Updated on September 24th, 2020 by Josh Arnold
Stepan Co. (SCL) has a dividend track record that few companies can rival. The company currently sports a streak of 52 consecutive years of increasing dividends, making it one of just 30 companies in the entire market with a dividend increase streak of that length.
That puts the company among the elite Dividend Kings, a small group of stocks that have increased their payouts for at least 50 consecutive years. You can see the full list of all 30 Dividend Kings here.
We have created a full list of all 30 Dividend Kings, along with important financial metrics such as price-to-earnings ratios and dividend yields. You can access the spreadsheet by clicking on the link below:
Dividend Kings are the “best of the best” when it comes to rewarding shareholders with cash and raising their dividend payouts every year. This article will discuss Stepan’s dividend and valuation outlook.
Stepan traces its origins back to 1932 when it was founded by 23-year old Alfred C. Stepan Jr, and was known at the time as Chemical Distributors. The fledgling enterprise’s first product was a chemical that controlled road dust on Illinois’ country thoroughfares, sold from a rented desk at Chicago’s North Pier Terminal. These humble beginnings were the start of what has become a multi-billion chemical powerhouse.
The company is still headquartered in Illinois and manufactures basic and intermediate chemicals, including surfactants, specialty products, germicidal and fabric softening quaternaries, phthalic anhydride, polyurethane polyols and special ingredients for the food, supplement and pharmaceutical markets.
It has expanded from that desk at the North Pier Terminal to a truly global reach with its 18 manufacturing sites in 11 countries throughout North and South America, Asia and Europe. Stepan also boasts global R&D centers, a worldwide distribution network and a broad portfolio of products to meet a diverse group of customer needs.
Stepan is organized into three distinct business lines: surfactants, polymers and specialty products. These businesses serve a wide variety of end markets, meaning that Stepan isn’t beholden to a handful of industries; an important trait during an economic downturn.
Source: Investor presentation, page 4
The surfactants business is Stepan’s largest by revenue, accounting for about two-thirds of total sales. A surfactant is an organic compound that contains both water-soluble and water-insoluble components. Surfactants are key ingredients in consumer and industrial cleaning compounds such as detergents, cleansing agents, emulsifiers, foaming or defoaming agents, viscosity builders, degreasers and others.
Stepan offers a broad range of surfactant chemicals and creates custom surfactants and formulated blends to meet unique customer demands. These surfactants are used in a wide variety of applications such as a foaming agent for shampoo, agents used in oil recovery and emulsifiers for agricultural insecticides.
The polymers business is Stepan’s second-largest by revenue, producing about 30% of the company’s total. The polymers division is further broken down into three segments: polyester polyols, powder coating resins, and phthalic anhydride. Polyester polyols are used in a wide variety of both polyurethane and polyisocyanurate applications. Stepan produces a full range of aromatic and aliphatic polyester polyols for use in rigid foams, as well as many coatings, adhesives, sealants and elastomers applications.
Polyester resins are designed with either hydroxyl or carboxyl functionality and combine with various curatives to form durable, attractive, environmentally friendly powder coatings. The company’s RUCOTE resins can enhance the quality, performance, and visual appeal of finishes on a wide variety of products.
Phthalic anhydride is an important part of Stepan’s Polymers division. In addition to being used in many of its polyester polyol chemistry, phthalic anhydride is a key raw material for plasticizers and unsaturated polyester resins.
The third division, specialty chemicals, is Stepan’s smallest by revenue, producing only about 5% of the company’s total. The segment produces science-based nutritional oils used in the food, nutrition and pharmaceutical industries. Its products are naturally derived ingredients that provide specific nutritional benefits in end markets like dietary supplements, beverages, nutritional powders, infant nutrition and weight management.
Stepan’s market cap is $2.5 billion and it is expected to produce about $1.8 billion in total revenue this year, representing a 2% decline from last year.
Stepan’s second-quarter report beat expectations on the top and bottom lines, but only because estimates had been lowered prior to the report. Total revenue was down 3% year-over-year as the unfavorable impact of foreign currency translation and lower selling prices more than offset a strong volume increase of 4%.
Surfactant sales were up 6% to $332 million, while Polymer sales plummeted 20% to $112 million, and Specialty Products followed suit, falling 17% to $16 million. Surfactant volume was up 10% due to higher demand from cleaning and disinfection end markets, attributable to COVID-19. Rigid polyol sales volume declined 8% due to construction project delays and cancellations.
Gross margin rate improved 170 basis points to 21.4% of revenue, and operating margin rose 100 bps to 9.7% of revenue, so margins performed quite well despite relatively weak revenue. Investors should remember that the polymer business, while providing only about 30% of total revenue, provides about half of Stepan’s operating profits. Any weakness there could mean a meaningful margin decline for the company so that is certainly something to watch for moving forward, particularly as the polymer business is struggling due to lower demand.
Stepan has diversified into polymers more and more in recent years because of the margin advantage, so if that fades further, so will its earnings growth potential. We believe the massive declines the segment is suffering today will be temporary, but note that demand may be much slower to return than it disappeared.
