Results of Operations

2006 Compared with 2005

Summary

Net income for 2006 declined 49 percent to $6.7 million, or $0.63 per diluted share, compared to $13.2 million, or $1.35 per diluted share, for 2005. Before the cumulative effect of a change in accounting principle for asset retirement obligations, 2005 net income was $13.5 million, or $1.39 per diluted share. Operating income for 2006 fell $9.6 million, or 38 percent, from operating income reported in 2005. The decline in operating income reflected a $5.2 million increase in legal and environmental expenses, a $1.6 million increase in deferred compensation expense and $2.8 million of fourth quarter 2006 severance expense related to the restructuring of the Company’s Europe surfactants organization. Included in the legal and environmental expense increase was a $3.0 million fourth quarter 2006 settlement for personal injury claims associated with the Company’s previously owned Wilmington, Massachusetts site (sold in 1980). In addition to the foregoing, the prior year income results benefited from $2.5 million of insurance settlement income related to the 2004 fire at the Company’s United Kingdom subsidiary, $2.1 million in non-recurring income related to a U.S. Department of Agriculture biodiesel incentive income and a large non-recurring polyurethane systems sales contract. Below is a summary discussion of the major factors leading to the year-to-year changes in net sales, profits and expenses. A detailed discussion of segment operating performance for 2006 follows the summary.

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Consolidated net sales for 2006 increased $94.2 million, or nine percent, higher than consolidated net sales for 2005. All reportable segments reported year-to-year increases in net sales. Increases in selling prices, due primarily to the pass through of higher raw material costs, along with a favorable mix of surfactants sales and greater polymers volume led to the increase in net sales. Consolidated sales volume increased one percent from year-to-year. Higher average selling prices and the small sales volume increase accounted for approximately $76.7 million and $11.4 million of the net sales growth, respectively. The favorable effects of foreign currency translations accounted for about $6.1 million of the year-to-year change.

Operating income for 2006 was $9.6 million, or 38 percent, lower than operating income for 2005. Gross profit was up $2.9 million, or two percent, while operating expenses increased $12.5 million, or 13 percent. The surfactants segment accounted for most of the gross profit increase as results for North America operations improved due to higher selling prices and a more favorable customer and product mix. Also, increased Latin America sales volume contributed to the higher surfactants profits. Gross profit for the polymers segment was up less than one percent from year-to-year as the effects of higher raw material costs, particularly for foreign operations, and a drop in sales volume for polyurethane systems largely offset the effect of sales volume growth for the polyols product line. Gross profit for the specialty products segment dropped due to higher raw material costs. In addition to the foregoing, consolidated 2005 gross profit benefited from the previously mentioned Stepan UK insurance income and the U.S. Department of Agriculture biodiesel incentive income.

The 13 percent increase in operating expenses was attributable to a $10.5 million, or 30 percent, increase in administrative expenses and a $2.0 million, or six percent, increase in marketing expenses. The above noted Europe severance expenses and increases in legal, deferred compensation and consulting expenses accounted for most of the increase in administrative expenses. See the ‘Corporate Expense’ section of this discussion for additional details about the year-to-year changes in legal, deferred compensation and consulting expenses. Approximately half of the marketing expense increase was attributable to higher U.S. salary expense. Personnel transfers from research areas into the U.S. marketing organization coupled with normal pay increases caused most of the salary expense increase. On a combined basis, marketing and research expense grew $2.0 million, or three percent, due to higher salary expense.

Interest expense increased $1.1 million, or 14 percent, between years due to higher average interest rates and higher average debt levels. The higher average interest rates reflected a greater mix of long-term fixed rate debt. The Company made a planned shift to a larger proportion of fixed rate debt in the final quarter of 2005. In addition, current year interest rates on short-term borrowings were higher than those for the same period of 2005. The inflationary impact of crude and natural oils on raw material costs led to higher levels of working capital resulting in the higher average debt levels.

Other, net, which includes foreign exchange gains and losses and investment related income and expense, was $1.2 million of income for 2006 compared to $0.7 million of income for 2005. Higher investment income generated by the mutual funds held for deferred compensation purposes accounted for the entire $0.5 million year-to-year increase.

The effective tax rate was 12.2 percent in 2006 compared to 23.6 percent in 2005. The decrease in the effective tax rate was primarily due to an increased level of biodiesel tax credits

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that were established as part of the American Jobs Creation Act of 2004 and the Energy Tax Incentives Act of 2005 (currently scheduled to expire December 31, 2008). The decrease was also due to the utilization of net operating loss carryforwards in Germany for which valuation allowances had previously been recorded and to the favorable effect of a new tax law in Mexico that reduced the current year tax provision. See Note 7 to the consolidated financial statements for a reconciliation between the statutory U.S. federal income tax rates and the effective tax rate.

