe that a settlement, if any, will have a material impact on itsthe financial position, results of operations or cash flows.flows of the Company. In addition, the Company also received notice from the New Jersey Department of Environmental Protection (NJDEP) dated March 21, 2001, that NJDEP has indicated it will pursue cost recovery against the alleged responsible parties, including the Company. The NJDEP’s claims include costs related to remediation of the D’Imperio Superfund Site in the amount of $434,406 and alleged natural resource damages in the amount of $529,584 (as of November 3, 2000). The NJDEP settled such claims against the alleged responsible parties, resulting in the Company paying its portion of $83,061 in July 2002. This

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payment is subject to reallocation after the allocation phase of the above-identified trial, if any. The paymentany, and did not have a material impact on the financial position, results of operations or cash flows of the Company. On November 6, 2003, the USEPA issued a Unilateral Administrative Order directed to all PRPs to perform the remedial design and implement the amended remedial action described in the Agency’s ROD Amendment.

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Lightman Drum Site

The Company received a Section 104(e) Request for Information from USEPA dated March 21, 2000, regarding the Lightman Drum Company Site located in Winslow Township, New Jersey. The Company responded to this request on May 18, 2000. In addition, the Company received a Notice of Potential Liability and Request to Perform RI/FS dated June 30, 2000, from USEPA. The Company has decided that it will participate in the performance of the RI/FS. However, based on the current information known regarding this site, the Company is unable to predict what its liability, if any, will be for this site.

Liquid Dynamics Site

The Company received a General Notice of Potential Liability letter from the USEPA dated October 18, 2002, regarding the Liquid Dynamics Site located in Chicago, Illinois. The Company submitted a response to USEPA on November 5, 2002, stating that it is interested in negotiating a resolution of its potential responsibility at this site. In addition, the Company recently joined the PRP group. Based on the fact that the Company believes it is de minimis at this site, the Company believes that a resolution of its liability at this site will not have a material impact on its financial position, results of operations or cash flows.

Wilmington Site

As reported previously in the Company’s Quarterly Report Form 10-Q for the quarter ended September 30, 1994 and various subsequent reports, theThe Company has received two Requests for Information from the Commonwealth of Massachusetts Department of Environmental Protection relating to the Company’s formerly-owned site at 51 Eames Street, Wilmington, Massachusetts, the most recent of which was in October 2002. The Company’s response to this latestthe October 2002 request was filed in December 2002. Remediation at this site is being managed by its current owner to whom the Company sold the property in 1980. The Company subsequently entered into an agreement with the current owner whereby the Company is obligated to contribute to the response costs associated with this site once total site remediation costs exceed certain levels. In July 2003, the Company received a notice that contribution levels had been reached and a demand for payment from the current owner as to the Company’s outstanding share of environmental response costs incurred to-date ($0.9 million) andis due under the terms of the agreement. The Company is currently evaluatingevaluated the current owner’s demand for payment.payment and paid the current owner $0.9 million in 2004, of which $0.8 million was paid prior to March 31, 2004. Under the agreement, the Company is obligated to contribute up to five percent of future response costs associated with this site.site with no

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limitation on the ultimate amount of contributions. The Company believes it has adequate reservesrecorded a reserve of $0.7 million for current and future claims associated with this site under the agreement.site. However, 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. In addition, the Company and other prior owners entered into an agreement in April 2004 waiving certain statute of limitations defenses for claims which may be filed by the Town of Wilmington, MA, 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.

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Martin Aaron Site

The Company received a Section 104(e) Request for Information from USEPA dated June 2, 2003, regarding the Martin Aaron Site located in Camden, New Jersey. The Company’s response was submitted on August 11, 2003. The Company is currently investigating this matter and therefore, cannot predict what its liability, if any, will be for this site.

Wells G & H Superfund Site

The Company received a Section 104(e) Request for Information from USEPA dated December 15, 2003, regarding the Wells G & H Superfund Site located in Woburn, Massachusetts. The Company’s response was submitted on March 18, 2004. The Company continues to investigate this matter and therefore, cannot predict what its liability, if any, will be for this site.

