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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, 2004

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, 2004, of voting stock held by nonaffiliates of the registrant: $146,959,910*

Number of shares outstanding of each of the issuer’s classes of common stock as of February 28, 2005:

Documents Incorporated by Reference

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STEPAN COMPANY

ANNUAL REPORT ON FORM 10-K

December 31, 2004

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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 include 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 global 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 companies, as well as with other small specialty chemical manufacturers. 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. 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’s domestic operations and its wholly-owned subsidiaries have not experienced any plant shutdowns or adverse effects upon its business in recent years that were caused by a lack of available energy sources. The Company’s Philippine joint venture has experienced periodic electrical supply interruptions, typically of several hours in duration, which have not had significant effect on its business.

RAW MATERIALS

The most important raw materials used by the Company are of a petroleum or vegetable nature. For 2005, 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 2004, 2003 and 2002 were $15.3 million, $15.2 million, and $15.0 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 $ 0.8 million during 2004. These expenditures represented approximately two percent of the Company’s capital expenditures in 2004. 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, 2004 and 2003, the Company employed 1,420 and 1,447 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 conduct, 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. The website also includes the Company’s corporate governance guidelines and the charters for the audit, nominating and compensation committees of the Board of Directors.

Item 2. Properties

The following properties are owned by the Company:

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In addition, the Company leases 49,000 square feet of office space in an office complex near its headquarters in Northfield, Illinois. Stepan Canada, Inc., which manufactures surfactants, is located on a 70 acre leased, with an option to purchase, site in Longford Mills, Ontario, Canada. Also, Stepan Canada, Inc. maintains a leased sales office in Mississauga, Canada. Stepan Mexico maintains a leased sales office in Mexico City, Mexico. Stepan China, a majority-owned joint venture that will produce polymers, is located on a four acre leased site in Nanjing, China. Stepan Brazil leases a small office in an office building in San Paulo, Brazil.

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 21 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 and the United States Justice Department have resolved certain claims alleged against the Company for certain response costs incurred at the Company’s site in Maywood, New Jersey and property formerly owned by the Company adjacent to its current site (Maywood site). Under the terms of a new settlement agreement reached on November 12, 2004, the United States and the Company agreed to fulfill the terms of a Cooperative Agreement reached in 1985 under which the United States will take title to and responsibility for radioactive waste removal, including past and future remediation costs incurred by the United States. The Company has also agreed to grant an easement and access to the Company’s Maywood property, relocate certain structures to allow for remediation work and maintain certain regulatory permits through completion of the remediation work.

In addition, discussions are continuing between the United States Environmental Protection Agency (USEPA) and the Company regarding the chemical remediation. The Maywood site was 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 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. The Company is awaiting the issuance of a Record of Decision (ROD) from USEPA relating to the Maywood site and the proposed remediation. The final ROD will be issued sometime after a public comment period.

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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 Maywood site related to remediation of chemical contamination. However, depending on the results of the ongoing discussions with USEPA, the final cost of the chemical 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). In December 2004, the Company entered into a Consent Decree with USEPA, which resolves all claims asserted against the Company for the alleged noncompliance with the Order. The settlement amount paid pursuant to the Consent Decree did 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 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 ($83,061) in July 2002. This payment is subject to reallocation after the allocation phase of the above-identified trial, if any. Also, USEPA issued a Unilateral Administrative Order dated November 5, 2003, directed to all PRPs to perform certain remedial activities at the D’Imperio Superfund Site. The cost for all PRPs for this work is estimated to be $300,000 to $450,000. The Company would be responsible for its allocated share of these costs. The amount due by the Company will not have a material impact on the financial position, results of operations or cash flows of the Company.

