Hercules 10-K 2005
Documents found in this filing:
A DELAWARE CORPORATION
I.R.S. EMPLOYER IDENTIFICATION NO. 51-0023450
1313 NORTH MARKET STREET
WILMINGTON, DELAWARE 19894-0001
Securities registered pursuant to Section 12(b) of the Act
(Each class is registered on the New York Stock Exchange, Inc.)
Title of each class
Common Stock ($25/48 Stated Value)
8% Convertible Subordinated Debentures due August 15, 2010
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 (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o.
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 Registrants 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 o.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes ý No o.
The aggregate market value of registrants common stock, $25/48 stated value (Common Stock) held by non-affiliates based on the closing price on the last business day of the Companys most recently completed second fiscal quarter, or June 30, 2004, was approximately $1.3 billion.
As of February 28, 2005, registrant had 112,950,778 shares of Common Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrants definitive Proxy Statement for its 2005 Annual Meeting of Shareholders (the Proxy Statement), when filed, will be incorporated by reference in Part III of this report.
This Annual Report on Form 10-K includes forward-looking statements, as defined in the Private Securities Litigation Reform Act of 1995, reflecting managements current analysis and expectations, based on what management believes to be reasonable assumptions. Forward-looking statements may involve known and unknown risks, uncertainties and other factors, which may cause the actual results to differ materially from those projected, stated or implied, depending on such factors as: ability to generate cash, ability to raise capital, ability to refinance, ability to execute productivity improvements and reduce costs, ability to raise product prices, business climate, business performance, changes in tax laws or regulations and related liabilities, economic and competitive uncertainties, higher manufacturing costs, reduced level of customer orders, changes in strategies, risks in developing new products and technologies, environmental and safety regulations and clean-up costs, foreign exchange rates and exchange control regulations, foreign investment laws, the impact of changes in the value of pension fund assets and liabilities, changes in generally accepted accounting principles, legislative changes, adverse legal and regulatory developments, including increases in the number or financial exposures of claims, lawsuits, settlements or judgments, the financial capacity of settling insurers, the impact of increased accruals and reserves for such exposures, and adverse changes in economic and political climates around the world, including terrorist activities, international hostilities, governmental instabilities and potential natural disasters. Accordingly, there can be no assurance that the Company will meet future results, performance or achievements expressed or implied by such forward-looking statements. As appropriate, additional factors are contained in other reports filed by the Company with the Securities and Exchange Commission. The words or phrases will likely result, are expected to, will continue, is anticipated, estimate, project or similar expressions identify forward-looking statements. This paragraph is included to provide safe harbor for forward-looking statements, which are not generally required to be publicly revised as circumstances change, and which the Company does not intend to update except as may be required by law.
Hercules Incorporated (Hercules or the Company) is a Delaware Corporation formed in 1912. The Company is a leading manufacturer and marketer of specialty chemicals and related services for a broad range of business, consumer and industrial applications. The Company is focused on maximizing cash flows and delivering shareholder value by concentrating on managed growth in its core businesses as well as continuous improvement in its operations. Hercules operates on a global scale, with significant operations in North America, Europe, Asia and Latin America. Product sales occur in over 125 countries with significant revenue streams generated on five continents.
The Companys principal products are chemicals used by the paper industry to increase paper and paperboard performance and enhance the manufacturing process; water-soluble polymers; polypropylene and polypropylene/polyethylene bicomponent fibers; and specialty resins. These products impart such qualities as durability, water-resistance and improved aesthetics for everyday consumer goods ranging from paper and packaging to toothpaste and diapers. The primary markets the Company serves include pulp and paper; paints and adhesives; construction materials; food, pharmaceutical and personal care; and industrial specialties, including oilfield, textiles and general industrial.
While the Companys products comprise a relatively minor component of its end customers total product cost, they frequently possess characteristics important to the functionality and aesthetics of the finished product or the efficient operation of the manufacturing process. Examples of the Companys products in consumer end-uses include strength additives for tissue and toweling, sizing agents for milk and juice cartons, fibers that comprise the inner and outer linings of disposable diapers and feminine hygiene products, thickeners in products such as toothpaste, shampoos and water-based paints, and water control additives for building products such as tile cements, grouts, stuccos, plasters and joint compounds. The Company also offers products and related services that improve and reduce the cost of the paper manufacturing processes, including water management programs that are designed to protect and maintain equipment and reduce operating costs.
Although the performance and quality of its products and high quality service are important to the Companys competitive strategy, other important factors such as lower manufacturing cost and improved reliability are becoming increasingly important. The Company strives to continually improve its products and manufacturing processes by investing in technology. The Company has committed substantial resources to its research and development efforts, including expenditures which totaled approximately $43 million in 2004. Such efforts enable the Company to consistently bring products to market that improve functional properties or that offer similar properties at a lower cost. Functional properties have become increasingly important, as customers have come to rely more on the Company to provide new solutions to improve their product offerings and processes. Additionally, the Company strives to make its products more cost-competitive by effectively managing production costs and advancing its application development with customers.
The Companys strategy is to focus on meeting customers needs and adding value to their businesses; continuously improving to extend competitive advantages; maximizing cash flows; reducing financial leverage and returning to investment grade; growing profitability and increasing return on invested capital; and mitigating and reducing legacy liabilities.
Pursuant to this strategy, on December 1, 2003, Hercules completed the acquisition of Jiangmen Quantum Hi-Tech Biochemical Engineering Co. Ltd. (Jiangmen) and on February 12, 2004, the Company completed the sale of its minority ownership in CP Kelco ApS to a subsidiary of J. M. Huber Corporation for $27 million in cash. Jiangmen is a leading producer of carboxymethylcellulose (CMC) products in China. Located in Jiangmen City, Guangdong Province, the plant has current production capacity in excess of 8,000 metric tons with room for expansion. Jiangmens key markets include food, toothpaste, ceramics and paper, with 2004 sales of approximately $14 million.
The Company operates through two reportable segments and four divisions. The Pulp and Paper and the Aqualon divisions comprise the Performance Products segment and the FiberVisions and Pinova divisions comprise the Engineered Materials and Additives segment. The financial information regarding these segments, which includes net sales and profit from operations for each of the three years ended December 31, 2004, 2003 and 2002 and capital employed as of December 31, 2004, 2003 and 2002, is provided in Note 23 to the Consolidated Financial Statements.
Products and services offered by Pulp and Paper are designed to enhance customers profitability by improving production yields and overall product quality, and to better enable customers to meet their environmental objectives and regulatory requirements.
Pulp and Paper is one of the largest suppliers of functional, process and water management chemicals for the pulp and paper industry. The division offers a wide and highly sophisticated range of technology and applications expertise with in-mill capabilities which run from influent treatment through the paper making process to paper finishing. The division is a broad-based global supplier able to offer a complete portfolio of products to its paper customers.
Products offered by Aqualon are designed to manage the properties of aqueous (water-based) systems. Most of the products are derived from renewable natural raw materials and are sold as key ingredients to other manufacturers where they are used as small-quantity additives to provide functionality such as thickening, water retention, film formation, emulsifying action and binding power. Major end uses for Aqualon products include personal care products, food additives, pharmaceutical products, construction materials, paints, coatings and oil recovery, where polymers are used to modify viscosity, gel strength and/or fluid loss.
At December 31, 2004, the principal products and primary markets of this segment were:
Engineered Materials and Additives
FiberVisions is one of the largest manufacturers of polyolefin staple fibers used in disposable products like diapers and wipes. FiberVisions produces monocomponent polypropylene fibers and bicomponent fibers comprised of a polypropylene core and a polyethylene sheath. FiberVisions also produces polyolefin fiber and yarn for the industrial and textile markets used in concrete and asphalt, wipes, upholstery and automotive fabrics, geotextile fabrics and filtration products.
Pinova consists of the rosin and terpenes specialty business. Pinova manufactures wood and gum rosin resins and terpene specialties and is the worlds only producer of pale wood rosin derivatives. Product applications and markets include adhesives, rubber and plastic modifiers, food and beverages, flavor and fragrances and construction specialties.
At December 31, 2004, the principal products and
primary markets of this segment were:
Raw Materials and Energy Supply
Raw materials and supplies are purchased from a variety of industry sources, including the agricultural, forestry, mining, petroleum and chemical industries.