The company’s stated growth strategy includes R&D that develops a continuous stream of value-added applications, developing new processes for current products as well as refining existing processes. It also makes targeted acquisitions from time to time when appropriate, picking up manufacturing capacity or some other strategic advantage from its acquisitions. It grows further by establishing manufacturing locations and sales offices where its customers are in the world, meaning it can more efficiently and effectively serve those varied customers.
Finally, it seeks to grow through strategic alliances via joint ventures where Stepan acts as a technical expert to complement the resources of a local partner with resources in the area. This comprehensive growth strategy has worked for Stepan in the past and while it is not a true growth stock, over time it has produced meaningful revenue expansion using these strategies.
Revenue is slated to decline in the area of 2% this year before a ~7% rebound into 2021 on normalizing demand for polymers, in particular. Keep in mind that acquisitions that may pop up could alter that course, but organically, mid-single digits growth is a reasonable guideline over the long-term. We also note that COVID-19 has introduced more volatility in the company’s outlook than previously existed.
The only bit of caution to note is that the company’s highest-margin business – polymers – is still suffering from lost share and margin losses in North America. That will weigh on this year’s results and if the weakness continues into 2021, its EPS growth could stall. The company is managing without a strong performance from polymers today, but we do not believe that can last given its reliance upon polymers for generating profits.
Stepan’s growth has been somewhat lumpy in the past, but on the whole, the company produces respectable growth over the long term. Lower demand in the polymers business is very clearly Stepan’s principal earnings risk right now.
Competitive Advantages & Recession Performance
Stepan’s competitive advantages include its customer base and end market diversity, its global supply chain and distribution network, as well as its technical expertise. Stepan is a true market leader in its niche and this has fueled its growth in the past 80+ years.
Stepan’s customers are extremely diverse, including end markets like agricultural products, construction, dietary supplements, cleaning products, personal care, laundry, oilfield services, pharmaceuticals and many more. There aren’t many businesses in the world that serve such diverse end markets, and that offers Stepan exposure to lots of different industries. This creates lots of opportunities for growth as well as recession resistance.
However, we note that the current recession is unlike any prior recession, given it is targeted to certain sectors of the economy. This is hurting the polymer business for Stepan, but producing higher demand for certain surfactants.
In addition, the company operates in 11 different countries around the world. This allows it to have technical experts and sales professionals on the ground near its customers, developing products and solving problems more quickly and efficiently than if it were centralized here in the US. Adding in its vertical supply chain – which improves margins and reduces supplier risk – Stepan’s global footprint is a sizable asset.
Stepan’s products are also needs and not wants, meaning that during recessions, the company fares very well. Indeed, during the Great Recession, it performed tremendously well; Stepan’s earnings-per-share during and after the Great Recession are below:
- 2007 earnings-per-share of $0.75
- 2008 earnings-per-share of $1.20 (increase of 60%)
- 2009 earnings-per-share of $2.92 (increase of 143%)
- 2010 earnings-per-share of $2.95 (increase of 1.0%)
Revenue moved higher each year during this period with the exception of 2009, but a tremendous amount of margin improvement during this period saw Stepan drastically increase its earnings despite the economic malaise that had the world in its grips. Operating margins were just 1.4% in 2006 but peaked at 8.2% in 2009, driving the earnings growth Stepan enjoyed during this period.
Stepan is a very recession-resistant business and that is one advantage it provides to shareholders. This recession, however, is obviously unusual and Stepan is seeing plummeting demand in two of its segments. Demand is moving higher in surfactants at just the right time, but Stepan relies heavily on polymers for profitability, so we are cautious as the company navigates this very uncertain environment for polymer demand.
Valuation & Expected Returns
We currently expect $5.20 in earnings-per-share for this year, which would represent a fractional gain against last year’s earnings. The company should see its margin strength produce a slightly larger gain in profits than is lost from waning demand.
With the current share price at $110, Stepan trades at a price-to-earnings ratio of 21.1, which is well in excess of our estimate of fair value, at 17 times earnings. Stepan has been valued fully for some time as dividend stocks continue to be bid up in a zero interest rate environment. We believe the valuation is too high to be supported by the company’s growth path and thus, we see a ~4% annual headwind to total returns from the valuation moving lower.
Stepan, as a Dividend King, has been returning to cash to shareholders for more than a half-century, and its recent growth rates in capital returns have been impressive.
In the past decade, Stepan has managed to boost its total annual capital returns – buybacks and dividends – by 13%. That’s very impressive and while we don’t think that sort of growth rate can be sustained for the long-term, the dividend is very safe at just one-fifth of earnings.
While the yield isn’t impressive at just 1.0%, investors can sleep well at night knowing their payout is safe, and will almost certainly continue to be raised for decades to come.
The 1% yield, combined with 5% projected annual growth and a 4% headwind from the valuation mean we project just 1.6% total annual returns for Stepan in the coming years.
Due to its low dividend yield, Stepan doesn’t qualify as a high-income stock despite its Dividend King status. It also looks overvalued against future expectations of earnings growth, meaning multiple contraction is likely to meaningfully dent total returns.
Based upon that, shareholders can expect weak total returns from here as the valuation and expected growth essentially offset each other. Stepan is a leader in its niche and it is a strong business, but it is being overpriced by the market at this point and thus, we rate the stock a sell.