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Wilmington Site

The Company is currently contractually obligated to contribute to the response costs associated with the Company’s formerly-owned site at 51 Eames Street, Wilmington, Massachusetts. Remediation at this site is being managed by its current owner to whom the Company sold the property in 1980. Under the agreement, once total site remediation costs exceed certain levels, the Company is obligated to contribute up to five percent of future response costs associated with this site with no limitation on the ultimate amount of contributions. In 2004, the Company paid the current owner $1.0 million for the Company’s portion of environmental response costs through the third quarter of 2004. At December 31, 2004, the Company has recorded a reserve of $0.7 million for current and future claims associated with this site. However, depending on the ultimate cost of the remediation at this site, the amount for which the company is liable could differ from the current estimates. In addition, the Company and other prior owners entered into an agreement in April 2004 waiving certain statute of limitations defenses for claims which may be filed by the Town of Wilmington, Massachusetts, in connection with this site. While the Company has denied any liability for any such claims, the Company agreed to this waiver while the parties continue to discuss the resolution of any potential claim, which may be filed.

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 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.

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. In addition, the Company and other PRPs received a Notice of Potential Liability and Demand for Reimbursement of Costs Expended at this site dated June 9, 2004. The Company has not yet filed a response. The Company also recently joined the PRP group. The Company continues to investigate this matter and therefore, cannot predict what its liability, if any, will be for this site.

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Wells G & H Superfund Site

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

Bottle House Site

The Company received a notice from the Pennsylvania Department of Environmental Protection dated June 23, 2004, regarding the Bottle House Site located in City of Allentown, Lehigh County, Pennsylvania. The Company’s response was submitted on September 24, 2004. The Company continues to investigate this matter, and therefore, cannot predict what its liability, if any, will be for this site.

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Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted to stockholders during the fourth quarter of the fiscal year ended December 31, 2004.

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.

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.

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 8, 2005, James E. Hurlbutt was elected Vice President – Finance. From February 11, 2002 until February 7, 2005, he served as Vice President and Corporate Controller. From August 7, 1996 until February 11, 2002, he served as Controller – International and Tax Accounting. Jim joined Stepan in 1982 as a Tax Accountant and has progressed through a series of increasingly responsible positions.

Effective April 28, 2003, Frank Pacholec was elected Vice President, Research and Development. From November, 1983 to April, 2003, Frank was employed with Monsanto and Solutia, where he last served as Director of R&D and Product Stewardship for Solutia’s Resins and Additives division in Germany.

Effective August 5, 2004, Richard S. Brennan was elected Vice President, General Counsel and Secretary. He retired on June 30, 2004, as a partner in the law firm of Mayer, Brown, Rowe & Maw LLP. He served as General Counsel and Secretary of Continental Bank Corporation of Chicago for 12 years. He was also General Counsel and Secretary of Case Corporation, headquartered in Racine, Wisconsin, for five years.

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The Executive Officers of the Company, their ages as of February 28, 2005, and certain other information are as follows:

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PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchase of Equity Securities

Quarterly Stock Data

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 7 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 private transactions 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 additional shares of common stock or the equivalent in Stepan preferred stock.

(b) On February 28, 2005, there were 1,086 holders of record of common stock of the Company.

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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 all over the world. The overall business comprises 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

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needs of customers. In some instances, particularly for the surfactants segment, the Company competes with internal manufacturing capabilities of its customers. The impact of such competition, particularly when combined with excess capacity in the chemical industry, was felt in late 2002, all of 2003 and the first half 2004 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. By the second half of 2004, the culmination of small to moderate sales volume gains for numerous Company product lines had offset the effects of the lost business.

A number of the Company’s key raw materials and energy sources are commodities, principally natural gas (used to power the Company’s plants) and petroleum-based and plant-based materials, whose prices fluctuate due to weather, general economic demand and other unpredictable factors. During 2003 and 2004, raw material costs increased due to instability in the Middle East and to tight supplies resulting from greater material consumption by China and other parts of Asia. This trend is likely to continue in 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 that 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. This was true in European markets during 2004, particularly with respect to the Company’s United Kingdom subsidiary.

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 disproportionate declines when volume decreases. Such cost behavior played an important role in the Company’s decreased profitability in 2003. Improved sales volume in 2004, coupled with the benefit of a salary freeze and the 2003 asset impairment charge, helped earnings recover from the impact of the volume decline in 2003.

