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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(MARK ONE)

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003

OR

FOR THE TRANSITION PERIOD FROM              TO             

Commission File Number 1-4462

STEPAN COMPANY

(Exact name of registrant as specified in its charter)

Registrant’s telephone number including area code: 847-446-7500

Securities registered pursuant to Section 12 (b) of the Act:

Securities registered pursuant to Section 12 (g) of the Act:

None

(Title of Class)

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in part III of this Form 10-K or any amendment to this Form 10-K.    ¨.

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, 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  ¨

Aggregate market value at June 30, 2003, of voting stock held by nonaffiliates of the registrant: $142,373,000*

Number of shares outstanding of each of the issuer’s classes of common stock as of February 29, 2004:

Documents Incorporated by Reference

* Based on reported ownership by all directors, officers and beneficial owners of more than 5% of registrant’s voting stock. However, this determination does not constitute an admission of affiliate status for any of these holders.

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STEPAN COMPANY

ANNUAL REPORT ON FORM 10-K

December 31, 2003

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PART I

Item 1. Business

Stepan Company, which was incorporated under the laws of the state of Delaware on February 19, 1959, and its subsidiaries (the “Company”) produce specialty and intermediate chemicals, which are sold to other manufacturers and then made into a variety of end products. The Company has three reportable segments: surfactants, polymers and specialty products. Surfactants refer to chemical agents that affect the interaction between two surfaces; they can provide actions such as detergency (i.e., the ability of water to remove soil from another surface), wetting and foaming, dispersing, emulsification (aiding two dissimilar liquids to mix), demulsification, viscosity modifications and biocidal disinfectants. Surfactants are the basic cleaning agent in detergents for washing clothes, dishes, carpets, fine fabrics, floors and walls. Surfactants are also used for the same purpose in shampoos and conditioners, fabric softeners, toothpastes, cosmetics and other personal care products. Commercial and industrial applications include emulsifiers for agricultural products, emulsion polymers such as floor polishes and latex foams and coatings, wetting and foaming agents for wallboard manufacturing and surfactants for enhanced oil recovery. Polymers, which include phthalic anhydride, polyols and polyurethane foam systems, are used in plastics, building materials and refrigeration industries. Polymers are also used in coating, adhesive, sealant and elastomer applications. Specialty products sell chemicals used in food, flavoring and pharmaceutical applications.

MARKETING AND COMPETITION

Principal markets for surfactants are manufacturers of detergents, shampoos, lotions, fabric softeners, toothpastes and cosmetics. In addition, surfactants are sold to the producers of emulsifiers and lubricating products. The Company also is a principal provider of polymers used in construction, refrigeration, automotive, boating and other consumer product industries. Specialty products are used primarily by food and pharmaceutical manufacturers.

The Company does not sell directly to the retail market, but sells to a wide range of manufacturers in many industries and has many competitors. The principal methods of competition are product performance, price and adaptability to the specific needs of individual customers. These factors allow the Company to compete on a basis other than price alone, reducing the severity of competition as experienced in the sales of commodity chemicals having identical performance characteristics. The Company is a leading merchant producer of surfactants in the United States. In the case of surfactants, much of the Company’s competition comes from several large national and regional producers and the internal divisions of larger customers. In the manufacture of polymers, the Company competes with the chemical divisions of several large customers, as well as with other small specialty chemical manufacturers. In recent years, the Company has also faced periodic competition from foreign imports of phthalic anhydride. In specialty products, the Company competes with several large firms plus numerous small companies.

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MAJOR CUSTOMER AND BACKLOG

The Company does not have any one customer whose business represents more than 10 percent of the Company’s consolidated revenue. Most of the Company’s business is essentially on the “spot delivery basis” and does not involve a significant backlog. The Company does have contract arrangements with certain customers, but purchases are generally contingent on purchaser requirements.

ENERGY SOURCES

Substantially all of the Company’s manufacturing plants operate on electricity and interruptable gas purchased from local utilities. During peak heating demand periods, gas service to all plants may be temporarily interrupted for varying periods ranging from a few days to several months. The plants operate on fuel oil during these periods of interruption. The Company has not experienced any plant shutdowns or adverse effects upon its business in recent years that were caused by a lack of available energy sources.

RAW MATERIALS

The most important raw materials used by the Company are of a petroleum or vegetable nature. For 2004, the Company has commitments from suppliers to cover its forecasted requirements and is not substantially dependent upon any one supplier.

RESEARCH AND DEVELOPMENT

The Company maintains an active research and development program to assist in the discovery and commercialization of new knowledge with the intent that such effort will be useful in developing a new product or in bringing about a significant improvement to an existing product or process. Total expenses for research and development during 2003, 2002 and 2001 were $15.2 million, $15.0 million, and $13.7 million, respectively. The balance of expenses reflected on the Consolidated Statements of Income relates to technical services, which include routine product testing, analytical methods development and sales support service.

ENVIRONMENTAL COMPLIANCE

Compliance with applicable federal, state and local regulations regarding the discharge of materials into the environment, or otherwise relating to the protection of the environment, resulted in capital expenditures by the Company of approximately $2.4 million during 2003. These expenditures represented approximately seven percent of the Company’s capital expenditures in 2003. These expenditures, when incurred, are depreciated and charged on a straight-line basis to pre-tax earnings over their estimated useful lives, which is typically 10 years. Compliance with such regulations is not expected to have a material adverse effect on the Company’s earnings and competitive position in the foreseeable future.

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EMPLOYMENT

At December 31, 2003 and 2002, the Company employed worldwide 1,447 and 1,529 persons, respectively.

FOREIGN OPERATIONS AND REPORTING SEGMENTS

See Note 15, Segment Reporting, of the Consolidated Financial Statements (Item 8 of this Form 10-K).

WEBSITE

The Company’s website address is www.stepan.com. The Company makes available free of charge on or through its website its code of ethics, annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission.