Surfactants

Surfactants net sales for 2006 increased $56.7 million, or seven percent, over net sales 2005. The effects of higher selling prices and a more favorable mix of sales accounted for the net sales growth. The favorable effects of foreign currency translations added $5.4 million to the increase in net sales. Sales volume was largely unchanged between years. A year-to-year comparison of net sales by region follows:

Selling price increases, a more favorable customer and product mix and a $3.4 million positive effect of foreign currency translation drove the four percent increase in net sales for North America operations. The average selling price was up seven percent between years. The effects of selling price increases and the more favorable mix of sales more than offset the effect of a three percent drop in sales volume. Most of the sales volume decline was attributable to a 17 percent fall in commodity laundry products, which resulted from customer product reformulations and market share fluctuations. Higher selling prices reflected the pass through of rising raw material costs to customers. The improved customer and product mix reflected higher

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sales volumes for the distributor and specialty foamers market, as focused efforts have proved successful in these markets. These products carry higher selling prices and are more profitable than commodity laundry products. In addition, current year sales volume for biodiesel products was up 57 percent over last year’s sales volume and resulted in $8.9 million of additional net sales.

Higher selling prices and a 14 percent growth in sales volume accounted for the 30 percent improvement in net sales for Latin America operations. All three Latin America subsidiaries reported higher net sales. Growth in fabric softener sales drove Latin America net sales and sales volume gains.

The seven percent year-to-year improvement in net sales for European operations resulted from a three percent increase in sales volume and average selling prices and $1.9 million related to the favorable effects of foreign currency translations. A more favorable mix of sales coupled with increased selling prices, particularly for Stepan UK, contributed to the increase in average selling prices.

Surfactants operating income for 2006 was up $1.2 million, or six percent, over operating income for 2005. Gross profit increased $4.6 million, or six percent, and operating expenses increased $3.4 million, or six percent. Approximately $2.8 million of the operating expense increase resulted from severance costs related to the restructuring of Europe’s surfactants organization. In addition, the operating income and gross profit results for 2005 benefited from $2.5 million of insurance income related to the 2004 fire at the Company’s United Kingdom subsidiary and $2.1 million of U.S. Department of Agriculture biodiesel incentives. Year-to-year comparisons of gross profit by region and total segment operating expenses and operating income follows:

The positive effects of higher selling prices along with a more favorable customer and product mix more than offset the effects of a three percent drop in sales volume and led to the nine percent increase in gross profit for North America operations. The selling price increases reflected the Company’s ongoing efforts to recapture margin lost due to higher raw material costs. Higher sales volumes for the distributor and specialty foamers product lines accounted for the improved mix. As noted earlier, sales for these product lines are more profitable than sales for the commodity laundry product line, which accounted for the reduced North America

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surfactants sales volume. Gross profit for the biodiesel product line fell $0.3 million, or four percent, from year to year despite greater sales volume. Gross profit in 2005 included $2.1 million of income for incentives received from the U.S. Department of Agriculture for increasing biodiesel production. The incentive program was discontinued during 2006. The biodiesel business generated $1.6 million of U.S. income tax credits that are not reflected in gross profit or operating income, but are included in the full year tax provision. Latin America’s nine percent gross profit improvement resulted from the 14 percent sales volume increase noted above. Stepan Brazil accounted for most of the Latin America gross profit improvement due to increased sales volume. Stepan Mexico’s gross profit was essentially unchanged between years. The Company is expanding its Mexican fabric softener capacity to meet increased demand. Gross profit for European operations fell eight percent from year to year primarily as a result of the non-recurring nature of the aforementioned insurance income. Excluding the insurance income, Europe’s gross profit increased $1.4 million, or 13 percent, between years due to the three percent increase in sales volume and the higher selling prices.

Surfactants segment operating expenses for 2006 increased $3.4 million, or six percent, over 2005 operating expenses due principally to the $2.8 million of Europe severance expense. The remainder of the year-to-year variance was primarily attributable to the unfavorable effects of foreign currency translation.

Polymers

2006 polymers segment net sales increased $35.7 million, or 16 percent, over net sales for 2005. Higher selling prices and a seven percent increase in sales volume accounted for approximately $18.3 million and $16.7 million of the net sales improvement, respectively. The favorable effects of foreign currency translation added $0.7 million to the increase. A year-to-year comparison of net sales by region is displayed below:

Higher average selling prices, due primarily to the pass through of raw material cost increases, accounted for the eight percent increase in net sales for North America operations. Sales volume was essentially unchanged from year to year. Sales volumes were up four percent and one percent for the phthalic anhydride and polyol product lines, respectively, but sales volume for polyurethane systems dropped 26 percent. In 2005, North America polyol sales volume included the unusual sale of two barges of raw materials. Excluding the raw material sales, North America polyol sales volume increased five percent between years as the downturn in roofing insulation board demand that began in the second half of 2005 subsided somewhat in 2006. A nonrecurring large sales contract that was filled in the second quarter of 2005 coupled with the loss of business at three customers drove a decline in sales volume for polyurethane

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systems. The year-to-year increase in net sales for European operations resulted from a 39 percent increase in polyol sales volume. The higher sales volume was the effect of concentrated efforts to recover market share that was lost in 2005 due to competitive pressures. The significant increase in net sales for Asia and other regions was due to increased sales volume of polyol generated by the Company’s China joint venture. Sales volume improved four-fold as the venture continued to attract new business. Stepan China commenced manufacturing operations in the second quarter of 2005.