The Company’s operating expenses, which include marketing, administrative and research and development expenses, are predisposed to period-to-period fluctuations due principally to 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 2004, fluctuations related to deferred compensation plans and environmental matters resulted in a $3.4 million decline in administrative expenses versus 2003. For further discussions of these matters, see the ‘Environmental and Legal Matters’ and ‘Critical Accounting Policies’ sections of this Management Discussion and Analysis. The unfavorable effects of foreign currency translation added $1.5 million to operating expenses in 2004, as the European euro, British pound sterling and the Canadian dollar all grew stronger against the U.S. dollar during 2004.

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Despite a 110 percent year-to-year increase in net income, 2004 was a challenging year. The effect of sales volume growth was largely offset by rapidly escalating raw material prices. Management is optimistic about 2005. Business fundamentals are favorable, particularly in North America. Sales volume for the polymers segment should continue to grow due to strong demand and greater market penetration. The Company continues to pursue new surfactant opportunities in soap bars and fabric softeners. Management also believes that European margins and volume should improve. During the fourth quarter of 2004, a primary competitor of the Company announced plans to shut down its United Kingdom surfactant plant. While the earnings contribution from the Company’s Chinese joint venture are expected to be minimal in 2005 (construction of the polyester polyol facility is expected to be complete by mid-year), management believes that, longer term, there is upside potential for this plant in serving Asia’s construction market. The Company’s research efforts will continue to focus on innovation into new markets or higher margin applications in existing markets. Building on the 2004 improvement in profits is essential to achieving the Company’s operating margin and return on capital goals.

Results of Operations

2004 Compared with 2003

Summary

Net income for 2004 increased $5.4 million, or 110 percent, to $10.3 million, or $1.05 per diluted share, compared to $4.9 million, or $0.45 per diluted share, for 2003. The weak prior year net income included $3.5 million, or $0.39 per diluted share, for environmental remediation charges, an asset write down, severance and higher deferred compensation expense. Below is a summary discussion of the major factors leading to the year-to-year improvement in net income. A detailed discussion of segment operating performance for 2004 follows the summary.

Consolidated net sales increased $150.9 million, or 19 percent, to $935.8 million for 2004 from $784.9 million for 2003. Approximately $22.2 million of the increase was attributable to the favorable effects of foreign currency translation, due particularly to the strengthening euro, British pound sterling and Canadian dollar against the U.S. dollar. All three segments reported year-to-year increases in net sales dollars. Surfactants segment net sales were up $89.4 million, or 14 percent, due to higher selling prices, favorable foreign currency translation and increased sales volumes. Net sales for the polymers segment increased $59.5 million, or 43 percent, due primarily to higher selling prices and higher sales volume. The specialty products segment reported a $2.1 million, or eight percent, increase in net sales due to higher sales volumes of food ingredient and pharmaceutical products.

Operating income was up $9.4 million, or 96 percent, to $19.2 million for 2004 from $9.8 million for 2003. All three segments reported higher operating income in 2004 than in 2003. Higher sales volumes across all segments and a favorable sales mix, particularly for domestic surfactants, contributed to the operating income improvement. In addition, $1.4 million of 2003 expenses for asset impairment losses did not recur in 2004. However, high raw material costs continued to temper profits, particularly in Europe where competitive pressures made it difficult to recover escalating raw material costs through selling price increases. Operating expenses, which include

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marketing, administrative and research and development expenses, declined $2.1 million, or two percent, to $91.8 million for 2004 from $93.9 million for 2003. Most of the decline was in administrative expenses, which reflected a $1.3 million decrease in deferred compensation expense and a $1.1 million decrease in legal and environmental expenses. In addition, 2003 operating expenses included $0.9 million of separation costs related to a planned reduction in the U.S. workforce. The foregoing reductions were partially offset by the $1.5 million unfavorable effect of foreign currency translation of the Company’s foreign subsidiary operating expenses. For additional details regarding the fluctuations of net sales and operating income, see the “Segment Results” discussion that follows this summary.

Interest expense declined $0.8 million, or 10 percent, between years due to a higher proportion of bank debt, which carries lower interest rates than the Company’s long-term notes.