Item 2. Properties

The Company’s corporate headquarters and central research laboratories are located in Northfield, Illinois. The Northfield facilities contain approximately 70,000 square feet on an eight acre site. In addition, the Company leases 49,000 square feet of office space in a nearby office complex.

Stepan Canada maintains a leased sales office in Mississauga, Canada. Stepan Mexico maintains a leased sales office in Mexico City, Mexico.

Surfactants are produced at four plants in the United States and six wholly owned subsidiaries: one each in France, United Kingdom, Canada, Mexico, Colombia and Germany. The principal U.S. plant is located on a 580 acre site at Millsdale (Joliet), Illinois. A second plant is located on a 45 acre tract in Fieldsboro, New Jersey. West Coast operations are conducted on an eight acre site in Anaheim, California. A fourth plant is located on a 202 acre site in Winder, Georgia. The plant, laboratory and office of Stepan Europe are located on a 20 acre site near Grenoble, France. Stepan Canada, Inc. is located on a 70 acre leased, with an option to purchase, site in Longford Mills, Ontario, Canada. Stepan Mexico is located on a 13 acre site in Matamoros, Mexico. Stepan Germany is located on a 12 acre site in Cologne, Germany. Stepan UK Limited is located on an 11 acre site in Stalybridge (Manchester), United Kingdom. Stepan Colombia is located on a five acre site in Manizales, Colombia. The phthalic anhydride, polyurethane systems and polyurethane polyols plants are also located at Millsdale. Specialty products are mainly produced at a plant located on a 19 acre site in Maywood, New Jersey.

The Company owns all of the foregoing facilities except the leased office space and Canadian plant site mentioned above. The Company believes these properties are adequate for its operations.

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Item 3. Legal Proceedings

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 has been named by the government as a potentially responsible party at 18 waste disposal sites where cleanup costs have been or may be incurred under CERCLA and similar state statutes. In addition, damages are being claimed against the Company in general liability actions for alleged personal injury or property damage in the case of some disposal and plant sites. The Company believes that it has made adequate provisions for the costs it may incur with respect to these sites. For most of these sites, the involvement of the Company is expected to be minimal, however, the more significant sites are described below:

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 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 regarding remediation alternatives 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 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.

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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 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 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, 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 case USEPA 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 previously indicated it would seek penalty claims against the Company based on the Company’s alleged noncompliance with the modified Unilateral Administrative Order (Order). The Company recently entered into a Consent Decree with USEPA which resolves all claims asserted against the Company for 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 have a material impact on the financial position, results of operations or cash flows of the Company. In addition, the Company received notice from the New Jersey Department of Environmental Protection (NJDEP) dated March 21, 2001, that

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NJDEP 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 payment is subject to reallocation after the allocation phase of the above-identified trial, if any, 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.

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 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 the financial position, results of operations or cash flows of the Company.

Wilmington Site

The 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 the 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) are due under the terms of the agreement. Under the agreement, the Company is obligated to contribute up to five percent of future response costs associated with this site with no

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limitation on the ultimate amount of contributions. The Company has recorded a reserve of $1.5 million for current and future claims associated with this site under the agreement. 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.

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 continues to investigate 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 to this request is due on February 20, 2004. The Company is currently investigating this matter and therefore, cannot predict what its liability, if any, will be for this site.

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Item 4. Results of Votes of Security Holders

No matters were submitted to stockholders during the fourth quarter of the fiscal year ended December 31, 2003.

Executive Officers of the Registrant

Executive Officers are elected annually by the Board of Directors at the first meeting following the Annual Meeting of Stockholders to serve until the next annual meeting of the Board and until their respective successors are duly elected and qualified.

Mr. F. Quinn Stepan has served the Company as Chairman and Chief Executive Officer since 1984 and President until February 15, 1999.

Effective February 15, 1999, F. Quinn Stepan, Jr., was elected President and Chief Operating Officer.

Effective February 16, 1999, John V. Venegoni was elected Vice President and General Manager - Surfactants.

Effective January 1, 2001, Robert J. Wood was elected Vice President and General Manager - Polymers. From March 1996 until January 1, 2001, he served as Director – Polyols.

Effective March 7, 2001, F. Samuel Eberts III was elected Vice President, General Counsel and Secretary. From 1998 until 2001, he served as an Assistant General Counsel for Cardinal Health Inc.

On November 17, 2003, Anthony J. Zoglio’s title changed to Vice President – Supply Chain. From July 1, 2001, until November 17, 2003, Anthony J. Zoglio served as Vice President – Manufacturing and Engineering. From June 1, 1999 to July 1, 2001, he served as Vice President, Plant Operations.

Effective February 11, 2002, James E. Hurlbutt was elected Vice President and Corporate Controller. From August 7, 1996 until February 11, 2002, he served as Controller – International and Tax Accounting.

Effective April 28, 2003, Frank Pacholec was elected Vice President, Research and Development. From 1983 to April, 2003, he served as Director of Safety and Compliance at Solutia, Inc. and its predecessor company.

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The Executive Officers of the Company, their ages as of February 29, 2004, and certain other information are as follows:

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PART II

Item 5. Market for Registrant’s Common Stock and Related Security Holder Matters

The Company’s 5 ¹/2 percent convertible preferred stock is listed and traded on the New York Stock Exchange and the Chicago Stock Exchange. See Note 8 of the Consolidated Financial Statements (Item 8 of this Form 10-K) for a description of the preferred stockholders’ rights.

From time to time the Company purchases shares of its common stock in the open market and in block transactions from dealers for the purpose of funding option grants under its stock option plans and deferred compensation plans for directors and officers. On February 10, 2004, the Board of Directors approved the open market and private transaction repurchase, from time to time, of 300,000 shares of common stock or the equivalent in Stepan preferred stock, in addition to approximately 82,000 shares remaining from its previous 600,000 share authorization. This brings the total authorization to 382,000 shares, which represents 4.5 percent of 8.9 million common shares outstanding.