Polymers 2006 operating income fell $0.5 million, or two percent, from operating income for 2005. Gross profit increased $0.2 million from year to year, while operating expenses increased $0.7 million. The prior year’s profit results benefited from a large polyurethane systems sales contract that was completely filled in the second quarter of 2005. The current year’s profit results benefited from $0.7 million of income related to the settlement of a 2005 claim for to an electrical outage in the Company’s phthalic anhydride plant precipitated by an undersized transformer installed by the Company’s electricity provider (the entire claim settlement was $0.9 million, of which $0.2 million was allocated to the surfactants segment). Year-to-year comparisons of gross profit by region and total segment operating expenses and operating income follows:

The year-to-year increase in gross profit for North America polymers was attributable to improved pricing for the polyols product line partially offset by the previously noted reduced sales volume for polyurethane systems. The 2006 settlement income related to the 2005 electric outage also contributed. Selling price increases for polyols enabled the business to continue recovering margin lost from persistent rising material costs. On average, selling prices for North America polymers were eight percent higher than selling prices for 2005. Despite higher sales volume, European operations reported an $0.8 million, or 16 percent, drop in gross profit between years primarily due to higher raw material costs that were difficult to entirely recapture with selling price increases. In 2005, the Europe operation benefited from a contractual arrangement that offered favorable raw material prices that did not carry into 2006. The China joint venture reported 2006 gross profit that was less than that reported in 2005, as the effect of higher sales volume was more than offset by higher raw material costs. Competitive situations made it difficult to raise selling prices in China enough to cover the increased raw material costs.

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North America operations accounted for the $0.7 million, or five percent, year-to-year operating expense increase. Marketing expenses were up $0.6 million and research and development expenses were up $0.1 million. Numerous small variances accounted for the increase in marketing expenses, including salary and travel related expenses.

Specialty Products

Net sales for 2006 were $1.8 million, or seven percent, higher than net sales reported for 2005. All product lines reported improved net sales on higher sales volumes. Despite higher sales volume, operating income declined $2.0 million, or 39 percent, between years due primarily to higher raw material costs for the segment’s food ingredients product line. Competitive pressures impeded the Company from raising selling prices. A $0.8 million, or 30 percent, increase in operating expenses, due mainly to a higher allocation of research expenses related to the pharmaceutical product line, contributed to the operating income decline.

Corporate Expenses

Corporate expenses, which primarily include corporate operating (including legal and environmental expenses) expenses that are not allocated to the reportable segments, increased $8.2 million, or 31 percent, to $34.7 million for 2006 from $26.5 million for 2005. The following table depicts the major items that accounted for the year-to-year corporate expense increase:

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Results of Operations

2005 Compared with 2004

Summary

Net income for 2005 increased 27 percent to $13.2 million, or $1.35 per diluted share, compared to $10.3 million, or $1.05 per diluted share, for 2004. Net income for 2005 before the cumulative effect of a change in accounting principle was $13.5 million, or $1.39 per diluted share. Operating income increased $6.3 million, or 33 percent, due primarily to improved profitability for the polymers and surfactants segments. Operating income benefited from higher selling prices, higher surfactants sales volumes, particularly for the Company’s foreign entities and domestic biodiesel product, and $2.5 million of insurance settlement income related to the 2004 fire at the United Kingdom manufacturing site. The foregoing benefits overcame utility expenses that increased $7.4 million, or 33 percent, and operating expenses that rose $5.6 million, or six percent. Increased research and marketing expenses, partially offset by reduced administrative expenses, accounted for the higher 2005 operating expenses. Despite the $6.3 million operating income improvement, pretax income grew just $3.0 million due primarily to a decline in the results of the Company’s Philippines joint venture. A $0.4 million after tax charge related to a change in accounting principle, necessitated by the adoption of a new accounting rule for conditional asset retirement obligations, also negatively affected 2005 net income. Below is a summary discussion of the major factors leading to the year-to-year changes in net sales, profits and expenses. A detailed discussion of segment operating performance for 2005 follows the summary.

In 2005, consolidated net sales exceeded the billion-dollar level for the first time in Company history. Net sales were $1.1 billion in 2005, a $142.5 million, or 15 percent, increase over net sales for 2004. Increases in selling prices, due primarily to the pass through of higher raw material costs, a seven percent increase in sales volume and the favorable effects of foreign currency translations, accounted for approximately $72.4 million, $61.5 million and $8.6 million, respectively, of the net sales increase.

Gross profit for 2005 was up $11.9 million, or 11 percent, over gross profit for 2004. On a consolidated basis, gross profit as a percent of net sales declined to 11 percent in 2005 from 12 percent in 2004, due primarily to cost increases outpacing selling price increases. Polymers and surfactants gross profits were up $7.1 million and $6.9 million, respectively, between years, and specialty products gross profit was down $1.3 million. Selling price increases implemented to mitigate the negative effects of rising material costs that eroded 2004 profit margins drove the polymers profit improvement. The increase in surfactants gross profit resulted from higher sales volume, particularly for the Company’s foreign entities and domestic biodiesel product, and $2.5 million in insurance proceeds related to the September 2004 fire at the Company’s UK subsidiary. Higher utility and labor expenses tempered the gross profit improvement. Lower sales volume, especially for the food ingredients product line, led to the drop in specialty products gross profit.