Important raw materials for Pulp and Paper are cationic and anionic polyacrylamides and emulsions, biocides, amines, surfactants, rosin, adipic acid, epichlorohydrin, fumaric acid, stearic acid, diethylenetriamine, phosphorous trichloride and starch.
Raw materials important to Aqualon are cellulose pulp (derived from wood and cotton linters) and guar splits, both renewable resources, ethylene oxide and caustic. Other commodity and specialty chemical inputs include acetaldehyde, fatty acids, methanol, ethyl chloride, propylene oxide, chlorine, monochloroacetic acid, methyl chloride and inorganic acids.
The important raw materials for the Engineered Materials and Additives segment are polypropylene, polyethylene, pine wood stumps, limonene, gum rosin and crude sulfate turpentine.
FiberVisions purchases polypropylene resins from a number of the major global producers. FiberVisions has undertaken initiatives to expand and fully qualify alternative suppliers, which allows for greater flexibility and reliability of supply.
Major requirements for key raw materials and fuels are typically purchased pursuant to contracts. The Company is not dependent on any one supplier for a material amount of its raw material or fuel requirements, but certain important raw materials, such as cotton linters, are obtained from a sole-source or a few major suppliers. Except for polypropylene, which represented approximately 11% of 2004 cost of goods sold, no single raw material accounts for more than 4% of total current year cost of goods sold.
While temporary shortages of raw materials and fuels may occur occasionally, these items are currently readily available. However, their continuing availability and price are subject to domestic and world market and political conditions as well as to the direct or indirect effect of governmental action or regulations. The impact of any future raw material and energy shortages on the Companys business as a whole or in specific world areas cannot be accurately predicted. Operations and products may, at times, be adversely affected by governmental action, shortages or international or domestic events.
The specialty chemicals industry is highly fragmented and its participants offer a broad array of product lines representing many different products designed to meet specific customer requirements. Individual product and portfolio offerings compete on a global, regional and/or local level subject to the nature of the businesses and products, as well as the end-markets and customers served. The industry has become increasingly global as participants focus on establishing and maintaining leadership positions in relatively narrow market niches. Many of the Companys product lines face competitive domestic and international pressures, including industry consolidation, pricing pressures and competing technologies. In Pulp and Paper, customers and competitors are consolidating to enhance market positions and product offerings on a worldwide basis. Aqualon is facing competitive threats from emerging Asian producers. To address this threat, Aqualon continues to pursue a lower cost strategy, which includes adding production capacity in the growing, low-cost Asian region, as evidenced by its December 2003 acquisition of Jiangmen, a Chinese manufacturing company, and reducing costs in existing facilities. In addition, certain of the Companys businesses are subject to intense competition from new technologies, such as FiberVisions in its hygiene products line. FiberVisions, as a fibers manufacturer for carded non-woven hygienic applications, faces competition from spunbond (SB) and spunbond/melt blown/spunbond (SMS) technologies. SB/SMS products may offer strength-driven cost savings compared to the products of FiberVisions in specific applications; however, FiberVisions believes that its carded products provide improved softness, uniformity, stretch and liquid management properties preferred in wipes and by certain segments of the disposable diaper market and other hygiene products markets. The threat of new producers in the thermal-bonded hygienic product line is relatively low due to the fact that the production process involves significant investments in plant, equipment and application know-how.
Patents and Trademarks
Patents covering a variety of products and processes have been issued to the Company and its subsidiaries. The Company is licensed under certain other patents held by other parties covering its products and processes. The Companys rights under these patents and licenses constitute a valuable asset.
The Company and its wholly-owned subsidiaries also have many global trademarks covering their products. Some of the more significant trademarks include: AquaCat clear cationic solution, Aquapel® sizing agent, Hercon® sizing emulsions, Aqualon® water-soluble polymers, Natrosol® hydroxyethylcellulose, Culminal® methylcellulose, Klucel® hydroxypropylcellulose, Natrosol FPS® water-soluble polymer suspension, Precis® sizing agent, Kymene® resin, Herculon® fiber, Presstige® deposit control additives, Spectrum® microbiocides, Ultra-pHase® sizing agent, Hercobond® dry strength resin, Chromaset® surface size, ProSoft® tissue softeners and Zenix® contaminant control.
The Company does not consider any individual patent, license or trademark to be of material importance to Hercules taken as a whole.
Research and Development
The Company is heavily focused on product innovation as one of its key growth strategies. Research and development efforts are directed toward the discovery and development of new products and processes, the improvement and refinement of existing products and processes, the development of new applications for existing products and cost improvement initiatives. Hercules spent $43 million on research and development activities in 2004, as compared to $39 million in 2003 and $42 million in 2002. The increase in spending for research and development activities is principally due to an expansion in the number and scope of research trials in support of new product initiatives. Technology resources were allocated to those programs according to the selection methods developed in 2003 and 2002 which evaluates each project by assessing its strategic alignment, value, platform leverage and balance. The decrease in spending for research and development activities in 2003 from 2002 was primarily due to efficiencies gained in the redesign of work processes.
Pulp and Paper currently focuses its technology efforts on innovative high-value product development, incremental improvements to existing products and services and cost reduction programs to meet diverse customer needs worldwide. The division currently operates three state-of-the-art facilities located in Europe and the U.S. that include large and sophisticated research and development laboratories with pilot plant capabilities that simulate actual operating conditions in a customers facilities. This allows an accurate assessment of the potential impact of new products on plant performance.
The divisions scientists conduct research and customer optimization studies focused on solving water and process treatment challenges by using sophisticated techniques and equipment to provide high level analytical testing and advanced technical support to customers worldwide.
Aqualon focuses its research and development efforts on market oriented product development, manufacturing process improvement and responsive technical service to customers. New product development is focused on products which manage the physical properties of water based systems, such as latex paint, construction mortars and personal care products, to meet customer demand for improved performance and efficiency.
Aqualon has application and development laboratories in Europe, Asia and the Americas that provide technical service to customers. At these laboratories, teams work in a network to develop products, identify new applications and solve customer problems.
Research and development efforts in FiberVisions are primarily focused on developing new and novel polyolefin fibers around four key platforms: high tenacity for industrial applications; dyeable fibers for apparel and upholstery; wetability for wipes; and shaped fibers for improved adhesion, wicking, coverage and visual appearance. A continued hygiene focus is to improve fiber strength while enhancing hygiene product properties for loft, softness and stretch, thereby creating a platform to better compete with SB/SMS products. The industrial and textile product units are investigating the use of specific fibers for new applications in the upholstery, wipes, geotextiles and construction applications.
FiberVisions has research and development facilities in the U.S. and Europe designed to serve the business needs of its customers. Pilot spinning and processing lines are used to examine new polymers and processing concepts such as monocomponent or bicomponent fibers from single filament spinning to full-scale production facilities.
Pinova, whose research facilities are located in the U.S., focuses its efforts on market driven product development and cost improvement techniques in its production processes.
The Company is subject to numerous environmental laws and regulations. The Company believes it is in compliance, in all material respects, with applicable federal, state and local environmental laws and regulations. Expenditures relating to environmental cleanup costs have not materially affected, and are not expected to materially affect, capital expenditures or competitive position. Additional information regarding environmental matters is provided in Notes 11 and 12 to the Consolidated Financial Statements and is incorporated herein by reference.
As of December 31, 2004, the Company had approximately 4,950 employees worldwide. Approximately half of the worldwide employees were located in the United States, of which approximately 23% were represented by various local or national unions. As of December 31, 2003, the Company had approximately 5,100 employees worldwide.
Information on net sales and capital employed by geographic area for each of the three years ended December 31, 2004, 2003 and 2002 appears in Note 23 to the Consolidated Financial Statements. Direct export sales from the United States to unaffiliated customers were $119 million, $122 million and $110 million for 2004, 2003 and 2002, respectively. The Companys operations outside the United States are subject to the usual risks and limitations related to investments in foreign countries, such as fluctuations in currency values, exchange control regulations, wage and price controls, employment regulations, foreign investment laws, governmental instability (including expropriation or confiscation of assets) and other potentially detrimental domestic and foreign governmental policies affecting U.S.-based companies doing business abroad, including risks related to terrorism and international hostilities.