Dividends Paid Per Common Share

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Item 6. Selected Financial Data

See the table below for selected financial information.

(In thousands, except per share and employee data)

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Some information contained in the Management’s Discussion and Analysis is forward looking and involves risks and uncertainties. The results achieved this year are not necessarily an indication of future prospects for the Company. Actual results in future years may differ materially. Potential risks and uncertainties include, among others, fluctuations in the volume and timing of product orders, changes in demand for the Company’s products, changes in technology, continued competitive pressures in the marketplace, availability of raw materials, foreign currency fluctuations and general economic conditions.

Overview

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

Because of the diverse markets it serves, the Company has numerous competitors. The Company generally competes on price, product performance and the ability to meet specific needs of customers. In some instances, particularly for the surfactants segment, the Company competes with large divisions of its customers. The impact of such competition, particularly when combined with excess capacity in the chemical industry, was felt in late 2002 and all of 2003 as the Company lost sales volume in its surfactants business when two major customers shifted business from the Company into the customers’ own internal production facilities.

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The Company relies heavily on processing equipment to manufacture its products. In that sense, the Company is capital intensive, and therefore, its manufacturing costs are relatively fixed in nature. As a result, gross profit (defined as net sales less cost of sales) is susceptible to declines when volume decreases. Such cost behavior played an important role in the Company’s decreased profitability in 2003.

A number of the Company’s key raw materials are commodities, principally natural gas (used to power the Company’s plants) and petroleum-based and other feedstocks, whose prices fluctuate due to weather, general economic demand and other unpredictable factors. During 2003, raw material costs increased due to political uncertainty in the Middle East and to tight supplies resulting from greater material consumption by China and other parts of Asia. This trend has continued into early 2004 and is likely to do so for the near future. Increased raw material costs are passed on to customers as quickly as the marketplace allows; however, certain customers have arrangements with the Company which allow for price changes only on a quarterly basis, and competitive pressures sometimes prevent raw material costs from being passed on to customers, particularly in periods when there is excess industry capacity. Accordingly, some product lines or market segments may take time to recover raw material cost increases.

The Company’s operating expenses, which include marketing, administrative and research and development expenses, are predisposed to period-to-period fluctuations. Such fluctuations are principally caused by the accounting for the Company’s deferred compensation plans, obligations associated with environmental remediation liabilities and the impact on translation of fluctuations in foreign currencies. The Company operates in a setting of extensive local, state and federal regulations concerning the environment. The Company has been named as a potentially responsible party, to perform environmental remediation at the Company’s expense, at a number of geographic sites. The Company believes it has adequate reserves for all known environmental sites, but an adverse determination could result in a significant negative effect on the Company’s financial position, results of operations and cash flows. In 2003, fluctuations related to deferred compensation plans and environmental matters resulted in a $3.9 million increase in administrative expenses versus 2002. For further discussions of these matters, see the ‘Environmental and Legal Matters’ and ‘Critical Accounting Policies’ sections of this Management Discussion and Analysis.

As reflected in the 76 percent year-to-year decline in net income, 2003 was an extremely challenging year for the Company. Replacing the aforementioned lost surfactants business has progressed slower than anticipated. As a result, the Company implemented a strategy to reduce costs and streamline operations by eliminating discretionary spending, reducing its U.S. work force by five percent and freezing salaries company-wide beginning in 2004. Although the Company will continue to seek ways to contain costs, the highest priority is to realize opportunities that have been targeted for growth. Surfactants opportunities include growing the Company’s global position in fabric softener markets and developing a greater presence in the soap bar market. In June 2003, the Company began producing polyurethane polyols at its new German manufacturing facility (30,000-ton capacity), which positions the Company to take further advantage of an increasing European demand for polyester polyol products. On February 12, 2004, the Company entered into an agreement with a partner to build a polyol plant outside Nanjing, China. The plant would require at least 12 months to build, so no earnings contributions are expected from this joint venture in 2004. However, longer term, the Company believes there is potential for serving Asia’s construction market.

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Results of Operations

2003 Compared with 2002

Summary

Net income for 2003 fell $15.2 million, or 76 percent, to $4.9 million, or $0.45 per diluted share, compared with $20.1 million, or $2.05 per diluted share, for 2002. Below is a summary discussion of the factors leading to the year-to-year drop in profitability. A more detailed discussion of 2003 segment operating performance follows the summary.

Consolidated net sales increased $36.3 million, or five percent, to $784.8 million in 2003 from $748.5 million in 2002. The effects of foreign currency translation contributed $21.5 million, or three percent, of the increase in consolidated net sales. The remaining two percent increase in consolidated net sales was attributable primarily to sales price increases, as consolidated volumes were essentially flat with last year. All three segments reported increases in net sales from year to year. Surfactants segment sales were up $20.7 million, or three percent, due to favorable foreign currency translation and higher sales prices, as higher European volumes were offset by lower U.S. (‘domestic’), Canada and South American sales volume. Net sales for the polymers segment increased $15.5 million, or 12 percent, due primarily to higher selling prices that reflected rising raw material costs and higher sales volume. The specialty products segment reported nearly flat year-to-year net sales.

Despite the increase in net sales, operating income fell $24.1 million, or 71 percent, to $9.8 million in 2003 from $33.9 million in 2002. Gross profit dropped $18.8 million, or 15 percent, from year to year, primarily due to lower domestic surfactants sales volume and higher surfactants and polymers raw material costs. In addition, gross profit was unfavorably impacted by a $1.4 million charge for impairment losses on specific surfactants equipment. Operating expenses, consisting of marketing, administrative and research and development expenses, increased $5.3 million, or six percent, to $93.9 million in 2003 from $88.6 million in 2002. The year-to year operating expense increase included $2.1 million of environmental expenses related to remediation requirements at previously and currently owned facilities, a $1.8 million increase in deferred compensation expense that resulted primarily from the appreciation in value of the mutual fund assets held for the deferred compensation plan, and a fourth quarter charge of $0.9 million for separation costs associated with a five percent reduction in the Company’s domestic work force. For additional details regarding the fluctuations in net sales, gross profit and operating income, see the “Segment Results” discussion that follows this overview.