Income from the Company’s Philippine joint venture increased $0.2 million between years. Income in the Other, net, caption, which includes foreign exchange gains and losses and investment-related income and expense, fell $1.0 million from year to year. The Other, net result reflected $0.1 million of foreign exchange loss in 2004 compared to $1.7 million of exchange gain in 2003. In addition, results for 2004 included investment-related income of $0.5 million compared to investment –related expense of $0.3 million in 2003.

The effective tax rate was 29.5 percent for 2004 compared to 6.8 percent for 2003. The higher effective tax rate was primarily attributable to factors that lowered the 2003 effective rate and did not reoccur. In 2003, the tax benefit realized on foreign joint venture equity income and federal and state tax credits increased as a percentage of consolidated income due to the decline in domestic operating results in that year. In 2004, the rate increased as a result of tax provided on a $2.0 million dividend received from the Company’s Philippine joint venture, which was more than offset by a tax benefit realized on a $2.8 million charitable contribution of intellectual property during 2004.

Segment Results

Surfactants

Surfactants net sales for 2004 increased $89.4 million, or 14 percent, over net sales for 2003. Approximately $20.0 million of the increase was attributable to the favorable effects of foreign currency translation, due particularly to the strengthening euro, British pound sterling and Canadian

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dollar against the U.S. dollar. Excluding the effects of foreign currency translation, surfactants net sales increased $69.4 million or 11 percent. Sales volume was up three percent from year to year. Domestic net sales increased $47.7 million, or 12 percent, on sales volume that increased one percent. Higher selling prices, due primarily to three current year price increases to partially pass rising raw material prices to customers, accounted for approximately $45.5 million of the domestic net sales gain. The 2004 first half decline in domestic sales volume that resulted from the prior year loss of business from two large customers who moved previously outsourced production into internal production facilities has been offset by the culmination of small to moderate sales volume gains for numerous Company product lines. The mix of sales has shifted somewhat as the sales volume gained tended to have higher unit selling prices than the sales volume lost. Excluding the effects of foreign currency translation, net sales for foreign operations increased $21.7 million, or 10 percent, on a seven percent volume increase. The Company’s Mexican and European operations accounted for most of the improvement in foreign operations’ net sales, reporting increases of $11.0 million and $9.2 million, respectively. Sales volume for Mexican operations increased 39 percent due to an increase in fabric softener sales volume. Sales volume for European operations increased six percent between years.

Surfactants operating income for 2004 increased $0.4 million, or two percent, over operating income reported for 2003. Excluding the effects of currency translation, surfactants operating income increased $0.2 million from year-to-year. Domestic operations operating income improved $2.5 million, or 16 percent, between years. A more favorable mix of sales, along with the modest sales volume gain, accounted for about half of the domestic operating income growth. Also factoring into the year-over-year operating income improvement were $1.4 million in 2003 expenses for impairment losses that did not recur in 2004. The impairment losses were recognized for equipment used in the manufacture of high viscosity paste at the Company’s Millsdale (Joliet), Illinois, plant. This equipment represented a small portion of the plant’s manufacturing capacity. Higher raw material costs, due to short supplies and high crude oil prices, dampened the year’s operating income. Operating income for foreign operations fell $2.1 million from year-to-year. European operations reported an operating loss of $0.8 million in 2004, a drop of $3.0 million from 2003 operating income of $2.2 million, as higher raw material costs more than offset the effect of higher sales volume. Due to excess industry manufacturing capacity and vertically integrated competitors, attempts to raise selling prices in Europe have not been successful in recovering all of the rapidly escalating raw material cost increases, particularly for the United Kingdom subsidiary. In the fourth quarter of 2004, the Company’s primary United Kingdom competitor announced plans to shut down its surfactant plant. Operating income for the Company’s Mexico subsidiary improved $0.5 million on the strength of the aforementioned sales volume increase.

