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Executives

James E. Hurlbutt – Vice President & Chief Financial Officer

Analysts

Daniel Rizzo – Sidoti & Company, LLC

George Gaspar – Robert W. Baird & Co.

Stepan Company (SCL) Q2 2008 Earnings Call July 30, 2008 2:00 PM ET

Operator

Welcome to the Stepan Company second quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the conference over to Jim Hurlbutt, Chief Financial Officer.

James E. Hurlbutt

Before I begin, please note that information in this conference call contains forward-looking statements which are not historical facts. These statements involve risk and uncertainties that could cause actual results to differ materially, including but not limited to prospects for our foreign operations, global and regional economic conditions and factors detailed in the company’s Securities and Exchange Commission filings.

I am pleased to announce that Stepan’s second quarter and first half 2008 results were significantly higher than the same periods in 2007. We continued to build momentum established in the first quarter of 2008 which was reflected in the company’s improved sales, net income and earnings per share performance. At this point let me walk you through our second quarter and first half 2008 operating results.

Starting with net sales, total net sales for the second quarter were $420 million, an increase of 25% year-over-year, benefiting primarily from higher selling prices which accounted for 21 percentage points of net sales growth and secondly, the positive effect of foreign exchange currency translation which accounted for 4 percentage points of net sales growth. Overall sales volume was flat from the prior period. Rising crude oil derivatives and inflationary impacts across most chemical feedstocks led to the higher selling prices.

During the quarter we implemented a series of product line price increases aimed at recapturing the effect of rising raw material prices. These efforts included broad based price increases across most surfactant and polymer products. Total net sales for the first half of 2008 were $802 million, an increase of 24% year-over-year, benefiting primarily from higher selling prices again accounting for 21 percentage points of net sales growth as well as the positive effect of foreign exchange currently translation contributing 4% to the increase in net sales. For the first size months, total sales volume declined by 1%.

Net income for the second quarter increased 106% to $9.8 million or $0.93 per diluted share compared to net income of $4.7 million or $0.47 per diluted share in the year ago quarter. First half 2008 net income increased 78% to $18.5 million or $1.79 per diluted share compared to net income of $10.4 million or $1.03 per diluted share in the year ago period.

Second quarter and six month gross profit increased $11.7 million and $22.8 million respectively, both rising 31% year-over-year. In the second quarter, our surfactant polymer segments both reported improved gross profit. The year-to-date improvement was led by a $21.2 million increase in surfactant gross profit driven by an improved customer and product mix as well as the recovery of fabric softener margins which had declined during the prior year.

Second quarter gross margin increased to 11.9% of revenue from a gross margin of 11.3% in the year ago period. For the six month period, the gross margin rose to 11.9% compared to 11.2% in the year ago period. Operating income increased $7.1 million in the second quarter or 67% with six month year-to-date operating income rising 64% to $34.5 million. I would point out that the second quarter of 2007 operating income included a $4.2 million net gain on the sale of a product line and a $3.5 million charge related to goodwill impairment.

Turning to operating expenses, second quarter operating expenses totaled $32.4 million, up 13% quarter-over-quarter and up 16% in the six month year-to-date comparison. The major contributors to higher operating expenses across all categories were incentive based compensation and higher foreign operating expenses due to the weaker U.S. dollar. Summarizing these impacts, the year-over-year incentive based compensation increased $1.2 million and $2.3 million in the second quarter in six month year-to-date period.

Year-over-year foreign exchange translation effect increased $800,000 and $1.6 million in the second quarter and six month year-to-date periods and deferred compensation increased $500,000 and $2.5 million respectively in the second quarter and six month periods. As you’ll recall, the accounting requirement for the company’s fully funded deferred compensation plan results in an expense being recorded when the price of Stepan Company’s stock or mutual funds held in the plan rise and income being recognized when they decline. For reference, Stepan Company’s common stock share price appreciated $7.39 per share during the quarter. For the second quarter, marketing expenses increased 14% year-over-year to $10.4 million and administrative costs increased 14% to $13.2 million and research an development costs 11% to $8.9 million.