Operating income for 2005 increased $6.3 million, or 33 percent, over operating income reported in 2004. Operating expenses increased $5.6 million, or six percent, from year to year. Research and development expenses were up $3.6 million, or 14 percent, between years due to

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higher salaried payroll and outside contracting services. Marketing expenses were $2.9 million, or 10 percent, higher in 2005 than in 2004, due primarily to higher salaried payroll expenses. For both the research and marketing categories, salaried payroll expenses increased largely due to higher healthcare, pension, bonus and profit sharing costs, normal pay increases and, to a lesser extent, additional personnel. Administrative expenses were down $0.9 million, or two percent, due largely to lower enterprise resource planning system implementation costs ($1.9 million) and legal expenses ($1.6 million), partially offset by higher deferred compensation expense ($1.4 million) and higher domestic healthcare, pension and bonus costs ($1.1 million in total).

Interest expense increased $0.6 million due primarily to a higher average level of debt and rising short term interest rates.

The Company reported a $0.7 million loss related to its Philippines joint venture in 2005 compared to income of $2.3 million in 2004, a $3.0 million unfavorable year-to-year change. An unfavorable change in product mix coupled with lower sales volume for Stepan Philippines led to the loss. A loss of sales of higher margin products was only partially replaced with sales of lower margin products.

Other, net, which includes foreign exchange gains and losses and investment-related income and expense, was $0.7 million of income for 2005 compared to $0.4 million of income for 2004, an increase of $0.3 million. The Company recorded foreign exchange gains of $0.1 million for 2005 compared to foreign exchange losses of $0.2 million for 2004.

The effective tax rate was 23.6 percent in 2005 compared to 29.5 percent in 2004. The decrease in the effective tax rate was primarily due to biodiesel tax credits that were enacted as part of the American Jobs Creation Act of 2004 and the Energy Tax Incentives Act of 2005. The decrease was also due to the utilization of net operating loss carryforwards in Germany and credit carryforwards in Mexico for which valuation allowances had previously been recorded. This decrease was partially offset by a lower tax benefit realized on foreign joint venture equity income during the current year. The year-to-year decline in the effective tax rate was somewhat mitigated by the non-recurring 2004 tax benefit realized on a $2.8 million charitable contribution of intellectual property. See Note 7 to the consolidated financial statements for a reconciliation between the statutory U.S. federal income tax rates and the effective tax rate.

In 2005, the Company adopted Financial Accounting Standards Board (FASB) Interpretation No. 47 (FIN No. 47), Accounting for Conditional Asset Retirement Obligations , which led to a $0.4 million after tax charge against income. Under the guidance of FIN No. 47, the Company was required to record a liability for the eventual, future disposal of asbestos at the Company’s various locations, a liability previously unrecorded as the timing and method of the settlement of the obligation were considered conditional on future events. The Company has no plans to shut down any of its facilities. In accordance with FIN No. 47, the charge for the cumulative effect of initially applying the interpretation was recorded as a change in accounting principle in the Consolidated Statements of Income. The effect on 2005 operating income was insignificant.

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Effective January 1, 2005, the Company changed the components of its segment operating income to reflect a change in the information now used by the chief operating decision makers in reviewing segment results. In 2005, the Company began charging corporate manufacturing expenses, which are corporate support expenses for engineering, purchasing and transportation, against the reportable segments’ operating income. In prior years, these expenses were charged to unallocated corporate expense. The pro forma amounts in the above table display 2004 segment operating income and corporate expense as if the specified corporate expenses were charged to the operating segments. For analysis purposes, the following segment discussion compares 2005 operating results to the 2004 pro forma results.

The growth in net sales for North America was attributable to higher selling prices, a five percent increase in sales volume and $4.0 million of favorable currency translation. The Company’s biodiesel product line accounted for about 77 percent of the North America sales volume improvement and about 26 percent of the North America net sales increase. Demand for the Company’s biodiesel product, which is made from soybean oil, was very strong due to the high cost of crude oil. Biodiesel accounted for five percent of North America surfactants net sales and sales

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volume in 2005 compared to one percent of net sales and sales volume in 2004. The Company’s laundry and cleaning and general surfactants product lines also contributed to the domestic net sales and sales volume increases. Excluding the positive effects of foreign currency translation, net sales for Latin America operations increased $12.1 million, or 27 percent, between 2005 and 2004. The Latin America net sales improvement was driven by the Company’s Mexico and Brazil operations. Stepan Mexico posted an $8.7 million improvement in net sales, due primarily to a 24 percent increase in sales volume. Fabric softener sales were a large contributor to Mexico’s net sales and sales volume growth. Stepan Brazil reported a $2.9 million improvement in net sales due to new sales attributable to the manufacturing facility acquired in January 2005. Excluding the negative effects of foreign currency translation, net sales for European operations increased $12.4 million, or eight percent, from year to year. The increase reflected price increases aimed at passing raw material cost increases to customers and a three percent growth in sales volume. The United Kingdom subsidiary accounted for most of the sales volume increase as it benefited from the mid-year plant closure by a major competitor.