Polymers

Polymers net sales increased $59.5 million, or 43 percent, from year to year. Higher selling prices, due primarily to partially passing raw material cost increases to customers, a 17 percent increase in sales volume, and $2.2 million of favorable foreign currency translation on European sales all led to the increase in net sales. The higher selling prices accounted for approximately $33.6 million of the year-to-year net sales improvement.

Excluding the effect of foreign currency translation, polyurethane polyols net sales increased $26.7 million, or 31 percent, on sales volume that grew 15 percent due primarily to an

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improved U. S. economy and to an increased share of the growing European laminate board market. Higher selling prices also contributed as the Company benefited from three 2004 selling price increases, which passed a portion of raw material cost increases on to customers. PA’s net sales were up $24.4 million, or 68 percent, due to higher selling prices that resulted primarily from passing raw material cost increases on to customers and, to a lesser extent, from increasing manufacturing fees to merchant market customers twice in 2004. Also contributing was sales volume that improved 15 percent due largely to an improved economy. Sales volumes improved for all major customers. Polyurethane systems net sales improved $6.2 million, or 34 percent, on sales volume that increased 45 percent due primarily to increased business with a customer that was first acquired during the second quarter of 2003.

Polymers operating income for 2004 increased $5.3 million, or 31 percent, over operating income for 2003. Gross profit was up $6.2 million, or 22 percent, from year to year. Gross profit for polyurethane polyols increased $3.8 million, or 19 percent, due to the 15 percent increase in sales volume and the benefit of a full year of internal production at the Company’s European polyurethane polyol plant, which commenced operations in July 2003. Prior to July 2003, the Company outsourced most of its production of polyurethane polyols for the European market. Rising diethylene glycol and orthoxylene costs partially offset the effect of increased sales volume, particularly in the first half of 2004. The 2004 selling price increases that were attained in the second, third and fourth quarters minimized the effect of rising raw material costs in the second half of the year. Gross profit for PA increased $2.4 million, or 51 percent, due primarily to higher sales volume. The manufacturing fee increases discussed above also contributed to the increase. Higher raw material costs somewhat tempered the year-to-year gross profit improvement. Gross profit for polyurethane systems declined $0.1 million, or two percent, despite higher sales volume. A change in sales mix coupled with higher raw material costs offset the effect of greater sales volume. It is expected that polymer raw material costs will continue to increase in the near-term. As a result, first quarter 2005 selling prices were raised for polyurethane polyol products. Polymer operating expenses for 2004 were $0.8 million, or eight percent, higher than operating expenses for 2003. Domestic research expenses increased $0.4 million due to an increased allocation of resources required to support the business. European operating expenses were up $0.4 million from year to year due to a full year of expenses for the German polyol facility that did not commence operations until the third quarter of 2003 and to the unfavorable effects of foreign currency translation.

Specialty Products

Net sales for 2004 were $27.1 million, a $2.1 million, or eight percent, increase from the $25.0 million reported for 2003. Operating income increased $0.9 million, or 17 percent, to $6.6 million for 2004 from $5.7 million for 2003. The net sales and operating income gains reflected increased volumes for food ingredient and pharmaceutical products. Operating expenses increased $0.1 million, or six percent, primarily due to a higher allocation of research resources to support the business.

Corporate Expenses

Corporate expenses, which primarily include corporate administrative (including legal and environmental expenses) and corporate manufacturing expenses that are not allocated to the reportable segments, decreased $2.6 million, or seven percent, to $34.9 million in 2004 from $37.5

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million in 2003. Deferred compensation expense was down $1.3 million from year-to-year to $0.7 million in 2004 from $2.0 million in 2003. A decrease in the Company’s common stock price to $24.36 per share at December 31, 2004, from $25.65 per share at December 31, 2003, led to the decline. Legal and environmental expenses fell $1.1 million between years due primarily to $2.1 million of additional remediation reserve requirements identified in 2003. No such expenses were necessary for 2004. General legal expenses were up $1.0 million from year-to-year, partially offsetting the effect of the lower remediation expenses. Also contributing to the overall decline in corporate expenses were $0.9 million of non-recurring charges for 2003 separation costs associated with a planned reduction in the U.S. work force. Current year expenses related to the Company’s enterprise resource planning (ERP) system implementation project were approximately $0.8 million higher than those of the prior year, as the Company completed its installation of the ERP system at its France and Germany subsidiaries. The implementation project is now complete.