Other

The Company performs ongoing ground water monitoring at a number of its plant sites. Recent results of such monitoring indicated that future remediation may be required at one of the Company’s sites. Although there has been no enforcement order, the Company is in the process of preparing a remediation plan that will be submitted to the appropriate governmental agency by the end of 2003.agency. The Company believes it has adequate reserves for the remediation of this site.

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Components of Net Periodic Benefit Cost

Employer Contributions

As disclosed in its financial statements for the year ended December 31, 2003, the Company expected to contribute $3,841,000 to its U.S. qualified pension plans and to pay $117,000 related to its unfunded non-qualified plans in 2004. In April 2004, pension relief legislation was signed into law; as a result, the Company now expects to contribute $1,574,000 to its U.S. qualified pension plans in 2004. The original estimate for the unfunded non-qualified is unchanged. As of March 31, 2004, no contributions had been made to the qualified plans and $54,000 had been paid related to the non-qualified plans.

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Below is the computation of basic and diluted earnings per share for the three and nine months ended September 30, 2003March 31, 2004 and 2002.2003.

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Comprehensive income includes net income and all other non-owner changes in equity that are not reported in net income. Below is the Company’s comprehensive income for the three and nine months ended September 30, 2003March 31, 2004 and 2002.2003.

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At September 30,March 31, 2004, the total accumulated other comprehensive loss of $18,162,000 consisted of $4,473,000 of foreign currency translation adjustments, $206,000 of unrealized gains on securities (net of income taxes of $138,000) and $13,895,000 of minimum pension liability adjustments (net of income taxes of $9,000,000). At December 31, 2003, the total accumulated other comprehensive loss of $23,797,000 consisted of $11,367,000$19,560,000 included $5,789,000 of foreign currency translation adjustments, $1,282,000$124,000 of unrealized lossesgains on securities (net of income taxes of $83,000) and $11,148,000$13,895,000 of minimum pension liability adjustments. At December 31, 2002, the total accumulated other comprehensive lossadjustments (net of $25,109,000 included $12,327,000income taxes of foreign currency translation adjustments, $1,634,000 of unrealized losses on securities and $11,148,000 of minimum pension liability adjustments.$9,000,000). Unrealized lossesgains on securities relate entirely to investments held for the deferred compensation plans.

The Company has three reportable segments: surfactants, polymers and specialty products. Financial results of the Company’s operating segments for the three and nine months ended September 30,March 31, 2004 and 2003, and 2002, are summarized below:

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Below are reconciliations of segment operating income to consolidated income before income taxes:

Unallocated corporate expenses include corporate administrative and corporate manufacturing expenses, which are not included in segment operating income and not used to evaluate segment performance.

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The Company’s net carrying values of goodwill were $6,232,000$7,731,000 and $6,182,000$7,621,000 as of September 30, 2003March 31, 2004 and December 31, 2002,2003, respectively. The entire amount of goodwill relates to the surfactants’ reporting unit. The change in net carrying value resulted from the effects of currency translation, as no additional goodwill was acquired in the first nine months of 2003.translation.

The following table reflects the components of all other intangible assets, which have finite lives, as of September 30, 2003March 31, 2004 and December 31, 2002.2003.

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Aggregate amortization expenses for the threequarters ended March 31, 2004 and nine months ended September 30,March 31, 2003, were $417,000$389,000 and $1,329,000, respectively. Aggregate amortization expenses for the three and nine months ended September 30, 2002, were $333,000 and $1,048,000,$374,000, respectively. Estimated amortization expense for identifiable intangibles assets, other than goodwill, for the current and each of the five succeeding fiscal years are as follows:

In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (FIN 46). FIN 46, which is an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements”, addresses consolidation by business enterprises of variable interest entities. This interpretation explains how a variable interest entity is identified and how an enterprise assesses its interest in a variable interest entity to decide whether it is the primary beneficiary of the entity. A variable interest entity is to be consolidated by its primary beneficiary if the entities do not effectively disperse risks among parties involved. FIN 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after December 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. The adoption of FIN 46 had no effect on the Company’s financial position, results of operations or cash flows, as the Company is not party to any variable interest entities as defined by this interpretation.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”. This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”. This statement is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. The adoption of SFAS No. 149 did not have a material effect on the Company’s financial position, results of operations or cash flows.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity”. This statement establishes standards for how an issuer classifies and measurers certain financial

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instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within the scope of the pronouncement as a liability (or an asset in some circumstances). This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 had no effect on the Company’s financial position, results of operations or cash flows, as the Company holds no financial instruments that fall within the scope of SFAS No. 150.