Let’s move to a review of the performance of our three key business segments. First, we’ll look at surfactants, the largest segment of our business accounting for 75% of total sales in the first half of the year. Quarterly, net sales of surfactants were up 27% and 25% year-over-year. Volume declined 1% in the quarter and 2% in the six month period as compared to the year ago. Surfactant gross profit increased $9.8 million or 42% to $33.3 million in the quarter driven by improved product and customer mix as well as recovery of higher raw material costs and selling prices.

In the six month year-to-date period, surfactant gross profit increased $21.2 million or 46% to $66.8 million. Sales of higher value added surfactants in the distributor market, agricultural, oil field contributed to the improved gross profit. Fabric softener margins recovered from erosion during 2007. The slight decline in volume was due to lower personal care sales volume due to a customer reformulation from a low active to a high active product that results in lower sales volumes. Commodity laundry and fabric softener volumes improved. Biodiesel continues to generate a small profit versus a year ago loss due to the higher diesel prices and our use of lower cost tallow as feedstock, in conjunction with soybean oil.

The improved surfactant segment performance was broad based geographically with North America, Latin America and Europe all showing improvement. Moving now to our polymer segment, which represents 23% of first half sales, net sales of polymers were up 21% quarter-over-quarter and 20% year-over-year. Volume grew 5% for the quarter and 4% for the six month period. Polymer segment gross profit rose $2.5 million in the second quarter, up 20% to $15.1 million on improved margin and higher profit and higher volumes. For the six month period, polymer gross profit increased $1.6 million or 7% to $25.7 million.

The company’s polyol product experienced a 13% increase in volume and represented most of the polymer segment improvement in profit. Stepan’s polyol is used primarily in rigid foam insulation for commercial roofing, the majority of this market being for replacement roofs versus new construction. This market remains strong in part due to the desire for greater energy savings achieved from increased insulation.

Our sales of polyol in Europe have been exceeding the capacity of our plant in Germany. Supplemental product has been supplied from our plants in the U.S. and China. The decision has been made to expand our German plant by 38,000 metric tons. This expansion, coupled with ongoing debottlenecking activities will bring the German polyol capacity to 86,000 metric tons by 2010. I would like to point out that we are planning the triennial maintenance turnaround for our phthalic anhydride and polyol manufacturing facilities at our Millsdale, Illinois plant during the fourth quarter of 2008. And as such, we do expect slightly higher fourth quarter maintenance and outsourcing cost. Longer term, this maintenance exercise is expected to yield improved reliability in 2009 and beyond.

And finally, our specialty products segment accounted for around 2% of the company’s sales in the second quarter and first half. Net sales of specialty products were up 9% for the quarter and 20% for the first six months of 2008. Specialty products second quarter gross profit remained unchanged for the quarter as improved pharmaceutical volume was offset by weaker food ingredient volume.

Turning to other income and expenses, interest expense for the company rose 2% for the quarter and six month period due to higher average debt levels brought about by increased working capital requirements. The second quarter loss associated with our 50% equity in the Philippine joint venture totaled $600,000, up from an essentially breakeven performance in the year ago period. The combination of production outages and factors around the reliability of raw material supply for the facility were the primary factors in the higher loss from this facility. Foreign exchange losses also contributed to the weaker Philippine performance. We expect an improved second half performance in the Philippine operation.

Our effective tax rate for the quarter was 32.8% compared to 37.6% in the year ago period. The decline in the tax rate was primarily due to the recording of Stepan U.K. goodwill impairment during the prior year for which no tax benefit was realized. Turning to the balance sheet, consolidated debt as of June 30, 2008 was $166.6 million, up by $28.1 million from $138.5 million one year ago. Our total debt to total capitalization at quarter end was 41.8% compared to 41.5% as of the prior year.

Capital expenditures were $8.4 million in the second quarter, down 17% from the same quarter last year. This is mainly due to timing of individual projects. We expect our 2008 full year cap ex to be in the range of $44 million to $52 million. Looking now to our cash flows during the quarter, operating activities consumed $5.7 million versus a source of $23 million for the prior year quarter. In the six month period, operating activities consumed $16.1 million compared to a $16.9 million source in 2007 due to significantly higher working capital requirements. The inflationary impact of crude oil derivatives was the primary cause of higher working capital requirements. Also during the quarter Stepan paid out $2.2 million in cash dividends to its common and preferred shareholders.