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 domestic, Canadian 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

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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.

Other, net, which includes foreign currency gains and losses and investment income and expense, increased $1.2 million between years. 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

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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 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

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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 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 to 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 ERP system 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.

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Liquidity and Financial Condition

Net cash provided by operating activities totaled $43.9 million for 2004 compared to $45.6 million for 2003. Net income increased by $5.4 million from year-to-year. Offsetting the net income increase in 2004 was working capital, which was cash neutral compared to a cash source of $0.9 million in 2003. Accounts receivable increased during 2004, reflecting generally higher selling prices. Accounts payable and inventories both increased, reflecting the impact of higher raw material costs. Additional factors in the change in cash from operations include a swing of $4.5 million in environmental and legal liabilities due to a $1.4 million net reduction in those reserves in 2004 versus a net increase of $3.1 million in the prior year

Capital spending totaled $33.8 million for 2004 compared to $32.9 million in 2003. For 2005, capital expenditures are projected to increase approximately 10 percent to 30 percent, including spending to support the new China joint venture (polymers) and the new plant in Brazil (surfactants).

Consolidated debt decreased by $3.7 million during 2004, from $115.7 million to $112.0 million. As of December 31, 2004, the ratio of long-term debt to long-term debt plus shareholders’ equity was 35.8 percent, compared to 36.2 percent one year earlier. Approximately $65.7 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 $60.0 million, which may be drawn upon as needed for general corporate purposes through May 2, 2007 under a revolving credit agreement. At December 31, 2004, there were borrowings totaling $14.0 million under this agreement. The Company also meets short-term liquidity requirements through uncommitted domestic bank lines of credit.

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. The Company’s Stepan Europe subsidiary completed a new euro-denominated bank term loan totaling $16.1 million during early 2004, which was used to repay short-term bank debt and to fund new capital spending. As of December 31, 2004, the Company’s European subsidiaries had euro-denominated term loans totaling $27.5 million including current maturities. The European subsidiaries also had short-term debt totaling $3.2 million under short-term bank credit lines at December 31, 2004, with unborrowed capacity of approximately $10.7 million at that date. The Company’s Mexican subsidiary had $1.5 million of debt outstanding at December 31, 2004. Additionally, the Company’s Chinese joint venture has entered into a credit agreement allowing the joint venture to borrow up to $2.4 million, in local currency, to finance plant construction. As of December 31, 2004, there were no borrowings under this loan facility; however, the Company expects this loan facility to be fully utilized during 2005. Stepan Company has issued a guaranty to the lender for the Company’s proportionate interest (55 percent) in this credit facility.

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. As of December 31, 2003, the Company would have been out of compliance with the interest coverage test under its U.S. loan agreements. The Company obtained amendments for these loan agreements, effective December 31, 2003, from all of its

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lenders. As a result, the Company was in compliance with its U.S. loan agreements as of December 31, 2003, and has remained in compliance since that date. Due to lower current year earnings in Europe, Stepan Europe has obtained agreements from its banks to waive certain required financial ratios under its bank term loans through December 31, 2004. The Company is in compliance with the rest of its loan agreements.

The majority of cash at December 31, 2004, was located outside the United States.

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, 2004, the Company’s contractual obligations, including estimated payments by period, were as follows:

Purchase obligations consist of raw material, utility and telecommunication service purchases made in the normal course of business. Other comprises deferred revenues that represent commitments to deliver products, expected 2005 required contributions to the Company’s funded defined benefit pension plans and estimated payments related to the Company’s unfunded defined benefit supplemental executive and outside directors pension plans. The above table does not include $59.3 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 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 13 to the consolidated financial statements).

Pension Funding

In 2004, the Company contributed $3.7 million and $0.3 million, respectively, to its funded U.S. and United Kingdom pension plans. The Company expects to contribute approximately $1.7 million and $0.4 million, respectively, to the U.S. and United Kingdom plans in 2005. Payments related to the unfunded non-qualified plans will approximate $0.2 million in 2005 compared to $0.1 million in 2004.