Interest expenses increased $0.7 million, or nine percent, between years due to a higher proportion of fixed rate debt. The Company secured additional fixed rate debt in first half of 2002 to lock in low long-term rates, although such rates are higher than current short-term rates.

Income from the Company’s Philippine joint venture decreased to $2.2 million in 2003 from $3.6 million a year ago. A change in product mix coupled with lower royalty income accounted for the drop in joint venture profit.

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Other, net, which includes foreign currency gains and losses and investment income and expense, increased $1.2 million between year. Foreign currency exchange gains on European operations’ debt that is denominated in U.S. dollars accounted for most of the increase. The gains reflected the strengthening of the euro against the U.S. dollar.

The effective tax rate was 6.8 percent in 2003 compared to 33.5 percent in 2002. The lower effective tax rate was primarily attributable to the tax benefit realized on foreign joint venture equity income and federal and state tax credits, which increased as a percentage of consolidated income due to the decline in domestic operating results. The decrease is also attributable to a greater percentage of consolidated income being generated in foreign countries where the overall effective tax rate is lower.

Segment Results

Surfactants

Surfactants net sales increased $20.7 million, or three percent, from year to year. Approximately $18.6 million of the increase was attributable to the favorable effects of foreign currency translation, due particularly to the strengthening euro and British pound sterling against the U.S. dollar. Excluding the effect of foreign currency translation, net sales for foreign operations increased $10.7 million, or six percent, on sales volume that increased four percent. Domestic net sales dropped $8.7 million, or two percent, on sales volume that declined five percent. European operations, most notably the Company’s UK subsidiary, accounted for the foreign volume gain. The Company’s growing share of the UK’s sulfonation market as well as new sales resulting from the late 2002 acquisition of the Pentagon Chemicals Specialties biocides and specialty surfactants businesses led to the improvement in the UK operations’ volume. 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. Lost share at some smaller laundry and cleaning products customers, due to competitive situations, also contributed to the drop in volume. The Company had anticipated that growth in its fabric softener products would reduce the impact of the lost business; however, while fabric softener growth has occurred, it has not materialized as rapidly as originally projected.

Surfactants operating income fell $19.5 million, or 44 percent, from 2002 to 2003, primarily due to a gross profit decline of $18.8 million, or 20 percent, to $76.3 million in 2003

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from $95.1 million in 2002. Essentially all of the gross profit decline represents a domestic gross profit decrease of $19.7 million, or 29 percent, from year to year due to the previously noted five percent drop in sales volume. Because of the generally fixed nature of the Company’s manufacturing costs, gross profit is susceptible to significant declines when sales volumes fall as occurred in the Company’s U.S. business in 2003. Cost increases for a number of key surfactant raw materials also contributed to the lower domestic gross profit. In addition to the lower sales volume and higher raw material costs, domestic gross profit was negatively affected by $1.4 million of asset impairment losses related primarily to equipment located at the Company’s Millsdale (Joliet, Illinois) plant that was specifically used for the processing of a product that will no longer be manufactured at that site. No alternative use could be found for the equipment, which represented a very small portion of the plant’s production capacity. Gross profit for foreign operations increased $0.9 million, or three percent, between years. Excluding the favorable effects of foreign currency translation, foreign gross profit fell $1.5 million from year to year. The positive impact of the sales volume increase was more than offset by higher raw material costs, particularly in Europe. Operating expenses increased $0.7 million, or 1 percent, from 2002 to 2003. Excluding the unfavorable effect of foreign currency translation, operating expenses declined $1.2 million. Domestic research and development expense accounted for the decrease, which resulted from lower payroll-related expenses and year-to-year reallocation of resources to the specialty products segment.

Polymers

Polymer net sales increased $15.5 million, or 12 percent, from year to year. Higher prices, due primarily to passing recent raw material cost increases to customers, a four percent increase in sales volume and $2.8 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 $13.6 million, or 19 percent, on sales volume that grew 11 percent due primarily to an improved U.S. construction market that led to higher sales volumes to existing customers and from an increased share of the growing European laminate board market. Polyurethane systems net sales improved $2.8 million, or 18 percent, on sales volume that increased 16 percent due to the acquisition of a major new customer during the year. PA’s net sales were down $1.0 million, or three percent, on sales volume that declined five percent, as demand from two major customers declined in 2003 as a result of a shrinking share of their respective markets.

Despite its increased net sales and sales volume, polymers operating income decreased $0.8 million, or four percent, to $17.2 million in 2003 from $18.0 million in 2002. Gross profit was up just $0.2 million, or one percent, between years. Gross profit for polyurethane systems and PA improved $0.5 million and $0.4 million, respectively, while gross profit for polyurethane polyols dropped $0.7 million. The aforementioned sales volume increase accounted for the improvement in polyurethane systems gross profit. PA’s gross profit was positively impacted by lower manufacturing costs, particularly utilities and depreciation. The decrease in polyurethane polyols gross profit was due to higher raw material costs that more than offset the effect of increased sales volume. Second quarter 2003 selling price increases were effective in passing on only a portion of the higher costs to customers. Polymer raw material prices are expected to increase further as global demand for ethylene and petroleum based products is high and current supplier inventories are low. Polymer operating expenses increased $0.9 million, or nine percent, from year to year. Higher expense in Europe led to $0.5 million of the increase. Foreign currency

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translation accounted $0.2 million of Europe’s increase, while the remainder of the change was due to higher administrative and marketing expenses supporting the new German facility. Domestic expense increased $0.4 million due primarily to higher product development expenses.