The Company’s U.S. loan agreements require minimum interest coverage (Earnings before interest and income taxes (EBIT) to interest expense) of 2.0 to 1.0. To enable continuing compliance with this requirement, beginning September 30, 2003, the Company has elected, as permitted by all of its U.S. loan agreements, to designate Stepan Canada Inc. as a restricted subsidiary.

The Company’s U.S. loan agreements also limit the ability of restricted subsidiaries to grant security interests in support of local credit facilities. As of September 30, 2003, Stepan Canada Inc. had an asset security lien in place for a credit arrangement with a Canadian bank, which caused the Company to be out of compliance with its U.S. loan agreements. Stepan Canada had no outstanding borrowings under this credit facility at any time during 2003. To achieve forward compliance with the U.S. loan agreements’ limitation, Stepan Canada Inc. has directed that its Canadian lending bank cancel the existing asset security lien. The Company’s U.S. lenders have waived the Company’s noncompliance of this limitation as of September 30, 2003, to permit time to process the security release.

Certain amounts in the 20022003 financial statements have been reclassified to conform to the 20032004 presentation.

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

The following is management’s discussion and analysis of certain significant factors, which have affected the Company’s financial condition and results of operations during the interim period included in the accompanying condensed consolidated financial statementsstatements.

OVERVIEW

Management’s discussion and analysis should be read in conjunction with the ‘Overview’ section of management’s discussion and analysis included in the Company’s 2003 Form 10-K.

RESULTS OF OPERATIONS

Three Months Ended March 31, 2004 and 2003

Summary

Net income for the first quarter of 2004 increased $1.7 million, or 76 percent, to $4.0 million, or $0.42 per diluted share, compared to $2.3 million, or $0.23 per diluted share, for the first quarter of 2003. Below is a summary discussion of the factors leading to the year-to-year improvement in profitability. A detailed discussion of first quarter 2004 segment operating performance follows the summary.

Consolidated net sales increased $34.3 million, or 18 percent, to $221.4 million for the first quarter of 2004 from $187.1 million for the first quarter of 2003. The effect of foreign currency translation, which reflected a year-to-year strengthening of the European euro, British pound sterling and Canadian dollar against the U.S. dollar, contributed $8.5 million of the increase in consolidated net sales. All three segments reported year-to-year increases in net sales dollars. Surfactants segment sales were up $22.6 million, or 15 percent, due to higher selling prices, favorable foreign currency translation, improved sales mix and increased sales volumes for foreign operations. Net sales for the polymers segment increased $9.6 million, or 34 percent, due primarily to higher sales volume and higher selling prices. The specialty products segment reported a $2.1 million, or 38 percent, increase in net sales due to higher sales volumes for all product lines.

Operating income was up $3.1 million, or 64 percent, to $8.0 million for the first quarter of 2004 from $4.9 million for the same quarter of 2003. Gross profit increased $4.5 million, or 18 percent, from year to year. All three segments reported gross profit increases over prior year results. Higher selling prices and sales volumes combined with a more favorable sales mix drove the improvement, although rising raw material costs continued to temper earnings. Operating expenses, which include marketing, administrative and research and development expenses, increased $1.4 million, or seven percent, to $21.6 million for the first three months of 2004 from $20.2 million for the same three months of 2003. Approximately half of the operating expense increase was due to the effect of foreign currency translation. Much of the remaining increase was attributable to higher domestic fringe benefit expense, primarily due to higher bonus and profit sharing expenses. Included in 2004 first quarter operating expenses was $0.8 million of income related to the Company’s deferred compensation plan compared to $0.9 million of income in the first quarter of 2003.

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Interest expenses declined $0.1 million, or six percent, between years due to a higher proportion of bank debt, which carries lower interest rates than the Company’s long-term notes.

Other, net, was $0.5 million of expense in the first quarter of 2004 compared to $0.3 million of income in the first quarter of 2003. Foreign exchange losses accounted for the current quarter results compared to foreign exchange gains in the same quarter of last year.

