Stepan Company (SCL) is an unlikely Dividend King. It is a chemical company and a small one at that with a market capitalization of only about $2.8 billion. But it keeps showing up on my Dividend Power ranking over the past few months in the top five. The stock has solid trailing averages for earnings growth and dividend growth. In addition, the safety metrics are decent with low debt-to-equity, low payout ratio, and a low beta. The balance sheet has improved over the past decade to a net cash position. Granted, the stock is not undervalued based on historical price-to-earnings ratio and the dividend yield is low at roughly 1%. Stepan is trading near its 52-week high now. The COVID-19 pandemic has created a high demand for consumer products, a major market for Stepan, but this has been somewhat offset by lower construction market sales. I am currently neutral on this stock.

Stepan LogoSource: Stepan

Overview of Stepan Company

Stepan Company was founded in 1932. Today, Stepan is a global producer of specialty chemicals with 18 manufacturing sites in 11 countries. The company operates in three business segments: Surfactants, Polymers, and Specialty Products. The largest segment is Surfactants at 68% of total revenue, Polymers has 28% of revenue, and Specialty Products generates 4% of revenue. Surfactants sells chemicals for consumer products (laundry care, shampoo, conditioners, dishwash, body wash, surface care, and cleaning & disinfection), agriculture, and oilfields. Polymers sell polyester polyols used in rigid foam insulation, specialty polyols used in adhesives and coatings, and phthalic anhydride used in insulation and paint and coatings. Specialty Products focuses on dietary supplements, food & beverages, cosmetics, and pharmaceuticals. The current CEO is the grandson of the founder. Insiders own about 6.2% of the common stock. Total revenue was $1,859 million in 2019.

Stepan Company Business SegmentsSource: Stepan Company 2020 Investor Presentation

Stepan Revenue Growth and Margins

Stepan has been growing revenue both organically and through M&A over the past decade. Revenue was $1,431 million 10-years ago and was $1,859 million in 2019. This rate of growth is OK but the chart below shows that Stepan’s top line is volatile on a year-to-year basis. This is likely due at least in part to the cyclicality of Stepan’s end markets such as construction and oil fields.

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From the perspective of organic growth, Stepan invests about 2% – 3% of total sales or roughly $50 million in R&D each year. Research is performed at 13 applications centers around the world by 230 scientists. This is roughly 10% of the total work force. Stepan has about 2,075 patents attesting to its success in R&D. Innovation and patented technologies lead to additional revenue that is often higher margin compared to commodity chemicals.

Stepan also conducts bolt on acquisitions. In the past five years this has included the Lipid Nutrition business, the Tebras business in Brazil, KMCO LLC oilfield chemicals product lines, the NatSurFact business, and plants in Georgia, Mexico, Poland, and Singapore. These business are incrementally adding to revenue but are also providing new markets for future growth.

Stepan Company Revenue and MarginsSource: TIKR.com

The real story here though is the upward trend in margins since 2014. One can see in the chart above that gross margins, operating margins, and net profit margins have trended up since then. Not all business segments or end markets have similar margins. Surfactants has operating income margins of about 10%, which is the lowest of the three segments. Polymers has an operating income margin of 14%. The highest margins are in Specialty Products at 22%. Stepan is focused on expanding sales in high margin product lines. For instance, margins in Specialty Products were 6% in 2015 and are now almost 4X that value at 22% only five years later. The trend for increasing margins should continue into the foreseeable future as innovation drives higher margin sales.

Stepan’s Dividend and Safety

No discussion of a Dividend King is complete without a discussion of the dividend. Stepan has been paying a growing dividend for 52 consecutive years. In the past 10 years the dividend growth rate has been 8.6% and in the past 5 years it has been 8.2%. The forward dividend is $1.22 per share giving a yield of 0.97%. Stepan announced a 10.9% increase to the regular quarterly cash dividend to $0.305 per share on October 21, 2020.

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Stepan’s dividend safety is excellent from the perspective of earnings, free cash flow, and debt. The forward payout ratio is about 23%, which is much lower than the 65% value I used as the maximum.

From a cash flow perspective, the dividend is also extremely safe. Operating cash flow was approximately $218 million in 2019. Capital expenditures were ~$106 million giving free cash flow of $112 million. The dividend required about $23 million giving a dividend-to-FCF ratio of 21%. This is well below my criterion of 70% for this metric.

The dividend is also safe from the perspective of the balance sheet in my opinion. At end of Q3 2020, Stepan had no short-term debt, the current portion of long-term debt was ~$106 million, and long-term debt was $170 million. This was offset by cash and equivalents of roughly $310 million. This means that Stepan has a net cash position. Interest coverage is high at about 25X. Stepan can clearly pay its obligations. The risk to the dividend is minimal based on the net cash position on the balance sheet.

Stepan’s Valuation

Stepan is trading at an earnings multiple of about 23.6X at the moment based on consensus 2020 earnings of $5.34 per share. I think that 16X is reasonable long-term multiple, which is the average over the past decade. At the current earnings estimate and a 16X fair value multiple estimate we get a fair value price of $85.44 based on consensus earnings.

Applying a sensitivity analysis using P/E ratios between 15X and 17X, I obtain a fair value range from $80.10 to $90.78. The current stock price is ~137% to ~155% of my estimated fair value. The current stock price is ~$124.11 suggesting that the stock is very overvalued at the moment.

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Estimated Current Valuation Based On P/E Ratio

P/E Ratio

15.0

16.0

17.0

Estimated Value

$80.10

$85.44

$90.78

% of Estimated Value at Current Stock Price

155%

145%

137%

Source: dividendpower.org Calculations

How does this compare to other valuation models? Morningstar is known to use a fairly conservative discounted cash flow model and provides a fair value of $108.21. The Gordon Growth Model gives a fair value of $122 assuming a desired return of 8% and dividend growth rate of 7%. An average of these three models is ~$105.23 suggesting that Stepan is overvalued at the current price.

Final Thoughts on Stepan

Stepan is one of only two chemical companies that is a Dividend King. From that perspective it provides some diversification. To reach 52 years of dividend growth, Stepan navigated through several recessions demonstrating the resilience of the business. I think much of this is due to the focus on consumer products markets which tend to have stable demand year in and year out. Stepan is also improving operating performance as seen in the upward trend in margins. The net cash position on the balance sheet is a plus. That said, the stock is trading at an elevated valuation. Investors should probably sit on the sidelines for now and wait for a better entry point. I am neutral on this stock.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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