Specialty Products

Net sales for the year were $25.0 million, a $0.2 million increase from the $24.8 million reported a year ago. Despite the increase in net sales, operating income declined $1.6 million, or 22 percent, due a lower sales volume of higher margin pharmaceutical products. Higher research expense also contributed to the operating income decline.

Corporate Expenses

Corporate expenses, which primarily include corporate administrative and corporate manufacturing expenses that are not allocated to the reportable segments, increased $2.2 million, or six percent, from $35.3 million in 2002 to $37.5 million in 2003. Environmental expenses were up $2.1 million between years due to contractual obligations for shared remediation costs associated with a formerly owned manufacturing site and anticipated remediation expenses for a currently owned facility. A $1.8 million increase in deferred compensation expense, arising primarily from the appreciation in value of the mutual fund investments held for the deferred compensation plan, contributed to the corporate expense increase (for an explanation regarding the Company’s deferred compensation plan see the “Critical Accounting Policies” section of this discussion.). Also factoring into the higher corporate expenses was a fourth quarter charge of $0.9 million for separation costs associated with a five percent reduction in the Company’s U.S. work force. The reduction in force, which was part of a strategy to reduce operating costs and streamline operations, was realized through a process of voluntary and involuntary terminations and through eliminating unfilled open positions. Costs associated with implementation of the Company’s enterprise resource planning system (ERP) were down $1.2 million due primarily to the completion of the North American implementation in the fourth quarter of 2002. Stepan UK’s ERP implementation was completed in the fourth quarter of 2003, and the ERP implementation throughout the rest of Europe will occur in 2004. A $1.0 million recovery of settlement costs related to an old legal case also offset the corporate expense increases.

Fourth Quarter 2003 Compared with 2002

The Company reported a fourth quarter 2003 net loss of $3.4 million, or $0.41 loss per diluted share, compared to fourth quarter 2002 net income of $2.4 million, or $0.25 per diluted share. Consolidated net sales increased $16.1 million, or nine percent, to $201.3 million for the fourth quarter of 2003 from $185.2 million for the fourth quarter of 2002. Net sales increased for all business segments. Excluding the favorable effects of foreign currency translation, consolidated net sales increased $9.0 million, or five percent. Despite the net sales increase, the Company posted an operating loss of $5.8 million in the last quarter of 2003 compared to operating income of $3.3 million for the same period of 2002. Gross profit fell $5.1 million, or 19 percent, from quarter to quarter. The surfactants segment accounted for the decline in gross profit, reporting a drop of $7.1 million, or 33 percent. Surfactants gross profit decline reflected lower domestic sales volume, higher global raw material costs and a fourth quarter 2003 asset impairment loss of $1.4 million. Gross profit for the polymers and specialty products segments increased by $1.1

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million, or 18 percent, and $0.7 million, or 67 percent, respectively. Operating expenses increased $4.0 million, or 17 percent, to $27.3 million in the fourth quarter of 2003 from $23.3 million in the fourth quarter of 2002. A $2.4 million increase in deferred compensation expense related to the appreciation in investment assets held for the deferred compensation plan accounted for a large part of the expense increase. Also contributing to the quarter to quarter operating expense increase were $0.9 million of severance charges related to the Company’s fourth quarter 2003 reduction in force and approximately $0.5 million related to the unfavorable effects of foreign currency translation. All of the foregoing factors combined with $0.8 million of lower Philippine joint venture income, resulting from a change in sales mix, and $0.6 million of realized losses on investment sales led to a fourth quarter loss before income taxes of $7.1 million compared to fourth quarter 2002 income before income taxes of $3.0 million.

2002 Compared with 2001

Summary

Net income for 2002 was $20.1 million, or $2.05 per diluted share, compared with $16.1 million, or $1.65 per diluted share, for 2001. Below is a summary discussion of the factors leading to the year-to-year increase in net income. A more detailed discussion of 2002 segment operating performance follows this summary.

Consolidated net sales increased $37.0 million, or five percent, to $748.5 million in 2002 from $711.5 million in 2001. Net sales for the surfactants segment increased $40.5 million, or seven percent. The inclusion of a full year of net sales for the Company’s United Kingdom subsidiary (Stepan UK) compared to one quarter of 2001 net sales accounted for approximately $32.2 million of the surfactants increase. Excluding net sales for Stepan UK, net sales for the surfactants segment grew $8.3 million, due primarily to increased sales volume for foreign operations, higher average selling prices for U.S. (‘domestic’) operations and $3.3 million of favorable currency translation. Net sales for the polymers segment fell $3.4 million, or three percent, due primarily to decreased domestic polyurethane polyols and polyurethane systems sales volumes. 2002 net sales for the specialty products segment approximated net sales for 2001.

Operating income increased $2.8 million, or nine percent, to $33.9 million in 2002 from $31.1 million in 2001. Gross profit grew $15.0 million, or 14 percent, from year to year, primarily due to lower domestic surfactants and polymers raw material costs, the full year results of Stepan UK (compared to one quarter of 2001) and higher foreign operations sales volume. Operating expenses, consisting of marketing, administrative and research and development expenses, increased $12.2 million, or 16 percent, to $88.6 million in 2002 from $76.4 million in 2001. The larger factors leading to the increase in operating expenses included a $3.5 million increase due to the inclusion of a full year of Stepan UK expense, a $1.9 million decrease in insurance recoveries, a $1.5 million increase in expense related to the implementation of an enterprise resource planning (ERP) system, and an additional $1.0 million of depreciation expense due to the ERP system. The fluctuations in operating income and gross profit are discussed further under “Segment Results” below.

Interest expenses rose $0.2 million, or three percent, from year-to-year, due primarily to higher average debt levels.