Hercules files its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports with the Securities and Exchange Commission (SEC). Hercules provides access to its SEC filings via a hyperlink to the SECs website on its corporate website, www.herc.com. These filings may also be read and copied at the SECs Public Reference Room which is located at 450 Fifth Street, N.W., Washington, DC 20549. Information about the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330.
The Companys Directors Code of Business Conduct and Ethics and its Business Practices Policy, as well as the charters of the Corporate Governance, Nominating and Ethics Committee, Audit Committee and Human Resources Committee, are available on the Companys website at www.herc.com.
These documents are also available in print to any shareholder who requests them in writing from Israel J. Floyd, Esq., Corporate Secretary, Hercules Incorporated, Hercules Plaza, 1313 North Market Street, Wilmington, Delaware 19894-0001.
The Companys corporate headquarters and major research center are located in Wilmington, Delaware. The Company also owns a number of plants and facilities worldwide, in locations strategic to the sources of raw materials or to customers. All of the Companys principal properties are owned by the Company, except for its corporate headquarters office building, which is leased. The following are the locations of the Companys worldwide plants:
Pulp and Paper Beringen, Belgium; Burlington, Ontario, Canada; Busnago, Italy; Chicopee, Massachusetts, U.S.; Franklin, Virginia, U.S.; Hattiesburg, Mississippi, U.S.; Helsingborg, Sweden; Kim Cheon, Korea; Macon, Georgia, U.S.; Mexico City, Mexico; Milwaukee, Wisconsin, U.S.; Nantou, Taiwan; Pandaan, Indonesia; Paulinia, Brazil; Pendlebury, United Kingdom; Portland, Oregon, U.S.; Savannah, Georgia, U.S.; Shanghai, China (60% joint venture interest); Sobernheim, Germany; Tampere, Finland; Tarragona, Spain; Voreppe, France; and Zwijndrecht, The Netherlands.
The division also owns a manufacturing facility in Pilar, Argentina, that has been leased to a major U.S. company under a five-year lease. The Company purchases its products for sale in Argentina from this plant under a five-year supply and distribution agreement which ends in 2009.
Aqualon Alizay, France; Doel, Belgium; Hopewell, Virginia, U.S.; Jiangmen City, China; Kenedy, Texas, U.S.; Louisiana, Missouri, U.S.; Parlin, New Jersey, U.S.; and Zwijndrecht, The Netherlands.
Engineered Materials and Additives
FiberVisions Athens, Georgia, U.S.; Covington, Georgia, U.S.; Suzhou, China; and Varde, Denmark.
Pinova Brunswick, Georgia, U.S.; Hattiesburg, Mississippi, U.S.; and Savannah, Georgia, U.S.
The Companys plants and facilities, many of which are continually upgraded and modernized, are generally considered to be in good condition with adequate capacity for projected business operations. From time to time, the Company discontinues operations at, or disposes of, facilities that have for one reason or another become unsuitable.
Information regarding legal proceedings is included in the Notes to Consolidated Financial Statements (see Note 12) and is incorporated herein by reference.
No matter was submitted to a vote of security holders during the fourth quarter of 2004 through the solicitations of proxies or otherwise.
EXECUTIVE OFFICERS OF THE REGISTRANT
The name, age and current position of each executive officer of Hercules as of February 28, 2005 is listed below. There are no family relationships among executive officers.
Craig A. Rogerson joined Hercules in 1979 and has held his current position since December 2003. He had been Vice President and General Manager, FiberVisions and Pinova since April 2002. Prior to that, he had been Vice President and General Manager of BetzDearborn since August 2000 and Vice President of Business Operations for BetzDearborn Division since May 2000. He was President and CEO of Wacker Silicones Corporation from 1997 to 2000.
Fred G. Aanonsen joined Hercules in July 2001. Prior to joining Hercules, he spent 25 years at Union Carbide Corporation, where most recently he had been the Director of Accounting and Financial Processing since 1998 and Business Director for the Finance SAP Design and Implementation Team from 1995 to 1998. Mr. Aanonsen is a Certified Public Accountant and a member of the American Institute of Certified Public Accountants, the New York State Society of Certified Public Accountants and the Financial Executives Institute.
Edward V. Carrington originally joined Hercules when it acquired Radiant Color in 1969 and assumed his current position in June 2001. Prior to that, he had served in a consulting role since October 2000. From 1997 until 2000, he was Vice President of Buttonwood Cottages, Inc., a vacation resort complex, and President of Rentals in Paradise, Inc., a vacation home rental business. From 1992 until his retirement from Hercules in 1997, he was Vice President, Human Resources. Mr. Carrington is a trustee of Christiana Care.
Marco F. Cenisio joined Hercules in 1980 and has held his current position since March 2004. From June 2002 through March 2004, Mr. Cenisio was Vice President, Europe and Global Strength, Pulp and Paper Division. From 1998 through June 2002, Mr. Cenisio was Global Business Director for Strength and Tissue Paper.
Richard G. Dahlen originally joined Hercules in 1996. Mr. Dahlen assumed his current position in June 2001. Prior to that, he had served in a consulting role since October 2000. From 1999 until 2000, he was retired and from 1996 until his retirement in 1999, he served as Vice President, Law and General Counsel.
Kathryn Fialkowski assumed her current position in January 2005. In March 2004, she was appointed Director, Hercules Project Management Office. From February 2003 to March 2004 she was Director, Work Process Redesign. From 2001 to 2002, she was Vice President, International Business Development with Partech International, a venture capital firm. Prior to that, she served as Vice President, Customer Services with UUNET Technologies, where she worked between 1997 and 2001.
Israel J. Floyd joined Hercules in 1973 and has held his current position since 2001. He had been Vice President, Secretary and General Counsel since 1999 and, prior to that was Secretary and Assistant General Counsel from 1992 to 1999.
Hanna M. Lukosavich joined Hercules in August 2004. She had been Vice President and Chief Information Officer at Resolution Performance Products (formerly part of Shell Chemicals) from 2001 to 2004. From 2000 to 2001 she was Chief
Information Officer at Ferrostaal Incorporated. Prior to that she was Director of Information Technology for Mannesmann Pipe & Steel Corp. from 1995 to 2000.
Paul C. Raymond, III joined Hercules in February 2005. From 2002 to 2005 he was Vice President and General Manager of Honeywell Electronic Materials. From 2000 to 2002, he was Vice President, Global Operations of Honeywell Electrical Materials.
Vincenzo M. Romano joined Hercules in March 2003 as Director, Federal Tax and has held his current position since July 2004. He was self-employed as a tax consultant from September 2001 until March 2003. Prior to that, he was a Tax Director for PricewaterhouseCoopers from January 1999 to August 2001.
Stuart C. Shears joined Hercules in 1978 and has held his current position since 1999.
Allen A. Spizzo joined Hercules in 1979 and has held his current position since March 2004. He had been Vice President, Corporate Affairs, Strategic Planning and Corporate Development from July 2002 to March 2004. Prior to that, Mr. Spizzo had been Vice President, Investor Relations and Strategic Planning since 2000. Prior to that, he was Director for Corporate Development since 1997.
Thomas H. Strang joined Hercules in 1982 and has held his current position since January 2004. He had held the positions of Director, Supply Chain for FiberVisions and Pinova and Plant Manager for the Brunswick, Georgia, facility from 2002 to January 2004. Prior to that, he was Plant Manager at the Brunswick, Georgia, facility since 1998.
John Y. Televantos joined Hercules in April 2002 as President of the Aqualon Division and Vice President of Hercules. He had been President and Chief Executive Officer, and prior to that Chief Operating Officer, of Foamex International during the period of time June 1999 through December 2001. Prior to that, he was Vice President, Development Businesses and Research at Lyondel Chemical Company since 1998.
Charles H. Wardlaw joined Hercules in August 2004. He had been Vice President, Strategic Sourcing for Tyco International since 2001. Previously he was Global Sourcing Director for DuPont Dow Elastomers since 1997.
The Companys common stock is listed on the New York Stock Exchange (ticker symbol HPC) and the Swiss Stock Exchange. It is also traded on the Philadelphia, Midwest and Pacific Stock Exchanges.
The approximate number of holders of record of its common stock ($25/48 stated value) as of February 28, 2005 was 15,573.