Segment Results

Surfactants

Surfactants net sales increased $22.6 million, or 15 percent, from year to year. Approximately $7.7 million of the increase was attributable to the favorable effects of foreign currency translation, due particularly to the strengthening euro, British pound sterling and Canadian dollar against the U.S. dollar. The current quarter also includes three months of Stepan UK financial results compared to two months of financial results for the prior year’s quarter as improvements resulting from the enterprise resource planning (ERP) system implementation for Stepan UK in the fourth quarter of 2003 allowed Stepan UK to report its quarterly results without a one-month lag. Excluding the effects of foreign currency translation and the additional month for Stepan UK, net surfactant sales increased $8.4 million. Foreign operations increased net sales $4.3 million on a 10 percent volume increase, primarily due to gains in France. Domestic net sales increased $4.1 million, or four percent, on sales volume that declined five percent. Second quarter 2003 price increases coupled with a change in sales mix more than compensated for the reduced sales volume and led to the rise in net sales. The decline in domestic sales volume was due principally to the loss of business from two large customers who brought previously outsourced production into internal production facilities. The effect of the lost business was mitigated by additional business with distributors, who serve a large diverse customer base, and by higher volumes of the Company’s fabric softener, agricultural chemical and emulsion polymerization product lines. The additional sales volume carries higher average selling prices than the business that was lost.

Surfactants operating income increased $0.8 million, or 11 percent, from year to year. Surfactants operating income included approximately $0.3 million related to the extra month of Stepan UK’s results in the first quarter of 2004. Gross profit increased $1.5 million, or eight percent, to $21.6 million for the first quarter of 2004 from $20.1 million for the first quarter of 2003. Excluding the effects of foreign currency translation and the additional month of Stepan

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UK, surfactants gross profit increased $0.1 million, to $20.2 million. Domestic gross profit was up $0.7 million, or five percent, due to the previously noted selling price increases and sales mix change. Gross profit for foreign operations fell $0.6 million to $5.6 million for the first quarter of 2004 from $6.2 million for the first quarter of 2003. The drop in foreign operations gross profit reflected the effect of higher raw material costs. Operating expenses increased $0.7 million, or five percent, between quarters. Excluding the unfavorable effect of foreign currency translation, operating expenses increased just $0.1 million.

Polymers

Polymers net sales increased $9.6 million, or 34 percent, from year to year. An 18 percent increase in sales volume, higher prices, due primarily to partially passing raw material cost increases to customers and $0.8 million of favorable foreign currency translation on European sales all led to the increase in net sales. Within the polymers segment, polyurethane polyols net sales increased $4.3 million, or 26 percent, on sales volume that grew 13 percent due primarily to an increased share of the growing European laminate board market and to gaining additional domestic volume. Higher selling prices also contributed as the Company benefited in the 2004 quarter from the second quarter 2003 increase in selling prices, which passed a portion of raw material cost increases on to customers. Phthalic Anhydride’s (PA) net sales were up $4.0 million, or 50 percent, due to higher selling prices that reflected passing raw material cost increases on to customers and to sales volume that improved 22 percent. Increased demand drove the higher volume. Polyurethane systems net sales improved $1.3 million, or 38 percent, on sales volume that increased 45 percent due to the acquisition of a new customer during the second quarter of 2003.

Polymers 2004 first quarter operating income increased $1.3 million, or 51 percent, over 2003 first quarter operating income. Gross profit increased $1.2 million, or 23 percent, from year to year. Polyurethane polyols accounted for the increase in gross profit, as 2004 first quarter results were $1.3 million, or 43 percent, greater than results for the same quarter of the prior year. The 13 percent increase in sales volume and the benefit of internal production economics of the Company’s European polyurethane polyol plant, which commenced operations in July 2003, partially offset the effect of rising raw material costs and led to the gross profit growth. Gross profit for polyurethane systems grew $0.1 million, or 16 percent due to the impact higher sales volume, which was partially offset by rising raw material costs. Despite improved sales volume, gross profit for PA fell $0.2 million, or 10 percent, due to the effects of higher raw material costs. Polymer raw material price volatility is expected to continue in the near future as global demand for diethylene glycol and ozthoxylene is high and current supplier inventories are low. Polymer operating expenses declined $0.1 million from year to year.