Looking forward overall we are pleased with our progress in the second quarter. Looking ahead to the second half we expect slightly higher maintenance and outsourcing cost in the fourth quarter and while we remain concerned about the state of the current economic environment, we believe our improved profitability is sustainable. Our business is increasingly diverse with a broader product line and greater number of end use markets contributing to our improved performance. While household cleaning products hold up reasonably well during recessionary periods, we are pleased that our improvement is being positively impacted by growth in rigid foam insulation, agricultural products and oil field products.

I would like to thank the Stepan team worldwide for their contributions to our strong second quarter results and we believe Stepan remains on track and well positioned to perform for the future. This concludes my prepared remarks. At this time I would like to turn the call over for questions. Operator, please review the instructions for the question portion of today’s call.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Daniel Rizzo – Sidoti & Company, LLC.

Daniel Rizzo – Sidoti & Company, LLC

I understand that you said a lot of the, some of the margin gains were because of just better product mix. Are you still cutting internal costs as well?

James E. Hurlbutt

Yes, we have. We implemented some cost saving efforts that are made with New Jersey plant last year. Then we continued to pursue, we’ve implemented a sigma project that take costs out of the system on a company wide basis as well as we’ve implemented purchasing , an initiative of which is, yes, we anticipate savings down the road. We have yet to see significant savings. It’s at a relatively early stage but we still put cost savings high in the priority list for improving the overall profitability of the company.

Daniel Rizzo – Sidoti & Company, LLC

So there is a long ways to go with the savings you think you can achieve then.

James E. Hurlbutt

We still see a lot of opportunity, yes.

Daniel Rizzo – Sidoti & Company, LLC

Has there been a pullback in the cost of the raw materials for biodiesels? I know oil’s pulled, I’m just talking the past few weeks with the pullback in price of oil and gas.

James E. Hurlbutt

Well, we’ve certainly seen selling price of crude oil coming down but I think we’ve yet to see any significant decline yet in soybean oil. I would expect it would come down some but it’s not moving in perfect tandem with crude oil because so much is used in the food industry. But we’re still using a significant amount of tallow in our biodiesel blend which is significantly lower cost than soybean oil.

Unfortunately, we can’t run tallow all winter because of the temperatures being too low and it doesn’t hold up as well in cold weather as soybean oil but for the summer months and well into the fall, we will be using a fairly high percentage of lower priced tallow to be able to put a biodiesel out on the market where we can make some improved profitability which had declined over the last year.

Daniel Rizzo – Sidoti & Company, LLC

And when would you start using tallow again? I guess March or something like that?

James E. Hurlbutt

Yes, in springtime.

Daniel Rizzo – Sidoti & Company, LLC

And finally, the Roman Haus was bought by Dow Chemical, I guess a month or so again now. Is that something that’s going to affect you guys negatively? I thought Roman Haus was a customer?

James E. Hurlbutt

We’re not aware of any. We’re not anticipating or expecting any significant impact to the company from that acquisition.

Operator

Your next question comes from George Gaspar – Robert W. Baird & Co.

George Gaspar – Robert W. Baird & Co.

First question on just your raw material cost outlook relative to the second quarter. Can you give us any color on what you might be experiencing on a relative basis?

James E. Hurlbutt

Well, before crude had started to back off, everybody had been going out with price increase announcements July 1. So as we sit here today, we’re still being faced with increased cost versus the second quarter which we in turn have attempted to get pushed through on our July 1 price increases as well. So if we see a backing off as a result of crude we won’t feel a significant impact for another month or two.

George Gaspar – Robert W. Baird & Co.

Then on the surfactant area, you mentioned one of the volume opportunities where oil field now. Is that still coming from a few projects that you have on secondary treatment or is there something starting to materialize on an ongoing opportunity basis?