The following table sets forth, for the periods indicated, the high and low closing price per share of the Companys common stock, as reported on the New York Stock Exchange:
On December 31, 2004, the closing price of the common stock was $14.85.
The payment of quarterly dividends was suspended in the fourth quarter of 2000, subject to reconsideration by the Board of Directors in its discretion, when warranted under appropriate circumstances and subject to restrictions in the indentures governing the Companys 11.125% senior notes due 2007, the 6.75% senior subordinated notes due 2029 and the Senior Credit Facility.
A summary of the selected financial data for Hercules for the years ended and as of the end of the years specified is set forth in the table below. Pursuant to Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144), the BetzDearborn Water Treatment Business has been treated as a discontinued operation as of February 12, 2002. See Note 25 in the Notes to the Consolidated Financial Statements for a summary of divestitures that have occurred in the last three years.
The following discussion should be read in connection with the information contained in the Consolidated Financial Statements and Notes thereto. All references to individual Notes refer to Notes to the Consolidated Financial Statements.
Hercules is a leading global manufacturer and marketer of specialty chemicals and related services for a broad range of business, consumer and industrial applications. The Companys principal products are chemicals used by the paper industry to improve performance and enhance the manufacturing process; water-soluble polymers; polypropylene and polyethylene fibers; and specialty resins. Key markets for the Companys products as a percentage by end market in the years ended December 31, 2004 and 2003 were:
More than 50% of the Companys revenues are generated outside of North America. Net sales by region expressed as a percentage of all sales for the years ended December 31, 2004 and 2003 were:
The Company operates through two reportable segments and four divisions: Performance Products (Pulp and Paper and Aqualon) and Engineered Materials and Additives (FiberVisions and Pinova). Net sales for the years ended December 31, 2004 and 2003 as a percent of total sales, by division, were:
Operating results for the year ended December 31, 2004 were positively impacted by increased sales volumes in the Aqualon, Pulp and Paper and Pinova divisions, coupled with the continued strength of the Euro, which has appreciated approximately 10% on average against the U.S. dollar from the year ended December 31, 2003. These gains were offset by higher costs, primarily for energy and energy-related raw materials, non-cash pension charges and freight.
Increased energy and natural gas/crude oil feedstock costs impacted many raw materials, particularly those derived from chlor-alkali, ethylene, benzene and propylene. Strong demand from China for many basic materials and the strengthening global economy also exerted upward pressure on the price of raw materials. The Company has initiated a number of programs to mitigate these negative effects, including product substitution, exploration of new sourcing opportunities and price increases for our products that use these raw materials.
In Pulp and Paper, production of paper and paperboard in North America improved throughout the year, consistent with improved economic conditions. European paper and paperboard production also increased as compared to 2003. Improved fourth quarter net sales results for both regions reflected the improving demand in the tissue and towel and process chemical segments. This favorable trend for paper and paperboard production is anticipated to continue into 2005, consistent with current economic forecasts. Sales in emerging markets remained strong in the quarter and for the year ended December 31, 2004. Net sales for the year ended December 31, 2004 increased 30% in China, 24% in Brazil and 30% in Eastern Europe, excluding Russia, as compared to 2003. These developing regions are important growth areas for the Pulp and Paper division as it is anticipated that economic development will increase per capita paper consumption and industrial demand for paper and paperboard products.
Market conditions affecting Aqualon remain favorable. Volume growth was fueled by strong personal care, pharmaceutical, paint, oil field and polyols markets. Volume and net sales also benefited from the Companys December 2003 acquisition of Jiangmen Quantum Hi-Tech BioChemical Engineering Co. Ltd. (Jiangmen). Unfavorable mix, reflecting increased sales of lower priced products, regional and industry mix, and lower pricing in certain mature product lines in order to retain market share, has partially offset the positive volume growth.
In FiberVisions, margins were under pressure due to unprecedented high polypropylene resin prices and continued competitive activity. Polypropylene resin prices, as reported by the Chemical Data Inc. Index (Index), increased to $0.657 per pound for the fourth quarter of 2004, up 51% compared to the same period in 2003. The Index for the year was $0.557 per pound as compared to an average of $0.434 per pound for 2003. FiberVisions has contractual arrangements with many of its customers that enable it to pass through higher polypropylene costs on a delayed basis. Sales continue to be adversely impacted by substitution in the baby diaper coverstock market and slower than anticipated sales growth into the disposable wipe market segments and other applications.
In the Pinova business, 2004 sales volumes were 29% higher than the prior year, but increases in raw material, energy and non-cash pension costs and lower tolling income negatively impacted profits. The business has been successful in regaining volume through increased sales to existing customers and the addition of new customers, albeit at lower pricing than the prior year.
In addition to these factors, results for the year ended December 31, 2004 were influenced by a number of other events, as discussed below.
On February 12, 2004, the Company completed the sale of its minority interest in CP Kelco ApS, realizing a pre-tax gain of $27 million. The Company completed the refinancing of its Senior Credit Facility on April 8, 2004 and redeemed its 9.42% debentures on May 10, 2004. As a result of the refinancing and redemption, $14 million in non-cash expense related to the write-off of unamortized debt issuance costs was recognized in Other expense, net. Also in April 2004, the Company reached a settlement agreement in the lawsuit captioned Douglas C. Smith, Individually and on Behalf of All Others Similarly Situated v. Hercules Incorporated and Thomas Gossage, resulting in the recognition of a charge of $6 million in the first quarter. The Company, as discussed below in Financial Condition, continued to repurchase its 11.125% senior notes due 2007, resulting in a $34 million loss on the repurchases for the year that includes the write-off of $4 million of unamortized debt issuance costs. All of these items were included in Other expense, net.
The Company recognized a $41 million non-cash tax expense during the third quarter 2004 to establish a valuation allowance for impaired foreign tax credit carryforwards. This charge was the result of lower actual and forecasted U.S. taxable income and the inability to execute certain tax initiatives. As a result of the October 2004 enactment of the American Jobs Creation Act of 2004 (the Act) and progress in implementing a structure to reduce future foreign taxes, the Company expects to be able to utilize available foreign tax credits within the ten-year carryforward period provided by the Act and therefore reversed the previously recognized $41 million non-cash valuation allowance in the fourth quarter 2004. The planning structure involves a reorganization of the European business around a new European headquarters to be located in Switzerland.
During September and October 2004, the Company reached settlement agreements with all of its insurers regarding coverage for the Companys asbestos-related claims. The settlements provide for cash payments and trust funding totaling $225 million (with a net present value of $218 million when discounted) over the next several years, subject in some cases to repayment of residual trust balances in the event that federal asbestos reform legislation is enacted. Concurrent with the completion of these settlements, the Company updated the analysis of its estimated asbestos claims exposure. Based upon the results of that analysis and a subsequent analysis as of December 31, 2004, the Company recorded additional reserves to recognize an estimated potential liability of $260 million as of December 31, 2004 for asbestos-related claims. As a result, the Company recorded a charge of $34 million for the year ended December 31, 2004, reflecting an $80 million increase in asbestos reserves, a $49 million increase in asbestos-related insurance receivables and $3 million of fees incurred in reaching the settlements.
On February 14, 2005, the Company received a Revenue Agent Report (RAR) from the Internal Revenue Service pertaining to the Companys tax returns for 1999 through 2001. Pursuant to its reconciliation and analysis of the proposed tax adjustments contained in the RAR, the Company recognized a net tax benefit of approximately $14 million in 2004 primarily reflecting its ability to utilize additional capital losses for which a full valuation allowance had been established.
On February 25, 2005, the Company reached a settlement in principle with the plaintiffs in the Thomas & Thomas Rodmakers v. Newport Adhesives and Composites litigation, resulting in the recognition of a charge of $11.25 million in the fourth quarter of 2004.
Critical Accounting Estimates
The Companys discussion and analysis of its financial condition and results of operations is based on its consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires Hercules to make estimates and assumptions that affect the amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Hercules evaluates its estimates on a regular basis, including those related to sales returns and allowances, bad debts, inventories, impairments of long-lived assets, income taxes, restructuring, contingencies, including litigation and environmental, and pension and other benefit obligations. Hercules bases its estimates on various factors including historical experience, consultation and advice from third party subject matter experts and various assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.
Hercules believes that the following accounting estimates are critical due to the significant subjectivity and judgment necessary to account for the matters or the susceptibility of such matters to change and the effect of the estimates and assumptions on its consolidated financial statements.