Specialty Products

Net sales for the first quarter of 2004 were $7.8 million, a $2.1 million, or 38 percent, increase from the $5.7 million reported in the prior year first quarter. Operating income increased $1.4 million to $2.7 million for the first quarter of 2004 from $1.3 million for the first quarter of 2003. The increases in net sales and operating income reflected higher sales volumes for all major product lines. The sales volume gain was partly attributable to two pharmaceutical customers who purchased approximately 50 percent of their annual requirements during the quarter. Operating expenses increased $0.2 million, or 42 percent, primarily due to a higher allocation of research resources to support the business.

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Corporate Expenses

Corporate expenses, which primarily include corporate administrative and corporate manufacturing expenses that are not allocated to the reportable segments, increased $0.4 million, or seven percent, to $6.9 million in 2004 from $6.5 million in 2003. Fringe benefit expense, which increased $0.5 million from year to year due to higher bonus and profit sharing expenses, accounted for the rise in corporate expenses. Higher year-to-year net income led to the increase in bonus and profit sharing expenses.

LIQUIDITY AND CAPITAL RESOURCES

Net cash provided byFor the first quarter of 2004, operating activities for the nine months ended September 30, 2003 totaled $34.7consumed $6.0 million up $3.8 million from $30.9of cash, compared to providing cash of $0.3 million for the equivalent period in 2002. Working capital required the use of $5.4same quarter last year. Net income was up by $1.7 million for the first nine monthscurrent year quarter; however, working capital consumed $20.5 million of 2003,cash in the quarter, or $8.3 million more than the prior year quarter.

For the current year quarter, accounts receivable increased by $35.7 million compared to a cash use$15.3 million last year, with little movement in days outstanding. The typical first quarter increase received an additional boost in the current period from strong March 2004 sales. Inventories decreased $5.6 million since year-end, reflecting successful management initiatives in the U.S. and strong March 2004 sales. Inventories had increased by $3.7 million in the first quarter of $18.82003. Accounts payable and accrued liabilities increased by $9.4 million during the quarter compared to an increase of $5.6 million for the same period in 2002. This fluctuation in working capital requirements, caused principally by an increase in accounts payable and inventories, was more than enough to offset the impact of lower net income for the current year period.

For the first three quarters of 2003, accounts receivable increased by $12.8 million due to normal seasonal sales patterns while inventories increased by $1.5 million. The inventory increase was more than offset by a $9.3 million increase in accounts payable and accrued liabilities. The accounts payable balance was down at December 31, 2002, due to an increased availability of cash.2003.

Capital expendituresspending totaled $24.7$6.2 million for the first ninethree months of 2003, nearly matching spending of $24.62004, compared to $8.7 million in the comparable period last year. Capital expenditures are projected to decrease during 2004 by approximately five percent as certain large projects, such as the German polyol manufacturing facility, were completed in 2003.

Consolidated debt was up by $12.7 million for the same period in 2002. The Company projects that 2003 total year spending will be close to the $36.1 million recorded in 2002. Significant capital projects for 2003 include a polyol reactor at our German plant site and fabric softener expansions.

Total Company debt has decreased by $1.2 million since last year-end,first quarter of 2004, from $117.7$115.7 million to $116.5 million. Despite lower current year earnings, net cash provided by operating activities has outpaced the combined levels of investing and financing activities primarily due$128.4 million, as debt increased to lowerfinance working capital requirements.capital. As of September 30, 2003,March 31, 2004, the ratio of long-term debt to long-term debt plus shareholders’ equity was 37.840.3 percent, compared to 39.636.2 percent atas of December 31, 2002.

The Company’s U.S. loan agreements require minimum interest coverage (Earnings before interest and income taxes (EBIT) to interest expense) of 2.0 to 1.0. To enable continuing compliance with this requirement, the Company has elected, as permitted by all of its U.S. loan agreements, to designate Stepan Canada Inc. as a restricted subsidiary beginning September 30, 2003.

The Company’s U.S. loan agreements also limit the ability of restricted subsidiaries to grant security interests in support of local credit facilities. To achieve forward compliance with that limitation, Stepan Canada Inc. has directed that its Canadian lending bank cancel an existing asset security lien. The Company’s U.S. lenders have waived the Company’s noncompliance with this limitation as of September 30, 2003, to permit time to process the security release.