Surfactants 2005 operating income was up $1.5 million, or eight percent, over 2004 operating income. Gross profit increased $6.9 million, or 10 percent, while operating expenses increased $5.4 million, or 11 percent. Gross profit for 2005 included $2.5 million of insurance settlement proceeds related to the fire damage done to the United Kingdom’s plant drying equipment in September 2004. The insurance proceeds were recorded as reductions to cost of sales. Year-to-year comparisons of gross profit by region and total segment operating expenses and operating income follows:

The gross profit growth for Latin America reflected the previously noted sales volume increases for the Company’s Mexico and Brazil subsidiaries. Stepan Mexico and Stepan Brazil contributed $2.8 million and $1.0 million, respectively, to the Latin America operations gross profit improvement. The four percent increase in gross profit for North America operations was largely due to higher sales of biodiesel and laundry and cleaning products, which more than offset lower gross profit in the remainder of the North America region that was largely attributable to higher natural gas costs. Gross profit for European operations increased $1.2 million, or nine percent, from year to year. Excluding the insurance settlement income, gross profit for European operations fell $1.3 million, or 11 percent. The European locations struggled during the first half of 2005 to recover the rising cost of raw materials from customers, as excess industry manufacturing capacity and vertically integrated competitors made it difficult for the Company to recover all of the costs. Margin improvement began to occur in the last half of 2005.

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Operating expenses for 2005 were $5.4 million, or 11 percent, higher than operating expenses for 2004. North America operations accounted for $4.0 million of the operating expense increase, due to research and development expenses and marketing expenses that were up $2.9 million and $1.1 million, respectively, from year to year. Higher salary and fringe benefit expenses accounted for about $1.6 million of the research and development increase. Outside services for the development, testing and registration of new technologies (up about $0.4 million from year to year) and various other expenses also contributed to the increase in research and development expenses. Higher salary and benefit expenses accounted for the marketing expense increase. Higher healthcare, pension, bonus and profit sharing expenses led to the increase in benefits for both research and development expenses and marketing expenses. Latin America accounted for the remainder of the increase in operating expenses for the surfactants segment. Approximately $0.4 million of Latin America’s $1.4 million year-to-year change resulted from the effects of foreign currency translation. Operating expenses for Stepan Brazil increased $1.0 million between years due to additional administrative and marketing costs needed to support its new business.

Net sales for North America operations were up 16 percent despite a nine percent drop in sales volume. Higher selling prices, due to the pass through of raw material cost increases to customers, more than offset the effect of the lower sales volume. Average selling prices were up about 27 percent from year to year. The decline in sales volume reflected reduced polyol demand from the roofing insulation board market, particularly in the second half of the year, in response to high material costs, as end-users delayed roofing repairs. Also contributing to the fall in sales volume was a planned manufacturing maintenance shutdown in the phthalic anhydride manufacturing facility that ran longer than anticipated due to an electrical fire caused by faulty utility company equipment. Net sales in 2005 benefited from a large, special polyurethane systems order that was shipped in the second quarter. The increase in net sales for European operations was due entirely to higher selling prices implemented primarily to pass on the rising raw material costs. Sales volume was down nine percent between years, as some market share

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was lost due to high prices and increased competition. Net sales for Asia and other regions were up due to the new Stepan China joint venture polyol production plant that commenced operations in the second quarter of the current year.

Polymers operating income was $26.7 million for 2005, up $5.2 million, or 24 percent, from operating income for 2004. Gross profit increased $7.1 million, or 21 percent, between years. The previously noted extended maintenance shutdown led to approximately $1.0 million in higher costs and lost profit. Year-to-year comparisons of gross profit by region and total segment operating expenses and operating income are displayed below:

The 13 percent improvement in gross profit for North America operations was attributable to the previously noted selling price increases, which aided in recovering past margin deterioration and more than compensated for the nine percent drop in sales volume and the additional expenses incurred as a result of the extended maintenance shutdown. The current year’s gross profit also benefited from the aforementioned large, special polyurethane systems order that was shipped in the second quarter. The increase in gross profit for European operations was driven by selling price increases and by a contractual arrangement that offered favorable raw material prices for a portion of the year. The Company’s China joint venture, which commenced operations in 2005, accounted for the higher gross profit reported by Asia and other regions.

Operating expenses were up $1.9 million, or 16 percent, from year to year. North America operations accounted for approximately $1.1 million of the operating expense increase. Research and development expenses were up $0.8 million, due largely to higher costs necessary to support polymer development projects. Marketing expenses were up $0.3 million, due largely to higher salary and fringe benefit expenses. The remainder of the polymer operating expense increase was attributable to Europe ($0.6 million) and Asia ($0.2 million) operations. Higher marketing expenses accounted for about half of the increased European operating expenses, while higher administrative and research and development expenses accounted for the remainder. The increased operating expenses for Asia reflected the fact that there were no operating expenses reported for Stepan China in 2004.