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Philippine joint venture equity income increased to $3.6 million in 2002 from $1.9 million a year ago. The rise was due to royalty income and higher equity income generated by higher sales volume.

Pre-tax income increased $4.5 million, or 17 percent, to $30.3 million in 2002 from $25.8 million in 2001.

The effective tax rate was 33.5 percent in 2002 compared to 37.7 percent in 2001. The lower effective tax rate was primarily attributable to a decrease in the effective tax rate on European earnings and a higher U.S. tax benefit realized on export sales. A decrease in the overall state apportionment factor also contributed to the lower effective tax rate.

Segment Results

Surfactants

Surfactants net sales, representing 80 percent of the Company’s revenue, increased $40.5 million, or seven percent, from $558.9 million in 2001 to $599.4 million in 2002, due primarily to a six percent rise in sales volume. Foreign operations net sales increased $38.2 million, or 25 percent, from $152.3 million in 2001 to $190.5 million in 2002. A 34 percent increase in sales volume more than offset a six percent decrease in average prices and led to the net sales growth. Approximately $32.2 million of the increase was due to the September 2001 acquisition of Stepan UK. European operations, excluding the United Kingdom, and Canadian operations posted net sales increases of $5.1 million and $2.5 million, respectively. The effect of favorable exchange rate fluctuations ($3.3 million) and increased sales volume led to the European operations net sales growth. The net sales increase for Canadian operations reflected higher sales volume. Latin American operations posted a $1.6 million decrease in revenue due to a decline in sales volume. Domestic operations, which accounted for 68 percent of total surfactant revenues, reported a $2.3 million, or one percent, increase in net sales, due to higher average prices, which offset a two percent decline in sales volume. The increase in average prices was primarily due to sales mix. Sales volume declined due to lower demand for laundry and cleaning products.

Surfactants operating income increased $8.8 million, or 25 percent, from 2001 to 2002. Gross profit was up $14.7 million, or 18 percent, from $80.4 million in 2001 to $95.1 million in 2002. Despite a two percent sales volume decline, domestic operations reported a $7.2 million, or 12 percent, increase in gross profit primarily due to lower raw material costs. The cost for most of the Company’s major surfactant raw materials fell from year to year. Gross profit for foreign

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operations rose $7.5 million, or 40 percent, to $26.0 million in 2002 from $18.5 million in 2001. European operations contributed $7.3 million to the improvement, of which $5.7 million related to the previously noted Stepan UK acquisition. Gross profit for Latin American operations was up $0.5 million, or 12 percent, due to more favorable sales mix at the Company’s Mexico subsidiary and to lower raw material costs at the Company’s Colombia subsidiary. Operating expenses increased $5.9 million, or 13 percent, to $51.2 million in 2002 from $45.3 million in 2001. The inclusion of a full year of 2002 Stepan UK expense compared to one quarter of 2001 expense accounted for approximately $3.5 million of the increase. Higher payroll-related expenses for marketing and research and development accounted for most of the remaining increase between years.

Polymers

Polymer net sales, accounting for 17 percent of the Company’s revenue, decreased $3.4 million, or three percent, from $127.7 million in 2001 to $124.3 million in 2002. The decrease was due to an 11 percent drop in average selling prices, which more than offset a nine percent increase in sales volume. Polyurethane polyols net sales decreased $3.4 million, or five percent, from $75.5 million in 2001 to $72.2 million in 2002. Sales volume decreased two percent. Domestic operations accounted for $5.7 million of the decline. The decrease was due to a seven percent drop in sales volume coupled with a two percent decline in average selling prices. Foreign operations reported increased net sales based on improved sales volume, notably, a 44 percent increase in Europe. PA’s net sales increased 12 percent to $36.8 million in 2002 from $32.8 million in 2001. A 33 percent gain in sales volume, due to increased market share, more than offset a 16 percent decrease in average selling prices. Lower raw material costs led to the average price decline. Polyurethane systems net sales fell $4.1 million, or 21 percent, between years. A 23 percent decline in sales volume, due primarily to competitive losses at key accounts, led to the decrease.

Polymers operating income increased $0.7 million, or four percent, from year to year. Gross profit increased $1.8 million, or seven percent, between years. PA’s gross profit increased $1.2 million, or 36 percent, from $3.2 million in 2001 to $4.3 million in 2002. Improved sales volume led to the increased gross profit. Polyurethane polyols gross profit increased $2.0 million, or 11 percent, from $18.6 million in 2001 to $20.7 million in 2002. Domestic operations reported an increase of $1.3 million, or seven percent, due primarily to lower raw material costs that more than offset the effect of lower sales volume. European gross profit increased $0.9 million due to lower material costs and higher sales volume, while Brazil’s gross profit dropped $0.2 million due to lower sales volume. Polyurethane systems gross profit declined $1.4 million, or 30 percent, from year to year. Lower sales volume and higher unit overhead costs, which resulted from decreased production volumes, led to the decline in gross profit. Polymer operating expenses increased $1.1 million, or 12 percent, due primarily to a favorable, non-recurring 2001 bad debt expense adjustment ($0.5 million) that reflected the recovery of a previously deemed uncollectible customer account balance and to higher research and development expenses ($0.4 million). An increase in the number of product development personnel and higher spending for outside technical support led to the increased research and development expenses.

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Specialty Products

Specialty products’ net sales for the year were $24.8 million, a slight decrease in comparison with $24.9 million a year ago. Operating income declined $0.5 million, or seven percent, from year-to-year, mainly due to higher research expenses coupled with a lower sales mix of higher margin products.