The Company maintains contractual relationships with its domesticU.S. banks that provide for revolving credit of up to $60 million, which may be drawn upon as needed for general corporate purposes through May 2, 2007 under a revolving credit agreement. As of September 30, 2003,

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At March 31, 2004, there were borrowings totaling $9.4$17.0 million were outstanding under this revolving credit agreement. The Company also meets short-term liquidity requirements through uncommitted domestic bank lines of credit.

On March 8, 2004, the Company obtained amendments to all of its U.S. loan agreements to modify the interest coverage test effective December 31, 2003. As a result, the Company is in compliance with all loan agreements.

The Company’s foreign subsidiaries maintain committed and uncommittedbank term loans as well as short-term bank lines of credit in their respective countries to meet working capital requirements as well as to fund capital expenditure programs and acquisitions. The Company’s European subsidiary completed $9.8 million of a new euro-denominated $16.0 million bank term loan during

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February 2004. The proceeds of this new loan were used repay short-term bank debt. As of March 31, 2004, the Company’s European subsidiaries had term loans totaling $23.0 million and short-term bank borrowings totaling $3.8 million, all in local currencies. As of March 31, 2004, the Company’s foreign subsidiaries had approximately $11.1 million in unused borrowing capacity, mostly in local currencies, under their short-term bank lines of credit.

The Company anticipates that cash from operations and from committed credit facilities will be sufficient to fund anticipated capital expenditures, dividends and other planned financial commitments for the foreseeable future, including larger pension plan funding requirements resulting from increased plan liabilities and declining plan asset market values due to market conditions in recent years.future. Any substantial acquisitions would require additional funding.

There have been no material changes in the Company’s market risks since December 31, 2002.2003.

RESULTS OF OPERATIONSPENSION FUNDING

Three Months Ended September 30, 2003 and 2002

Overall Results

Consolidated net sales were $196.1 millionAs disclosed in its Form 10-K for the third quarter ofyear ended December 31, 2003, a $2.8 million, or one percent, increase from net sales of $193.3 million for the same period of 2002. Excluding the effects of foreign currency translation, consolidated net sales decreased $2.1 million, or one percent, from quarterCompany expected to quarter. Net sales for the surfactants segment fell $1.8 million on a declinecontribute $3,841,000 to its U.S. qualified pension plans and to pay $117,000 related to its unfunded non-qualified plans in U.S. (‘domestic’) sales volume, partially offset by favorable foreign currency translation of European sales. Net sales for the polymers segment were up $5.1 million from quarter to quarter due to higher sales volume, particularly for polyurethane polyols. Net sales for the specialty products segment declined $0.6 million on a lower volume of higher priced products.

Operating income dropped 67 percent to $3.1 million for the third quarter of 2003 from $9.2 million for the third quarter of 2002. Gross profit declined $4.1 million, or 13 percent, from quarter to quarter. The surfactants segment accounted for most of the gross profit decrease, as sales volume declined. Despite sales volume improvement, polymers gross profit fell due primarily to a production outage in the manufacture of phthalic anhydride. Specialty products gross profit2004. In April 2004, pension relief legislation was downsigned into law; as a result, the Company now expects to contribute $1,574,000 to is U.S. qualified pension plans in 2004. The original estimate for the unfunded non-qualified is unchanged. As of product mix. Consolidated operating expenses, which include marketing, administrative,March 31, 2004, no contributions had been made to the qualified plans and research, development and technical services expenses, increased $2.1 million, or ten percent, from quarter to quarter due largely to increased environmental remediation reserve requirements of $1.5 million and $1.3 million of higher expense$54,000 had been paid related to the Company’s deferred compensation plan. The fluctuations in operating income and gross profit are discussed further under “Segment Results” below.

Net interest expense increased $0.2 million, or 10 percent, from quarter to quarter, due a higher proportion of fixed rate debt. The Company secured more fixed rate debt in 2002 to lock in recent low interest rates for the long term, although such debt has a higher cost than current short-term interest rates.

Income from the Company’s Philippine joint venture declined $0.2 million, or 22 percent, between quarters. A less favorable sales mix accounted for the decline.