Specialty Products

Net sales for 2005 were $0.8 million, or three percent, lower than net sales reported for 2004. Operating income declined $1.4 million, or 21 percent, from year-to-year. Although all product

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lines posted lower sales volumes, most of the declines in net sales and operating income resulted from a 13 percent drop in sales volumes for the food ingredient product line. Loss of market share due to competitive pressures led to the lower sales volume.

Corporate Expenses

Corporate expenses, which primarily include corporate administrative (including legal and environmental expenses) expenses that are not allocated to the reportable segments, decreased $1.0 million, or four percent, to $26.5 million in 2005 from $27.5 million in 2004. The following table depicts the major items that accounted for the year-to-year corporate expense decline:

Liquidity and Financial Condition

Cash provided by operating activities totaled $38.8 million for full year 2006, compared to $42.0 million for 2005. Net income decreased by $6.5 million from year to year. Working capital consumed $5.9 million in 2006 compared to $10.3 million in 2005. For 2006, inventory growth was higher while accounts receivable growth was lower when compared to 2005. Higher raw material costs, precipitated by the rising costs of crude oil and natural oils, accounted for most of the inventory growth. A lower growth rate in period-to-period sales led to the lower year-to-year growth of accounts receivable. Operating cash flows for 2006 included customer prepayments totaling $5.5 million for future product delivery, which were received in the fourth quarter.

Capital expenditures totaled $46.0 million for 2006, an increase of $4.5 million from $41.5 million in 2005. The year-to-year increase reflected the expansion of fabric softener

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capacity and the implementation of a multi-purpose reactor for the Company’s Latin American operations. For 2007, the Company projects that capital spending will be basically flat from year to year.

During 2006, total company debt, excluding capitalized leases, increased by $5.5 million, from $125.7 million to $131.2 million. An increase in working capital requirements, brought on by higher raw material costs, led to the year-to-year increase in Company debt. During 2006, the Company also reduced its cash by $11.3 million, to a more typical $5.4 million at December 31, 2006, compared to $16.6 million one year earlier. During late 2005, the Company completed a new term loan of $40 million, partly to pre-fund anticipated cash needs for 2006. As a result, 2005 year-end cash levels were higher than normal. As of December 31, 2006, the ratio of total debt to total debt plus shareholders’ equity was 42.0 percent, compared to 43.0 percent as of December 31, 2005.

As of December 31, 2006, Company debt included $91.8 million of unsecured promissory notes with maturities extending through 2018. These notes are the Company’s primary source of long-term debt financing, and are supplemented by bank credit facilities to meet short and medium term needs.

The Company maintains contractual relationships with its U.S. banks that provide for revolving credit of up to $60.0 million, which may be drawn upon as needed for general corporate purposes through April 20, 2011 under a revolving credit agreement. On April 20, 2006, the Company entered into a new revolving credit agreement with its U.S. banks to replace the prior agreement, which would have expired in May 2007. The new unsecured agreement provides committed credit of up to $60 million with terms that are similar to those in the prior agreement. At December 31, 2006, borrowings under committed U.S. credit lines totaled $9.4 million. The Company also meets short-term liquidity requirements through uncommitted U.S. bank lines of credit.

The Company’s foreign subsidiaries maintain bank term loans and short-term bank lines of credit in their respective local currencies to meet working capital requirements as well as to fund capital expenditure programs and acquisitions. At December 31, 2006, the Company’s European subsidiaries had term loans totaling $15.3 million including current maturities. The European subsidiaries also had short-term bank debt totaling $9.3 million with unborrowed capacity of approximately $12.7 million at that date. The Company’s Mexican subsidiary had $1.0 million of debt outstanding at December 31, 2006. The Company’s Chinese joint venture had $4.4 million of bank debt for which Stepan Company has issued guaranties for the Company’s proportionate interest (55 percent) of the credit facilities.

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. The Company is in compliance with its U.S. loan agreements.

Due to European severance costs and changes to French pension accounting standards, the Company’s French subsidiary was out of compliance with its loan agreements as of December 31, 2006. The Company obtained a compliance waiver from its French banks.

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. Any substantial acquisitions would require additional funding.

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The above table does not include $63.1 million of other non-current liabilities recorded on the balance sheet, as summarized in Note 13 to the consolidated financial statements. The non-current liabilities consist of liabilities related to the Company’s funded defined benefit pension plans and deferred compensation plans for which payment periods can not be determined. Non-current liabilities also include environmental and legal liabilities that are primarily contingent in nature (see Note 14 to the consolidated financial statements).