Corporate Expenses

Corporate expenses, which primarily include corporate administrative and corporate manufacturing expenses that are not allocated to the reportable segments, increased $6.2 million, or 21 percent, from 2001 to 2002. Expenses related to the implementation of an ERP system for the Company’s North American operations were $1.5 million higher in 2002 than those incurred in 2001. Depreciation expense increased $1.0 million from year to year, due primarily to the addition of the new ERP system. A $0.6 million increase in audit fees and a $0.5 million increase in general legal expense also contributed to the greater 2002 corporate expenses. In addition to the foregoing expense increases, 2001 corporate expenses were reduced by $1.9 million of insurance recoveries that did not recur in 2002.

Liquidity and Financial Condition

Net cash provided by operating activities for 2003 totaled $45.6 million compared to $46.1 million for 2002. Net income, adjusted for non-cash items, decreased by $13.5 million from year-to-year. Offsetting the impact on cash flows of lower net income was working capital, which was a cash source of $0.9 million in 2003 compared to a cash use of $12.1 million last year. During 2003, accounts receivable increased by $14.1 million due primarily to growth in trade receivables for foreign subsidiaries. Accounts payable and accrued liabilities increased by $18.9 million from year to year, attributable to a moderate inventory increase during December 2003, as well as a return to more typical trade payment timing at December 31, 2003 as compared to one year earlier when excess cash balances in December 2002 were used to pay down accounts payable.

Capital expenditures totaled $32.9 million in 2003 compared to $36.1 million for 2002. Capital spending is projected to decrease during 2004 by 10 to 15 percent as certain large projects, such as the German polyol manufacturing facility, were completed in 2003.

Total company debt decreased by $2.0 million from year to year, from $117.7 million to $115.7 million. As of December 31, 2003, the ratio of long-term debt to long-term debt plus shareholders’ equity was 36.2 percent, compared to 39.6 percent one year earlier. Approximately $85.0 million of total Company debt relates to unsecured promissory notes with maturities extending until 2015. 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 domestic 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. At December 31, 2003, there were borrowings totaling $6.6 million under this agreement. The Company also meets short-term liquidity requirements through uncommitted domestic bank lines of credit.

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As of December 31, 2003, the Company would have been out of compliance with the interest coverage test under its U.S. loan agreements with pre-tax earnings as reported. The Company notified its banks and long-term lenders of the potential non-compliance in a timely manner, in accordance with the terms of all loan agreements. As of March 8, 2004, the Company had obtained amendments, effective as of December 31, 2003, to the interest coverage test for all of its U.S. loan agreements. As a result, the Company was in compliance with all loan agreements, as amended, as of December 31, 2003.

The Company’s foreign subsidiaries maintain bank term loans and 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. As of December 31, 2003, the Company’s European subsidiaries had term loans, including current maturities, totaling $14.1 million and short-term debt totaling $10.4 million, all in local currencies. These short-term bank borrowings represented full utilization of available credit lines. The Company’s European subsidiary expects to complete a new medium-term bank loan totaling $16.6 million, in euros, during early 2004, which will be used to repay short-term bank debt and to fund new capital spending.

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.

Contractual Obligations

At December 31, 2003, the Company’s contractual obligations, including estimated payments by period, were as follows:

Purchase obligations consist of raw material and natural gas purchases made in the normal course of business. Other consists of deferred revenues that represent commitments to deliver products and 2004 required pension plan contributions. The above table does not include $57.1 million of other non-current liabilities recorded on the balance sheet, as summarized in Note 12 to the consolidated financial statements. The non-current liabilities consist of liabilities related to the Company’s 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 13 to the consolidated financial statements).

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Pension Funding

The Company made the 2003 plan year contribution of $3.7 million to its funded U.S. pension plans in December 2003. During 2004, the Company expects to contribute approximately $3.8 million for the 2004 plan year. If pension funding relief legislation were enacted as proposed by the U.S. Congress, the contribution would be $1.6 million. Payments related to the unfunded non-qualified plans in 2004 will approximate the $0.1 million paid in 2003.

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, 2003, the Company had $1.3 million in standby letters of credit for these agreements.

Off-Balance Sheet Arrangements

As of December 31, 2003 and 2002, the Company did not have any off-balance sheet arrangements.

Environmental and Legal Matters

The Company is subject to extensive federal, state and local environmental laws and 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 2003, the Company’s expenditures for capital projects related to the environment were $2.4 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 $8.1 million for 2003 and $8.5 million for 2002. While difficult to project, it is not anticipated that these recurring expenses will increase significantly in the future.

The Company has been named by the government as a potentially responsible party at 18 waste disposal sites where cleanup costs have been or may be incurred under CERCLA and similar state statutes. In addition, damages are being claimed against the Company in general liability actions for alleged personal injury or property damage in the case of some disposal and plant sites. The Company believes that it has made adequate provisions for the costs it may incur with respect to 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

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sites, the Company has estimated a range of possible environmental and legal losses from $9.5 million to $40.4 million at December 31, 2003, compared to $7.5 million to $35.1 million at December 31, 2002. At December 31, 2003 the Company’s reserve was $19.6 million for legal contingencies and environmental matters compared to $17.6 million at December 31, 2002. During 2003, non-capital expenditures related to legal and environmental matters approximated $2.7 million compared to $3.0 million expended in 2002.

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 13, 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 from the Company. The plans allow for the compensation being deferred to grow (or decline) based on the results of investment options chosen by the participants. Such options include either (a) the appreciation/depreciation in Stepan Company common stock or (b) a limited variety of mutual funds. 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.

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As of December 31, 2003, the Company’s deferred compensation liability is approximately $20 million, of which approximately 48 percent represents deferred compensation tied to the performance of Stepan Company common stock and the remainder is tied to the mutual fund investment choices. A $1.00 increase in the market price of Stepan Company common stock will result in approximately $375,000 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.

The Company funds its obligations associated with these plans by buying a portfolio of mutual funds that matches the investment choices made by the plan participants. When plan participants choose the Stepan Company common stock option, the Company will generally acquire, and put into treasury stock, an equivalent number of Stepan Company common shares from the open market.