The Company maintains allowances for doubtful accounts. The recorded amount reflects various factors, including accounts receivable aging, customer-specific risk issues, country risk and historical write-off experience. It includes, but is not limited to, a formula driven calculation applied to the aging of trade accounts receivable balances. When a specific accounts receivable balance is deemed uncollectible, a charge is taken to this reserve. Recoveries of balances previously written off are also reflected in this reserve.
Hercules adopted the provisions of Statement of Financial Accounting Standards No.142 Goodwill and Other Intangible Assets (SFAS 142) effective January 1, 2002. As of December 31, 2004, Hercules recognized the following reporting units: Pulp and Paper, Aqualon, FiberVisions and Pinova. Pursuant to SFAS 142, the Company is required to perform an annual assessment of its reporting units for impairment. To assess impairment, the Company compares the reporting units book value of net assets, including goodwill, to its fair value. Fair value is estimated using a combination of valuation approaches including the market value and income approaches. In the event that the book value exceeds the fair value, the Company recognizes an impairment to the extent the book value of goodwill exceeds the implied fair value of goodwill for any reporting unit, calculated by determining the fair value of the assets and liabilities for the reporting unit. Deterioration in future economic conditions, poor operating results in the reporting units, new or stronger competitors, or changes in technology could result in an inability to recover the carrying value of the goodwill and intangible assets, thereby requiring an impairment in the future.
The Company tests other long-lived assets for impairment based on the guidance provided in Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-lived Assets (SFAS 144) which was adopted January 1, 2002. If the Company determines that an impairment loss has occurred, the loss is recognized in the income statement. Deterioration in future economic conditions, poor operating results in a business, the determination that the long-lived asset is unsuitable for one reason or another, new or stronger competitors, or changes in technology, could result in an inability to recover the carrying value of the asset, thereby requiring an impairment in the future.
Hercules records a valuation allowance to reduce its deferred tax assets to an amount that is more likely than not to be realized after consideration of future taxable income and reasonable tax planning strategies. In the event that Hercules were to determine that it would not be able to realize all or part of its deferred tax assets for which a valuation allowance had not been established, or is able to utilize capital and/or operating loss carryforwards for which a valuation allowance has been established, an adjustment to the deferred tax asset will be reflected in income in the period such determination is made.
Hercules has and will continue to record charges for the estimated costs of employee severance and other exit costs pursuant to the Companys strategy to continuously improve return on capital, streamline organizational structure, improve work processes and consolidate manufacturing and non-manufacturing resources. In the event that it is determined that additional employees must be involuntarily terminated, or that additional manufacturing or non-manufacturing facilities must be closed pursuant to work process redesign or other cost reduction initiatives, supplemental reserves would be required, which would result in an incremental charge against earnings.
Hercules establishes reserves for environmental matters, litigation and other contingencies when it is probable that a liability has been incurred and the amount of the liability is reasonably estimable. At December 31, 2004, the Company had $117 million accrued for contingencies and asset retirement obligations in accordance with Statement of Financial Accounting Standards No. 5, Accounting for Contingencies (SFAS 5) and Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations (SFAS 143). The actual costs will depend upon numerous factors, including the number of parties found responsible at each environmental site and their ability to pay, the actual methods of remediation required or agreed to, outcomes of negotiations with regulatory authorities, outcomes of litigation, changes in the timing of required remedial activities, changes in environmental laws and regulations, technological developments, the years of remedial activity required and changes in the number or financial exposures of claims, lawsuits, settlements or judgments, or in the ability to reduce such financial exposures by collecting indemnity payments from insurers. If the contingency is resolved for an amount greater or less than has been accrued, Hercules share of the contingency increases or decreases, or other assumptions relevant to the development of the estimate were to change, Hercules would recognize an additional expense or benefit in income in the period such determination was made.
Hercules has established reserves for asbestos-related personal injury lawsuits and claims. The Companys estimates are based on a number of assumptions including the number of future claims, the timing and amount of future payments, disease, venue, and the dynamic nature of asbestos litigation and other circumstances. At December 31, 2004, the Company had a gross accrued liability of $260 million for present and future potential asbestos claims. The Company had $169 million of asbestos-related receivables pertaining to the aforementioned lawsuits and claims at December 31, 2004.
In the United States, the Company provides defined benefit pension plan coverage for eligible employees hired prior to January 1, 2005 and postretirement welfare benefit plan coverage to eligible employees hired prior to January 1, 2003. Similar plans are provided outside the United States in accordance with local practice. Pension and other postretirement benefit obligations and the related expense (income) are determined based upon actuarial assumptions regarding mortality, medical inflation rates, discount rates, long-term return on assets, salary increases, Medicare availability and other factors. Changes in these assumptions can result in changes to the recognized pension expense and recorded liability. At December 31, 2004, the accumulated benefit obligation (ABO) of the Companys U.S. and certain foreign defined benefit pension plans, on a consolidated basis, exceeded their funded basis. The Company is required to recognize an additional liability equal to the sum of such excess plus the prepaid pension asset balance, with a corresponding after-tax charge to other comprehensive income in stockholders equity. For the year ended December 31, 2004 the Company increased its additional minimum liability (AML) to $578 million (pre-tax) by recording an additional minimum liability of $23 million (pre-tax). The Company also reduced its previously deferred pension asset by $20 million resulting in an after tax charge of $30 million to other comprehensive income (see Note 16). The increase to the AML primarily was a result of changes to discount rate and other assumptions that caused the ABO to be higher than the fair value of the plan assets. At the present time, the U.S. defined benefit pension plan is at a sufficient funding level as to not require ERISA mandated contributions. The Company has determined, however, that it is in the best interests of the Company and its pension plan participants to make voluntary contributions to the plan. If the U.S. qualified pension plan performs in accordance with actuarial assumptions, the Company presently anticipates making voluntary cash contributions of approximately $40 million per year over the next few years, including $40 million contributed to the U.S. defined benefit plan in January 2005.
Results of Operations
2004 vs. 2003
The tables below reflect Net sales and Profit from operations for the years ended December 31, 2004 and 2003. Substantially all reconciling items have been allocated to the segments.
The table below reflects Net sales percentage changes for the year ended December 31, 2004 when compared with the year ended December 31, 2003:
The tables below reflect Net sales per region and percentage change from the year ended December 31, 2003.
Consolidated net sales were $1,997 million for the year ended December 31, 2004, an increase of $151 million, or 8%. Compared to 2003, volumes generated an 8% improvement, mix had a negative impact of 4%, the effect of price changes was minimal and rates of exchange had a 4% positive effect.
For the year ended December 31, 2004, regional sales were up 4% in North America, 5% in Latin America, 24% in Asia Pacific and 10% in Europe (1% excluding the stronger Euro). The European region remained challenging most of the year due to the competitive Pulp and Paper market and substitution of competitors product taking volumes from FiberVisions in the diaper coverstock market. North America sales improved in all businesses. The Pulp and Paper market for containerboard and packaging materials in this region has improved. Sales in Asia Pacific have increased primarily as a result of the acquisition of Jiangmen in China and stronger economic conditions in Asia.
Profit from operations for the year ended December 31, 2004 was $227 million, a decrease of $28 million or 11% as compared to 2003. Improved volume growth and a $12 million benefit from favorable rates of exchange was more than offset by higher non-cash pension charges, raw material, freight and insurance costs across all businesses; non-cash asset impairment charges in Aqualon and Pulp and Paper; and bad debt and severance accruals related to our Pulp and Paper division. Additionally, profit from operations in 2003 benefited from income recognized as a result of a favorable legal settlement and the receipt of insurance demutualization proceeds.
During the year ended December 31, 2004, Performance Products net sales grew $134 million, or 9%, and profit from operations decreased by $14 million.
In the Pulp and Paper Division, net sales for the year ended December 31, 2004 grew $52 million or 6%, with 5% resulting from higher volumes and a 4% benefit from favorable rates of exchange, partially offset by 1% lower pricing and 2% unfavorable product mix. The higher volumes were primarily a result of increased sales under our supply agreement with G.E. Water Technologies and the improving North American market for containerboard. Europe remained challenging as volume growth was offset by competitive price pressure and unfavorable mix. Price erosion occurred in both functional and process chemicals.