Pension Plans

The Company contributed $6.4 million to its funded defined benefit pension plans in 2006. The Company expects to contribute approximately $4.6 million to the plans in 2007. Payments related to the unfunded non-qualified plans will approximate $0.3 million in 2007 compared to $0.1 million in 2006. During the first half of 2006, amendments were made to four of the Company’s defined benefit pension plans: the U.S. funded salaried defined benefit pension plan, the non-qualified unfunded supplemental executive defined benefit pension plan, the Maywood, New Jersey, hourly defined benefit pension plan and the Stepan United Kingdom defined benefit pension plan. The effect of the amendments was to freeze the noted defined benefit pension plans at June 30, 2006, after which no service benefits will be accrued. In July 2006, the Company established defined contribution plans whereby fixed Company contributions are made to the

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accounts of eligible participants based on participants’ base earnings. The Company does not expect any full year savings in the near future, as the expense related to the defined contribution plans is expected to offset any reduction in defined benefit pension expense. The volatility in pension expense should decline. See Note 11 to the consolidated financial statements for further information about the Company’s post retirement plans.

In August 2006, the Pension Protection Act of 2006 (PPA) was signed into law. The PPA changes the funding rules for defined benefit pension plans and alters other rules regarding defined contribution and deferred compensation plans. The funding rules are effective beginning January 1, 2008, while some of the defined contribution changes take effect by January 1, 2007. The Company is currently evaluating the effect the PPA will have on its funding practices. The changes to the defined contribution and deferred compensation plan rules are expected to have no effect on Company expenses.

Letters of Credit

The Company maintains two standby letters of credit under its workers’ compensation insurance agreements. These letters of credit are renewed annually and amended to the amounts required by the insurance agreements each year. As of December 31, 2006, the Company had $1.4 million in standby letters of credit for these agreements.

Off-Balance Sheet Arrangements

The Securities and Exchange Commission requires disclosure of off-balance sheet arrangements that either have, or are reasonably likely to have, a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. As of December 31, 2006 and 2005, the Company did not have any of the noted off-balance sheet arrangements.

Environmental and Legal Matters

The Company’s operations are subject to extensive local, state and federal regulations. Although the Company’s environmental policies and practices are designed to ensure compliance with these laws and regulations, future developments and increasingly stringent environmental regulation could require the Company to make additional unforeseen environmental expenditures. The Company will continue to invest in the equipment and facilities necessary to comply with existing and future regulations. During 2006, the Company’s expenditures for capital projects related to the environment were $2.2 million. These projects are capitalized and depreciated over their estimated useful lives, which is typically 10 years. Recurring costs associated with the operation and maintenance of facilities for waste treatment and disposal and managing environmental compliance in ongoing operations at our manufacturing locations were approximately $13.1 million for 2006, $11.1 million for 2005 and $12.1 million for 2004. While difficult to project, it is not anticipated that these recurring expenses will increase significantly in the future.

Over the years, the Company has received requests for information related to or has been named by the government as a potentially responsible party at 22 waste disposal sites where

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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 the sites. It is the Company’s accounting policy to record liabilities when environmental assessments and/or remedial efforts are probable and the cost or range of possible costs can be reasonably estimated. When no amount within the range is a better estimate than any other amount, the minimum is accrued. Some of the factors on which the Company bases its estimates include information provided by feasibility studies, potentially responsible party negotiations and the development of remedial action plans. Because reported liabilities are recorded based on estimates, actual amounts could differ from those estimates. After partial remediation payments at certain sites, the Company has estimated a range of possible environmental and legal losses from $13.8 million to $42.9 million at December 31, 2006, compared to $8.4 million to $39.2 million at December 31, 2005. At December 31, 2006 the Company’s accrued liability for such losses, which represents the Company’s best estimate within the estimated range of possible environmental and legal losses, was $22.1 million compared to $18.6 million at December 31, 2005. During 2006, non-capital cash outlays related to legal and environmental matters approximated $3.1 million compared to $2.1 million expended in 2005.

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 or results of operations 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. Certain of these matters are discussed in Item 3, Legal Proceedings, in this report and in other filings of the Company with the Securities and Exchange Commission, which are available upon request from the Company. See also Note 14, Contingencies, in the Notes to Consolidated Financial Statements for a summary of the environmental proceedings related to certain environmental sites.

Critical Accounting Policies

We prepare our financial statements in accordance with accounting principles generally accepted in the United States of America (“generally accepted accounting principles”). Preparing our financial statements in accordance with generally accepted accounting principles requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The following is a summary of the accounting policies the Company believes are the most important to aid in understanding its financial results.

Deferred Compensation

The Company maintains deferred compensation plans. These plans allow management to defer receipt of its bonuses and directors to defer receipt of director fees until retirement or departure

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from the Company or as elected. The Company funds its obligations associated with these plans by purchasing investment assets that match the investment choices – a limited selection of mutual funds or Company common stock – made by the plan participants. The Company maintains at least enough Company common stock in treasury to cover the equivalent number of common stock shares resulting from participants electing the Company common stock option, which periodically requires the Company to purchase its common shares from the open market. The plans allow for the compensation being deferred to grow or decline based on the results of investment options chosen by the participants. Ultimately, upon retirement or departure from the Company, participants receive the cash equivalent value of the investment choices they have made as of the date of plan distribution. As a result, any appreciation in the value of Stepan Company common stock or the mutual fund options under the plan result is additional compensation expense to the Company. Conversely, declines in the market price of Stepan Company stock or the value of the mutual funds results in a reduction of compensation expense since such declines reduce the cash obligation of the Company as of the date of the financial statements. It is these market price movements that result in the significant period-to-period fluctuations that impact the Company’s Consolidated Statements of Income.