James E. Hurlbutt

Well, today most of our improved volume going into the oil field industry is primarily in foamers for down well foam for improving recovery of biocides for preventing plugging in corrosion inhibitors in the wells and then fracturing additives. So today the improvement has really been in the more traditional oil field service markets. We still continue to pursue the enhanced oil recovery field where you’re actually using the surfactant in the water flood of a field to generate a stimulation of production, increasing yields by targets of anywhere from 10% to 25% more oil coming out of the ground. That business has still yet to see much commercial success from the standpoint of any large or significant volume of new business.

Now there are a lot of field tests, pilot floods going on that are expected to result in full floods in the next six to twelve months so depending on the outcome of their pilots floods, if they’re happy with the results we would expect to see some improved volume.

George Gaspar – Robert W. Baird & Co.

Just from a general point of view, your general sales to the patch was, are you getting any significant percentage increase relative to what you’ve seen before?

James E. Hurlbutt

Well, today it’s a very small part of Stepan’s business but it has been growing so yes, we’re seeing significant improvement in the interest and demand for those products.

George Gaspar – Robert W. Baird & Co.

Back on surfactant and fabric softener, can you describe your condition that your markets in Mexico, South America and the Philippine/China area and how are the Philippine and China operations coming along on a volume comparison basis?

James E. Hurlbutt

Well, let me circle back to North America. North America fabric softener volume is doing very well and we’re bumping up against our capacity, our production capacity in North America and Mexico combined, on a combined basis because we have a fair amount of fabric softener capacity in Mexico. So that business in good shape and with the improved margins we’ve experienced this year versus last year we’re very pleased with the performance of fabric softeners. The fabric softener plant that was put into the Philippines is progressing along very well. They should be starting to bump up against the capacity of that plant by next year so on that basis the fabric softener plant in the Philippines, which is currently profitable, will be making a nice little profit next year.

Some of the problems we’re having in the Philippines that are precluding us from delivering an operating profit is the on the traditional sulfination side for detergent products where we have had this succession of production outages due to logistical reasons of not having raw materials on hand, having manufacturing problems with the facility due to equipment failures. So we’ve had a whole host of issues in the Philippines to deal with. We do believe that the product mix and the current margins that we have and the volume of business we have under contract should allow for that facility to be profitable once we solve some of these current, hopefully shorter term problems, but that the product mix and pricing is different from the most recent two years and should allow us to get this thing back to a profit point.

So the real issue is more on the sulfination. The fabric softener is right on track to what we had hoped to accomplish at that sight. And then you mentioned China; we currently don’t have a softener capacity capability in China. We just have the polyol plant in China.

George Gaspar – Robert W. Baird & Co.

Yes, I think I miscued a little bit on the China request from you. I was looking just at your general business over how do you just see operations there.

James E. Hurlbutt

It’s still coming up slower than we’d like in terms of total takeaway from that plant. We’re probably running that plant, it’s a 30,000 metric ton plant and today we’re probably only selling 25% of that capacity. Fortunately, we are sold out in Europe so we have started to divert some of the Chinese capacity to Europe. The volume growth is progressing and they still feel very optimistic that we will sell that plant out but it’s certainly going to take several more years to get it sold out.

It’s trying; it did turn profitable. We’ve had several straight months now of profitability on the Chinese operation so it’s encouraging.

Operator

Your next question is from George Gaspar – Robert W. Baird & Co.

George Gaspar – Robert W. Baird & Co.

On South America, does the agricultural area, this is the area that you expanded into if I recall in the last year or two and you can correct me or highlight. I thought you maybe made a modest acquisition to of a product line to help penetrate that area. How do you see the Brazil or South America market in general and what opportunity skill do you have going there that you can take advantage of?

James E. Hurlbutt

Well, we got into a situation that was primarily taking over Unilever plant and baseloading it with a 10 year contract with Unilever. And our goal was then to broaden to diversify the product line. We’ve added the multipurpose reactor down there which today it has been diverted primarily into the agricultural market in Brazil so we have taken and been successful in getting access into niche markets in Brazil for particularly ag products.

Longer term we’ve got a lot of opportunity in Brazil. We’re not sure as to how the timing will play out but we would still look to add neutralization capability so we can product the product portfolio from the base sulfonic acid type detergent product to a more robust surfactant portfolio. And then we do not have fabric softener capability today in Brazil and while that may be not real near term, it is something we are actively exploring based on several customers’ potential demands for that region of the world. But it is, between the time we negotiate anything with a customer and build a plant, that would probably 12 to 18 months away. Those are not short term construction products.