Pricing in Pulp and Paper deteriorated from 2003 levels as a result of competitive pressures. Pricing was down in North America and Europe, our two largest markets. The division initiated two price increases with a combined increase of 11% to 19% on all process and functional products late in the second half of 2004, which is expected to benefit 2005 results. Profit from operations was $22 million or 21% lower than the prior year. Higher volumes and favorable rates of exchange were more than offset by lower pricing, higher energy, raw materials, and non-cash pension expense, as well as selling expenses associated with new product growth. Raw material costs were higher in the fourth quarter than in previous quarters reflecting increases in adipic acid and epichlorohydrin prices. Additionally, during 2004 severance charges of approximately $8 million were incurred for headcount reductions in the general and administrative functions.
Aqualon net sales for the year ended December 31, 2004 increased $82 million or 14% compared to 2003. The growth was driven by 18% higher volumes and a 4% benefit from higher rates of exchange, partially offset by negative mix of 7% and 1% lower prices. Volume improvements were made in many of our markets including personal care, pharmaceutical, paint, oilfield, lubricants, adhesives and coatings. Volumes also continued to benefit from our Jiangmen acquisition completed in the fourth quarter of 2003 which accounted for approximately 40% of the increase. The unfavorable product mix reflected higher sales of lower priced products, primarily related to CMC sales in China, and
unfavorable regional and industry mix. Price increases announced and implemented in the fourth quarter resulted in pricing being flat in the aggregate for the quarter and down only 1% for the year. The continued competitive pricing in one product line due to temporary industry overcapacity was offset by price increases in other product lines. The U.S. CMC business continues to be under pressure due to aggressive behavior of several foreign producers that are exporting into the U.S. market. The Company is seeking governmental remedies to address such behavior.
Profit from operations for the year ended December 31, 2004 improved $8 million, or 5%, as compared to 2003, as increased volumes, favorable rates of exchange, higher plant utilization rates and lower raw material costs in the aggregate were partially offset by higher non-cash pension, freight, plant maintenance, utilities and increased selling, general and administrative costs. Raw material costs were higher in the fourth quarter than the previous three quarters reflecting increases in ethylene oxide, caustic and methanol. In addition, an asset impairment charge of $4 million was incurred in the first quarter of 2004 as a result of the closure of a raw material production line.
In the Engineered Materials and Additives segment, net sales for the year ended December 31, 2004 increased $17 million, or 5%. The segment had a loss from operations of $15 million compared with a profit from operations of $9 million in 2003 primarily due to the results of the FiberVisions divisions operations.
FiberVisions net sales for the year ended December 31, 2004 increased $3 million or 1% when compared with 2003. The growth in sales resulted from improved pricing of 5%, higher rates of exchange of 4%, partially offset by 6% lower volumes and a 2% unfavorable mix. Volumes in the fourth quarter were up 2%, reflecting gains in wipes and other applications markets, offsetting the losses experienced in diaper coverstock applications from the prior year. Results of operations for the year ended December 31, 2004 decreased by $17 million. Improved pricing, rates of exchange and lower management fees charged by our ES FiberVisions joint venture partner were more than offset by higher polymer costs and lower plant utilization. Polypropylene costs increased 28% year over year. In addition, the Division recognized legal costs associated with the now terminated Meraklon S.p.A. acquisition.
Net sales in Pinova increased $14 million or 16% in 2004 as compared to 2003. Sales benefited from significantly higher volumes of 28%, partially offset by 5% lower pricing and unfavorable mix of 7%. The increase in volumes was related to recapturing lost market share in the highly competitive chewing gum, adhesives and other industrial markets. The lower pricing and unfavorable product mix was related to these efforts to regain lost business and a strategic shift into lower priced industrial segments aimed at reducing inventory and increasing sales volumes, thereby generating positive cash flow. Losses from operations of $11 million and $4 million were recorded in 2004 and 2003, respectively. Improved plant utilization rates associated with higher volumes were offset by lower pricing, higher raw materials, energy and non-cash pension costs and lower tolling fees.
Corporate items included net operating charges and benefits that were not directly related to the business segments. The charges typically appear in Other operating expense, net, although a portion was included in Cost of sales. The table below reflects the components of Corporate items.
Corporate items for the year ended December 31, 2004 resulted in a net expense of $6 million versus $16 million net expense in 2003. The results for the year ended December 31, 2004 included charges of $7 million related to the shutdown of the former Nitrocellulose facility and $1 million for a special executive pension adjustment, offset by a $3 million reduction in insurance claims reserves. The comparable 2003 period included a $1 million charge related to the shutdown of the former Nitrocellulose facility, a $7 million special executive pension adjustment, $5 million in corporate severance and restructuring charges, $4 million in proxy costs and $1 million of other gains, net.
Interest and debt expense for the year ended December 31, 2004 was $109 million, or $22 million lower than the $131 million incurred in 2003, reflecting lower outstanding debt balances, improved debt mix and reduced rates on the Companys bank debt. The April 2004 refinancing of the Term B loan, combined with a third quarter amendment to the credit agreement resulted in a 150 basis point rate reduction on the bank debt. In addition to the repurchase of $150 million of its 11.125% senior notes during 2004, the Company also repaid its 9.42% trust preferred securities in May 2004 with the proceeds of the April 2004 private placement of $250 million 6.75% senior subordinated debt and a portion of the proceeds of the new Senior Credit Facility.
Other expense, net, was $116 million for the year ended December 31, 2004, an increase of $87 million compared to $29 million of expense for 2003. The increase was primarily attributable to the net $34 million adjustment related to the asbestos litigation consisting of an $80 million increase in the asbestos reserves, a $49 million increase in the insurance receivables and $3 million in fees incurred in reaching the settlements with the insurance carriers. Additionally, the Company wrote off $14 million of debt issuance costs associated with its April 2004 debt refinancing and paid premiums of $30 million and wrote off $4 million of debt issuance costs associated with the Companys open market repurchase of its 11.125% senior notes throughout 2004. Legal settlements of $19 million in 2004 exceeded 2003 levels of $8 million primarily due to the recent settlement of the Thomas & Thomas Rodmakers v. Newport Adhesives and Composites litigation (see Note 12 to the Consolidated Financial Statements).
The provision for income taxes on continuing operations reflected effective tax rates of 7% in 2004 and 22% in 2003. The effective tax rate in 2004 reflected the benefit of the CP Kelco ApS gain and the reduction of the valuation allowance related to capital losses partially offset by an increase in tax reserves. The effective tax rate for 2003 reflected the tax benefit from the donation of intellectual property to qualified organizations and the use of prior year capital losses.
2003 vs. 2002
The tables below reflect Net sales and Profit from operations for the years ended December 31, 2003 and 2002. Substantially all reconciling items have been allocated to the segments.
The table below reflects Net sales percentage changes for the year ended December 31, 2003 when compared with the year ended December 31, 2002:
(1) Includes the effect of the consolidation of ES FiberVisions in 2003 in accordance with FASB Interpretation No. 46 (R) Consolidation of Variable Interest Entities (FIN 46R). FiberVisions volume improvement without ES FiberVisions was 1%.
The tables below reflect Net sales per region and percentage change from the year ended December 31, 2002:
Net sales in 2003 increased 8% from 2002. Growth in sales for 2003 compared to 2002 was driven by a 6%, or $110 million, benefit from rate of exchange and a 2%, or $29 million, benefit from the consolidation of ES FiberVisions pursuant to FIN 46R. The Euro appreciated approximately 20% in 2003 from 2002 levels. Volume and price in the aggregate were flat compared to 2002. Volumes were essentially flat in Pulp and Paper, with declines in the weak North American and European markets offset by strong sales growth in the emerging regions of China, Brazil and Russia. Volume growth in Aqualon was a result of stronger demand in the oil and gas drilling and recovery markets. FiberVisions volume growth principally reflected the consolidation of ES FiberVisions. Lower volumes in the Pinova business were driven by lost business in its chewing gum and adhesives markets.
Profit from operations improved 16% compared to 2002. Higher costs in 2003 for energy, raw materials and pension were more than offset by productivity improvements and the positive effect of the stronger Euro. Worldwide non-cash pension expense was approximately $28 million in 2003, an increase of $22 million versus 2002.