At December 31, 2006, the Company’s deferred compensation liability was $24.1 million, of which approximately 43 percent represents deferred compensation tied to the performance of the Company’s common stock and the remainder is tied to the mutual fund investment choices. A $1.00 increase in the market price of the Company’s common stock will result in approximately $0.3 million of additional compensation expense. Similarly, a $1.00 reduction in the market price of the common stock will reduce compensation expense by a like amount. The expense or income associated with the mutual fund component will fluctuate generally in line with the overall percentage increase or decrease of the U.S. stock markets.

In December 2006, the Company, with prior Board of Director approval, adopted an amended and restated management incentive plan. The amendment provided participants with an irrevocable 2006 election to transfer all or a portion of their deferred compensation accounts attributable to pre-2007 bonuses to an alternate Company common stock investment option. The number of share equivalents credited to the participants’ accounts for this option was based on the December 31, 2006, closing price of the Company’s common stock. The share equivalents transferred to the alternate investment option can be distributed (upon a participant’s retirement or departure from the Company) only in shares of Stepan Company common stock (i.e., there can be no cash settlements of these amounts). Furthermore, such amounts cannot be transferred to the plan’s other investment options. As a result of the irrevocable 2006 election, the share equivalent amounts transferred to the participants’ deferred compensation accounts were treated as equity instruments. Therefore, the deferred compensation obligation that is tied to the alternate Company common stock investment option is fixed and will not increase or decrease with the value of the Company’s common stock. All future deferrals of bonuses to the Company common stock investment option will be directed to the alternate Company common stock investment option. The Company implemented this plan change to reduce some of the deferred compensation plan expense volatility as expense treatment is not required for future fluctuations in the value of these shares.

The mutual fund assets are recorded on the Company’s balance sheet at cost when acquired and adjusted to their market values at the end of each reporting period. While these market value adjustments affect the income statement due to their impact on the Company’s

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ultimate cash liability, there is not an offsetting income statement impact from fluctuation in the asset value, as generally accepted accounting principles require unrealized gains and losses on investments in marketable securities be recorded as a direct adjustment to shareholders’ equity as accumulated other comprehensive income/loss. Dividends and capital gains received from the mutual funds, as well as impairment losses and realized gains and losses from sales of mutual fund shares, are recognized as investment income/loss under the “Other, net” caption of the Consolidated Statements of Income.

Because the Company’s common stock is held as treasury stock, no further adjustments are made to equity as a result of market price movements in the stock.

Environmental Liabilities

It is the Company’s accounting policy to record environmental liabilities when environmental assessments and/or remedial efforts are probable and the cost or range of possible costs can be reasonably estimated. When no amount within the range is a better estimate than any other amount, the minimum is accrued. Some of the factors on which the Company bases its estimates include information provided by feasibility studies, potentially responsible party negotiations and the development of remedial action plans.

Estimates for environmental liabilities are subject to significant fluctuations as new facts emerge related to the various sites where the Company is exposed to liability for the remediation of environmental contamination. See the Environmental and Legal Matters section of this Management’s Discussion and Analysis for discussion of the Company’s reserves and range of loss estimates.

Revenue Recognition

Revenue is recognized upon shipment of goods to customers, at which time title and risk of loss pass to the customer. For arrangements where the Company consigns product to a customer location, revenue is recognized when the customer uses the inventory. The Company records shipping and handling billed to a customer in a sales transaction as revenue. Costs incurred for shipping and handling are recorded in cost of sales. Volume discounts due to customers are estimated and recorded in the same period as the sales to which the discounts relate and reported as reductions of revenue in the Consolidated Statements of Income.

Cost of sales comprises raw material costs, including inbound freight expense to deliver the raw materials, manufacturing plant labor expenses and various manufacturing overhead expenses, which include utility, maintenance, operating supply, amortization and manufacturing asset depreciation expenses. Cost of sales also includes outbound freight expenses, purchasing and receiving costs, quality assurance expenses, inter-plant transfer costs and warehouse expenses.

Marketing expense comprises salary and the related fringe benefit expenses for marketing and sales personnel and operating costs, such as outside agent commissions, automobile rental and travel-related expenses, which support the sales and marketing functions. Bad debt charges and any depreciation expenses related to marketing assets (e.g. computers) are also classified as marketing expense.

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Administrative expense comprises salary and the related fringe benefit expenses and operating costs for the Company’s various administrative functions, which include information services, finance, legal, and human resources. Compensation expense related to the Company’s deferred compensation plans and legal and environmental expenses are also classified as administrative expense.

Recent Accounting Pronouncements

See Note 1 to the consolidated financial statements, included in Part II, Item 8, for information on recent accounting pronouncements, which affect the Company.

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