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 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 loss”. Dividends and capital gains received from the mutual funds, as well as 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.

Since the Stepan Company 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. For example, during 2003, the Company recorded $2.1 million of expense related to estimated liabilities at two sites for which no prior reserves had been established based on new information received, whereas, in 2002, there were no such similar charges.

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Revenue Recognition

Revenue is recognized upon shipment of goods to customers, at which time title and risk of loss has passed to the customer. 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. The Company believes recognition of revenue upon shipment is the appropriate point of revenue recognition as the Company has no further performance obligations to the customer other than in connection with customer volume discount programs. Volume discounts due customers are estimated and recorded in the same period as the sales to which the discounts relate and are reported as reductions of revenue in the statements of income. Volume discount programs are specific and unique to each customer and are based on negotiated contract rates. Such contracts are generally annual in nature. The Company computes its allowance for customer discounts based on shipment information and the specific details of each customer’s program. Depending upon demand, the annual contract program provisions and the mix of customers, the Company’s allowance for volume discounts will fluctuate from period-to-period. For arrangements where the Company consigns product to a customer location, revenue is recognized when the customer uses the inventory.

Reserves for Doubtful Accounts

Accounts receivable are reported net of reserves for doubtful accounts. The Company determines the reserve requirement based upon the estimated collectibility of specific delinquent accounts, the Company’s historical loss experience and the level of non-delinquent accounts receivable.

Reserves for Obsolete and Slow Moving Inventories

The Company provides reserves for obsolete and slow moving inventory items. The reserve requirement is estimated based upon a review of specific inventory items that are identified as slow moving and consideration of potential salvage value and disposal costs.

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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Item 7A. Quantitative and Qualitative Disclosures About Market Risk

FOREIGN CURRENCY EXCHANGE RISK

Because the Company operates in the global marketplace, its cash flows and operating results are exposed to foreign currency fluctuations. The Company manufactures and sells products in many foreign locations and, therefore, believes its currency exchange risk is well diversified. Except as noted below, substantially all the Company’s foreign subsidiaries’ financial instruments are denominated in their respective functional currencies. As such, exposure to exchange rate risk on foreign currency financial instruments is not considered significant. Gains or losses on unhedged foreign currency transactions are included in income.

The Company and its foreign subsidiaries periodically use short-term forward exchange contracts to limit the exposure of certain foreign currency transactions and balances to fluctuating exchange rates. As of December 31, 2003, the Company had no outstanding forward exchange contracts.

From time to time, the Company extends U.S. dollar denominated loans or extended trade receivables to its foreign subsidiaries. Gains or losses on such transactions are recorded in income. As of December 31, 2003, the Company had an outstanding loan balance of $15.9 million due from its European subsidiary and trade receivables of $1.4 million due from its Brazilian subsidiary. A hypothetical fluctuation of 10 percent in the exchange rate of the euro or the Brazilian real would result in a gain or loss of $1.6 million or $0.1 million, respectively.

INTEREST RATES

The Company’s debt was composed of fixed-rate and variable-rate borrowings totaling $85.4 million and $30.3 million, respectively, as of December 31, 2003. For 2004, it is projected that interest on variable-rate borrowings will comprise about 32 percent of the Company’s total interest expense. A 10 percent increase or decrease to short-term interest rates would be immaterial to the Company’s operating results or cash flow.

The fair value of the Company’s fixed-rate debt, including current maturities, was estimated to be $90.4 million as of December 31, 2003, which was approximately $5.0 million above the carrying value. Market risk was estimated as the potential increase to the fair value that would result from a hypothetical 10 percent decrease in the Company’s weighted average long-term borrowing rates at December 31, 2003, or $2.3 million.

COMMODITY PRICE RISK

Certain raw materials used in the manufacture of the Company’s products are subject to price volatility caused by weather, petroleum prices, general economic demand and other unpredictable factors. Increased raw material costs are passed on to customers as quickly as the marketplace allows; however, certain customers have arrangements that allow for price changes only on a quarterly basis, and competitive pressures sometimes prevent cost increases from being passed on to customers, particularly in periods where there is excess industry capacity. As a result, for some product lines or market segments it may take time to recover raw material price increases. Periodically, firm purchase commitments are entered into which fix the price of a specific

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commodity that will be delivered at a future time. Forward contracts are sometimes used to aid in managing the Company’s natural gas costs. The Company may contract up to 100 percent of its manufacturing facilities’ forecasted natural gas requirements. At December 31, 2003, the Company had open forward contracts for the purchase of 1.1 million MMBTUs (MMBTU equals one million British thermal units) of natural gas in 2004 at a cost of $5.4 million. A hypothetical 10 percent fluctuation in the price of natural gas covered by forward contracts would result in the Company’s natural gas cost being $0.5 million higher or lower than the contractual price in the Company’s results of operations.

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Item 8. Financial Statements and Supplementary Data

The following statements and data are included in this item:

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Independent Auditors’ Report

To the Board of Directors and Stockholders of

Stepan Company

Northfield, Illinois

We have audited the accompanying consolidated balance sheets of Stepan Company and subsidiaries (the “Company”) as of December 31, 2003 and 2002 and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Stepan Company and subsidiaries at December 31, 2003 and 2002 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

As discussed in Note 3, effective January 1, 2002 the Company changed its method of accounting for goodwill and intangible assets upon adoption of Statement of Financial Accounting Standard No. 142, “Goodwill and Other Intangible Assets.”

DELOITTE & TOUCHE LLP

Chicago, Illinois

March 8, 2004

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Stepan Company

Consolidated Statements of Income

For the years ended December 31, 2003, 2002 and 2001

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

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Stepan Company

Consolidated Balance Sheets

December 31, 2003 and 2002

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

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Stepan Company

Consolidated Statements of Cash Flows

For the years ended December 31, 2003, 2002 and 2001