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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, 2004, the Company had $1.6 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. An off-balance sheet arrangement is defined as any transaction, agreement or other contractual arrangement to which an entity unconsolidated with the Company is a party, under which the Company has any obligation under certain guarantee contracts; a retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity or market risk support to such entity for such assets; any obligation under certain derivative instruments; or an obligation under a material variable interest in an unconsolidated entity that is held by, and material to, the registrant, where such entity provides financing, liquidity, market risk or credit risk support to, or engages in leasing, hedging or research and development services with, the registrant. As of December 31, 2004 and 2003, the Company did not have any of the noted 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 2004, the Company’s expenditures for capital projects related to the environment were $ 0.8 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 $8.5 million for 2004, $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 21 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

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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 $8.8 million to $40.1 million at December 31, 2004, compared to $9.5 million to $40.4 million at December 31, 2003. At December 31, 2004 the Company’s reserve was $18.9 million for legal contingencies and environmental matters compared to $19.6 million at December 31, 2003. During 2004, non-capital cash outlays related to legal and environmental matters approximated $5.7 million compared to $2.7 million expended in 2003.

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 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

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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.

As of December 31, 2004, the Company’s deferred compensation liability is $20.7 million, of which approximately 46 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 $0.4 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.

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 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.

Since the Stepan Company 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.

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Revenue Recognition

Revenue is recognized upon shipment of goods to customers, at which time title and risk of loss pass 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 based on the terms of the customer contracts and related shipment information and recorded in the same period as the sales to which the discounts relate and are reported as reductions of revenue in the Consolidated Statements of Income. Customer contracts are generally annual in nature. 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.

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, 2004, 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, 2004, the Company had an outstanding loan balance of $17.9 million due from its Stepan Europe subsidiary and trade receivables of $2.4 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 $1.8 million or $0.2 million, respectively.

INTEREST RATES

The Company’s debt was composed of fixed-rate and variable-rate borrowings totaling $67.8 million and $44.2 million, respectively, as of December 31, 2004. For 2005, it is projected that interest on variable-rate borrowings will total approximately $2.7 million. A hypothetical 10 percent average change to short-term interest rates would result in a $0.3 million increase or decrease to interest expense for 2005.

The fair value of the Company’s fixed-rate debt, including current maturities, was estimated to be $71.6 million as of December 31, 2004, which was approximately $3.8 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, 2004, or $1.8 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 forecasted annual natural gas requirements. At December 31, 2004, the Company had open forward contracts for the purchase of 0.3 million dekatherms of natural gas in 2005 at a cost of $2.4 million. The current contracts cover expected natural gas usage for the first quarter of 2005. 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 $0.2 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:

Report of Independent Registered Public Accounting Firm

Consolidated Statements of Income (For years ended December 31, 2004, 2003 and 2002)

Consolidated Balance Sheets (December 31, 2004 and 2003)

Consolidated Statements of Cash Flow (For years ended December 31, 2004, 2003 and 2002)

Consolidated Statements of Stockholders’ Equity (For years ended December 31, 2004, 2003 and 2002)

Notes to Consolidated Financial Statements

Selected Quarterly Financial Data

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Report of Independent Registered Public Accounting Firm

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, 2004 and 2003 and the related consolidated statements of income, cash flows and stockholders’ equity for each of the three years in the period ended December 31, 2004. Our audits also included the accompanying financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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 as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 24, 2005, expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

/S/ DELOITTE & TOUCHE LLP

DELOITTE & TOUCHE LLP

Chicago, Illinois

February 24, 2005

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Table of Contents

Stepan Company

Consolidated Statements of Income

For the years ended December 31, 2004, 2003 and 2002

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

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Table of Contents

Stepan Company

Consolidated Balance Sheets

December 31, 2004 and 2003

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

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Table of Contents

Stepan Company

Consolidated Statements of Cash Flows

For the years ended December 31, 2004, 2003 and 2002