George Gaspar – Robert W. Baird & Co.

In terms of, it sounds like Europe is moving along pretty good for your product lines and do you see, and it sounded like just your commentary on the shipping out of China, potentially, for the European market, do you see the European market hanging in there pretty good? There have been some parts of it that, from recently, we’d been hearing in other levels of activity that because of economic pullback that things are softening up. But how do you see your market there?

James E. Hurlbutt

Well, we’re hearing the same, same broad based information that Europe may be starting to slow down. However, we’re not experiencing that in our market; just the opposite. With the increased demand for energy savings, we’re seeing the business gaining momentum still and we did just recommend and have the Board approve the expansion of our German polyol plant so we will now take it up from 42,000 metric tons to 86,000 metric tons through further debottlenecking of the existing plant coupled with a 38,000 new reactor for polyols in Europe.

We see the Europeans’ demand as a fairly broad based improvement. It’s tougher, more stringent energy standards for building plus a very short term payback on energy savings for the person putting more foam into his building and then coupled with greater interest coming out of Eastern Europe for insulation products. So we’re feeling fairly confident about the polyol business in Europe at this point.

George Gaspar – Robert W. Baird & Co.

Your German expansion; what’s the timeframe on concluding that?

James E. Hurlbutt

Yes, again, that would be, it would be over a 12 month completion so we would not expect to see capacity from the new reactor until 2010. We’re in debottlenecking on the old reactor that hopefully will add another 6,000 to 8,000 metric tons over the next four to six months.

George Gaspar – Robert W. Baird & Co.

What kind of expenditure is this involving going from 42,000 to 86,000?

James E. Hurlbutt

It’s close to a $20 million project that will, the spend will spread over just a little bit in 08, the majority in 09.

George Gaspar – Robert W. Baird & Co.

In the United States, you mentioned North American very strong on the overall fabric softener, general surfactant market. Is there any particular precise area within that market that’s really showing extra strength for you? Is it the fabric softener aspect of it?

James E. Hurlbutt

Well, fabric softener’s been very strong. That’s been a push by us strategically over the last more than five years to take a major position and market share in fabric softeners. So yes, we’re pleased with the progress on fabric softeners and then the robust farm economy is certainly helping the ag business and all the companies selling and the herbicides, pesticides and fertilizers. Anybody using a surfactant to help the delivery of their product and to their crops is benefiting from that so we’re certainly not seeing any signs that the, the whole issue of where is the farmer going to shake out once the fight over food versus fuel on the biodiesel and ethanol debates subsides but right now the farmers are certainly in a boom time and have money in their pocket to buy fertilizer and farm equipment so it’s a plus.

George Gaspar – Robert W. Baird & Co.

On this biodiesel market you’ve pretty much have decided, I would assume here from past conversations and comments on a quarterly basis, that you’re going to hold at where you are in the biodiesel market, that you’re not going to do any further expansion on it?

James E. Hurlbutt

That’s correct. The margins have, we made a nice profit on that business for two or three years before the price of soybean all ran up and the margins deteriorated so today we’re viewing it more as an opportunistic opportunity if we can use those assets and make more money on surfactants or other products, intermediates for surfactants, we’ll divert those assets to that use.

George Gaspar – Robert W. Baird & Co.

Lastly, on your stock performance which is outstanding, is there any chance that you would look to split the stock along the way to increase the share count? Get a little more flexibility in the trading activity in it?

James E. Hurlbutt

Well, we’ve discussed that but quite honestly, the trading volume has improved quite a bit over the past year so we’re not seeing a imminent pressure to try and improve liquidity in the marketplace so today, no we don’t have any near term intention to look at a stock split, depending on, obviously, I don’t want to say never because I don’t know what the stock price will be down the road. But as long as the liquidity in the marketplace remains robust, there may not be a need.

Operator

We have no further questions at this time.

James E. Hurlbutt

I would just like to thank everybody for participating in today’s phone call. Thank you very much.

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