In the Performance Products segment, net sales increased $98 million, or 7%. Net sales were positively impacted 6%, or $91 million, by rates of exchange. Profit from operations in the segment improved $19 million, or 8%, equal to the benefit from favorable rates of exchange. Cost increases in energy, raw materials and non-cash pension expense were offset by productivity improvements.
In Pulp and Paper, net sales increased $37 million, or 4%, reflecting a $48 million positive impact from rates of exchange, principally the Euro, and strong growth in emerging markets. Net sales increased 29% in China, 40% in Brazil
and 17% in Russia. Net sales were negatively impacted by $11 million as a result of price erosion and unfavorable mix. Global volumes were essentially flat reflecting the impact of weak market conditions in North America. For 2003, paper and paperboard production was down 2% in North America. Office paper production in Europe, a key market for Hercules, was also down 2%. Factors impacting the North American industry included a declining manufacturing base as more production shifted off-shore to countries such as China, lower classified advertising (newsprint), lower weight magazines and a slowdown in print advertising and plastics substitutes for liquid packaging. Profit from operations was essentially flat, down $1 million versus 2002. Profit from operations was negatively impacted by higher energy and energy related raw materials in addition to non-cash pension expense. These higher costs, in part, were offset by supply chain improvements and lower selling, general and administrative expense.
Aqualons net sales grew $61 million, or 11% compared to 2002. Rate of exchange, principally the Euro, had a $43 million, or 8%, favorable impact and volume/mix had an $18 million, or 3%, favorable impact. Volume growth was fueled by an increase in the construction, oil field and personal care businesses. Global price increases were implemented in the first half of 2003, partially offsetting higher raw material and energy costs. Profit from operations improved $20 million, or 14%, compared to 2002, driven by positive rate of exchange impact ($11 million or 8%) and volume increases even as the business experienced higher costs for energy, raw material and non-cash pension expense.
In the Engineered Materials and Additives segment, net sales increased $43 million, or 13%. The consolidation of the ES FiberVisions joint ventures contributed $29 million, or 9%, to the improvement. Favorable impacts due to rate of exchange contributed $19 million, or 6%. Lower volumes in Pinova due to the lost business in its chewing gum and adhesives markets negatively impacted the segments net sales. Profit from operations decreased $9 million, or 50%, from 2002. Improvement in FiberVisions profit from operations was more than completely offset by Pinovas losses from operations.
FiberVisions net sales increased $57 million, or 26% from 2002, reflecting the positive impacts from the consolidation of the ES FiberVisions joint ventures of $29 million or 13%, favorable rates of exchange of $19 million or 9%, and pricing and volume/mix totaling $9 million or 4%. FiberVisions contractual arrangements with many of its customers enable it to pass through higher polypropylene costs on a delayed basis. Lower volumes for fibers used in diapers were partially offset by higher volumes in the wipes markets. New wipes products generated approximately $23 million and new bicomponent products generated approximately $10 million in net sales, respectively. Profit from operations improved $3 million, or 30% as compared to 2002, primarily as a result of the consolidation of the ES FiberVisions joint ventures.
Pinova net sales decreased $14 million, or 14%, from 2002 reflecting a 13% decrease in volumes due to the lost business in its chewing gum and adhesives markets. Loss from operations was $4 million compared to an $8 million profit from operations in 2002. The business has a significant fixed cost structure that is not easily reduced. The business has been successful in regaining most of the lost volumes through increased sales to existing customers and the addition of new customers.
Corporate items included net operating charges and
benefits that were not directly related to the business segments. The charges typically appear in Other
operating expense, net, although a portion was also included in Cost of
sales. The table below reflects the
components of Corporate items.
Corporate items for the year ended December 31, 2003 resulted in a net expense of $16 million versus $41 million of net expense in 2002. The results for the year ended December 31, 2003 included a charge of $1 million related to the shutdown of the former Nitrocellulose facility, $5 million for severance charges, $7 million for special executive pension adjustments, $4 million for proxy expenses and $1 million in other gains, net, whereas the comparable 2002 period included $22 million for severance and restructuring charges, $12 million in environmental charges and $7 million of other charges, net.
Interest and debt expense for the year ended December 31, 2003 was $131 million, representing a $26 million decrease from the combined $157 million in interest, debt expense and preferred security distributions of subsidiary trusts recognized in 2002. This reduction was a reflection of lower outstanding debt balances, improved debt mix and lower interest rates on the Companys bank debt. In June 2003, upon its maturity, the Company paid $125 million to settle its 6.625% notes. Additionally, interest rates were decreased in the December 2002 refinancing of the Senior Credit Facility and the Company repurchased $24 million (book value) of 11.125% senior notes during the fourth quarter of 2003.
Other expense, net was $29 million for the year ended December 31, 2003, a decrease of $86 million compared to the $115 million expense for 2002. Other expense, net for the year ended December 31, 2003 included asbestos related accruals and costs of $13 million, a $2 million net gain on debt settlements and $18 million in other costs and expenses. Other expense, net for the year ended December 31, 2002 included $68 million in asbestos related accruals and costs, a $44 million charge for debt extinguishment expenses and $3 million in other costs and expenses.
The provision for income taxes on continuing operations reflected effective tax rates of 22% in 2003 and 6% in 2002. The effective tax rate for 2003 reflected the tax benefit from the donation of intellectual property to qualified organizations and the use of prior year capital losses. The effective tax rate for 2002 reflected the tax benefit of the pre-tax loss partially offset by the effect of increases to tax reserves related to anticipated tax assessments and other provisions.
Liquidity and financial resources: Net cash provided by (used in) operations was $121 million, $23 million, and $(215) million for 2004, 2003, and 2002, respectively. The improvement in operating cash flows in 2004 as compared to previous years reflected the insurance settlements related to asbestos, the favorable impact of reduced payments for interest and income taxes, decreased contributions to defined benefit pension plans, and the lower debt repayment penalties and premiums. By the end of October 2004, the Company had reached agreement with each of its insurance carriers to reimburse certain costs incurred by Hercules in defending and resolving its asbestos-related matters. As a result of these settlements, the Company recorded additional receivables totaling $49 million and during 2004 received cash payments totaling $50 million as compared to $17 million in 2003. During 2004, the Company recognized $80 million of additional asbestos-related charges in order to re-establish its total accrual to $260 million at December 31, 2004, based on the results of updated studies of its asbestos-related liabilities. Total asbestos claim payments made during 2004 of $41 million have decreased from the 2003 payments which totaled $50 million. The Company projects asbestos-related settlement payments of approximately $47 million in 2005; however, it is anticipated that these amounts as well as legal fees incurred, will be fully reimbursable via the funding provided by the insurance carriers which is held in trust. Interest and preferred security payments were reduced to $97 million in 2004 compared with $122 million and $153 million, respectively, for 2003 and 2002. The decrease in interest payments was primarily due to the Companys repurchase of approximately $174 million of its 11.125% senior notes since October 2003. Interest rates were reduced by 150 basis points through the April 2004 refinancing of the Term B loan and the August 2004 amendment to the Senior Credit Facility. The decrease in net income tax payments was primarily due to the $20 million federal tax refund received during 2004. The large amount of tax payments in 2002 was a result of the sale of the Companys BetzDearborn Water Treatment Business (Water Treatment Business). Additionally, as a result of the settlement of debt obligations with the proceeds from the sale of the Water Treatment Business, the Company incurred considerable prepayment fees during 2002. Similarly, during 2004 the Company had to pay more than the face value of its debt in order to repurchase its high yield notes. During 2004, the Company contributed $43 million to its defined benefit pension plans compared to contributions of $55 million and $92 million in 2003 and 2002, respectively.
Other significant cash flow changes as compared to previous years resulted from the Companys severance, restructuring and other exit costs. The majority of current severance payments were related to activity under the Companys Dismissal Salary and Dismissal Wage Plans. Severance and restructuring payments have been reduced to $10 million in 2004 as compared to $21 million in 2003 and $39 million in 2002 as the majority of payments related to the significant workforce reduction plan authorized by management in late 2001 have been made.