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The effective tax rate was 26.5 percent for the third quarter of 2003 compared to 31.6 percent for the third quarter of 2002. The rate for both quarters reflected revisions to adjust the cumulative year-to-date tax rate to the estimated annual effective rates of 32.5 percent and 35.0 percent for 2003 and 2002, respectively. The lower annual effective tax rate was primarily attributable to the tax benefit realized on foreign joint venture equity income as a percentage of consolidated income being higher in 2003 than in 2002 due to the decline in domestic profitability. A decrease in the state tax rate due to the impact of tax credits on a lower level of earnings also contributed to the lower effective tax rate.

Net income for the quarter was $1.3 million, or $0.12 per diluted share, compared to $5.7 million, or $0.58 per diluted share, for the prior year’s third quarter.

Segment Results

Surfactants third quarter 2003 net sales decreased $1.8 million, or one percent, from third quarter 2002 net sales. Sales volume fell ten percent from quarter to quarter, as domestic volume dropped 16 percent, and foreign subsidiaries’ volume increased six percent. Lower demand from two major customers accounted for the domestic sales volume decline, as such customers brought outsourced volume back into their facilities. Increased volumes for European operations accounted for most of the foreign subsidiaries’ improvement. As a result of lower sales volume, domestic net sales decreased $10.5 million, or ten percent. Net sales for foreign operations increased $8.7 million, or 18 percent. Approximately $4.2 million of the increase was attributable to the favorable effects of foreign currency translation, particularly the strengthening euro and British pound sterling against the U.S. dollar. Excluding the effect of foreign currency translation, total surfactants net sales declined $6.0 million, or four percent, between quarters.

Surfactants operating income fell $3.8 million, or 41 percent, principally due to a decline in gross profit. Gross profit for the third quarter of 2003 was $18.7 million, which was 17 percent lower than the $22.5 million reported for the same period of 2002. Domestic gross profit declined $4.2 million, or 26 percent, from quarter to quarter due to lower sales volume resulting from the lower demand from two major customers. A change in sales mix also contributed to the decline in domestic gross profit. The Company’s domestic operations are susceptible to significant gross profit declines when volumes decrease due to the primarily fixed nature of the Company’s manufacturing costs. Foreign operations’ gross profit increased $0.4 million, or

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seven percent, between quarters. European operations accounted for most of the improvement. Operating expenses remained flat at $13.2 million. Lower domestic research and development expense was offset by United Kingdom ERP implementation expense and the negative effect of foreign currency translation. Excluding the effect of foreign currency translation, operating expenses decreased $0.3 million, or two percent.

Polymers third quarter 2003 net sales increased $5.1 million, or 15 percent, from third quarter 2002 net sales. Sales volume increased five percent. Phthalic Anhydride (PA) net sales increased $0.8 million, or nine percent, between quarters, despite a one percent drop in sales volume. The net sales increase was primarily due to higher average selling prices that resulted from a change in customer mix. Net sales for polyurethane polyols increased $3.4 million, or 16 percent, between quarters. An eight percent increase in sales volume and selling price increases, which were effected in the second quarter of 2003, led to the improvement. Sales volume grew for both domestic and European operations. Polymers net sales were also affected by favorable euro to U.S. dollar foreign currency translation, which contributed approximately $0.6 million to the net sales increase. Third quarter 2003 polyurethane systems net sales grew $0.9 million, due primarily to a 16 percent sales volume increase. New business accounted for most of the volume improvement in polyurethane systems.

Polymers operating income decreased $0.9 million, or 15 percent, from quarter to quarter. Third quarter 2003 gross profit was $7.8 million, which was $0.9 million less than the $8.7 million reported in the third quarter of 2002. PA gross profit fell $1.3 million, or 66 percent, in large part due to costs associated with unscheduled plant outages. Polyurethane polyols gross profit increased $0.1 million, or two percent. The effect of higher sales volume was largely offset by lower margins. Second quarter 2003 selling price increases only partially negated the impact of rising raw material costs. Increased sales volumes for polyurethane systems led to a $0.3 million, or 36 percent, growth in gross profit. Polymer operating expenses remained flat at $2.7 million.

Specialty products net sales decreased $0.6 million, or eight percent, over net sales for the same period of 2002. Operating income dropped $0.6 million, or 26 percent, on lower sales volume of higher margin products. Increased research costs also contributed to the decline.