Net cash (used in) provided by investing activities was $(49) million, $49 million, and $1,659 million for 2004, 2003, and 2002, respectively. Capital expenditures of $77 million during the year ended December 31, 2004 were partially offset by $27 million of gross proceeds from the sale of the Companys minority interest in CP Kelco ApS. During 2003, the Company used the $125 million in escrowed funds from its December 2002 refinancing to redeem its 6.625% notes. The positive cash flow from the release of the escrowed funds was partially offset by $48 million of capital expenditures, $9 million for the acquisition of Jiangmen, and the recording of a $27 million investment in CRESTS Units preferred securities. As noted in further detail in Note 5 to the Consolidated Financial Statements, the $27 million investment resulted from the Companys de-consolidation of Hercules Trust II pursuant to FIN 46R. Hercules significant cash provided by investing activities in 2002 was due to receipt of $1.8 billion of proceeds from the sale of its Water Treatment Business, partially offset by $43 million of capital expenditures and by the escrow of $125 million of funds to redeem the 6.625% notes due June 2003.
Net cash used in financing activities was $74 million, $171 million, and $1,334 million for 2004, 2003, and 2002, respectively. The Company used the cash provided by operations in 2004 and 2003 to pay down its long-term debt. Funding for the pay down of indebtedness during 2002 resulted from cash provided via the Companys refinancing and business divestitures. During 2004 and 2003 the Company repurchased $150 million and $24 million, respectively of its 11.125% senior notes. The 2004 usage of cash for these payments was partially offset by the net proceeds of the Companys refinancing of its Senior Credit Facility and the private placement of the 6.75% senior subordinated notes during the second quarter of 2004. Additional cash used during 2003 was the result of the Company repaying its $125 million 6.625% notes which came due in June 2003. Cash used in 2002 is primarily due to the Companys use of approximately $1.8 billion of net proceeds from the sale of its Water Treatment Business to permanently reduce long-term debt, repaying in full several outstanding borrowings. These payments were partially offset by $450 million of additional borrowings under new refinanced agreements.
On April 8, 2004, the Company completed the refinancing of its existing Senior Credit Facility with a new $400 million term loan (the Term B Loan) and a new $150 million committed revolving credit facility (the Revolving Facility). The Company also has the ability under its new Senior Credit Facility, subject to lender approval, to borrow an additional $250 million in the form of an incremental term note. The Term B Loan matures October 8, 2010 and the Revolving Facility matures April 8, 2009 unless accelerated. Borrowings under the Term B Loan bear interest at LIBOR + 1.75% (weighted-averaged rate of 4% at December 31, 2004) with the Company holding the option to reset interest rates for one, two, three or six month periods. The new Senior Credit Facility is secured by liens on the Companys assets (including real, personal and intellectual properties) and is guaranteed by substantially all of the Companys current and future wholly owned domestic subsidiaries. The Company also completed a private placement of $250 million aggregate principal amount of 6.75% senior subordinated notes due 2029. These notes were exchanged for similar notes registered with the Securities and Exchange Commission on October 21, 2004.
Proceeds from the refinancing were used in part to fully repay the outstanding Term B loan. On May 10, 2004, proceeds from the refinancing and the issuance of the 6.75% senior subordinated notes were also used to fully redeem the Companys 9.42% junior subordinated deferrable interest debentures due 2029 distributed to the holders of the 9.42% trust preferred securities of Hercules Trust I (the Trust) upon dissolution of the Trust. As a result of the debt repayment and redemption, the Company recognized approximately $14 million of non-cash expense during the second quarter of 2004 for the write-off of unamortized debt issuance costs.
During 2003, the Board of Directors authorized the Company, from time to time, subject to market conditions and provisions of the Companys credit agreements and indentures, to repurchase up to $200 million of its outstanding indebtedness. During 2003 the Company repurchased $24 million (book value) of its 11.125% senior notes for $29 million and recorded a $5 million loss in Other expense, net. The Company repurchased an additional $131 million (book value) of its 11.125% senior notes through September 30, 2004 for $157 million. In October 2004, the Board terminated the unused portion of the initial debt repurchase program, concurrently authorizing a new $200 million debt repurchase program. During the remainder of 2004 the Company repurchased $19 million (book value) of 11.125% senior notes for $23 million under this new program. The Company recognized a $30 million loss as a result of its 2004 repurchases of debt and recorded a non-cash expense of $4 million for the write-off of the unamortized debt issuance costs related to the repurchased debt. These charges were reflected in Other expense, net. In January and March 2005, the Company acquired an additional $14 million (book value) for $17 million.
As of December 31, 2004, $81 million of the $150 million Revolving Facility under the Companys Senior Credit Facility was available for use. The Company had $69 million of outstanding letters of credit associated with its Senior Credit Facility at December 31, 2004.
Capital Structure and Commitments
Total capitalization (stockholders equity and debt) was $1.337 billion and $1.359 billion at December 31, 2004 and 2003, respectively. Total debt was $1.240 billion at December 31, 2004, a decrease of $108 million from December 31, 2003. The decrease reflects the $363 million repayment of the 9.42% junior subordinated deferrable interest debentures in April 2004, the repayment of the old Term B loan of $198 million, the repurchase of $150 million of the 11.125% senior notes throughout 2004, the net retirement of the $33 million of the 6.5% junior subordinated debentures and a reduction of $14 million for payments on term notes and other debt instruments and current amounts due on the new Term B Loan. These reductions were partially offset by the $250 million proceeds from the private placement of the 6.75% senior subordinated debentures and the $400 million net proceeds of the new Term B Loan. Total capitalization at December 31, 2003 increased $23 million from December 31, 2002 principally from improvements in the components of Accumulated other comprehensive losses. The current ratio decreased to 1.62 at December 31, 2004 compared to 1.82 at December 31, 2003. The quick ratio decreased to 1.22 at December 31, 2004 compared to 1.41 at December 31, 2003.
Capital expenditures are expected to be between $70 and $80 million per year in 2005 and 2006.
The Companys contractual commitments as of December 31, 2004 are summarized as follows:
The Company had the following commercial commitments at December 31, 2004: lines of credit of $20 million outstanding and letters of credit of $69 million, both of which may require payments in the future. If required, these commitments would be funded from general corporate funds.
The Company projects cash flow from operations will be sufficient to meet its investing and financing requirements in the next several years.
As of December 31, 2004, the Companys total debt was approximately $1,240 million, of which 66% is fixed rate indebtedness. The Companys indebtedness has significant consequences. For example, it could: increase the Companys vulnerability to economic downturns and competitive pressures; require the Company to dedicate a substantial portion of its cash flow from operations to payments on its indebtedness, thereby reducing the availability of its cash flow to fund working capital, capital expenditures, research and development efforts and other general corporate purposes; limit the Companys flexibility in planning for, or reacting to, changes in its business and the industries in which it operates or in pursuing attractive business opportunities requiring debt financing; place the Company at a disadvantage to its competitors that have less debt; and limit the Companys ability to borrow additional funds due to restrictive covenants.
The Senior Credit Facility and the indentures governing the 11.125% senior notes due 2007 and the 6.75% senior subordinated notes due 2029, which together account for a large portion of the Companys debt, contain numerous restrictive covenants, including, among other things, covenants that limit the Companys ability to: borrow money and incur contingent liabilities; make dividend or other restricted payments; use assets as security in other transactions; enter into transactions with affiliates; enter into new lines of business; issue and sell stock of restricted subsidiaries; sell assets or merge with or into other companies and make capital expenditures. In addition, the Senior Credit Facility requires the Company to meet financial ratios and tests, including maximum leverage and interest coverage levels. These restrictions could limit the Companys ability to plan for or react to market conditions or meet extraordinary capital needs and could otherwise restrict corporate activities.
The Companys ability to comply with the covenants and other terms of the Senior Credit Facility and the indentures governing the senior notes and to satisfy these and other debt obligations will depend upon the Companys current and future performance. The Companys performance is affected by general economic conditions and by financial, competitive, political, business and other factors, many of which are beyond the Companys control. The Company believes that the
cash generated from its businesses will be sufficient to enable the Company to comply with the covenants and other terms of the Senior Credit Facility and the indentures governing the senior notes and to make debt payments as they become due.
The Company and its subsidiaries may incur additional indebtedness in the future. As of December 31, 2004, the Company had a $550 million Senior Credit Facility with a syndicate of banks. Under the Senior Credit Facility, the Company has a $150 million revolving credit agreement, which permits certain additional borrowings. In addition, the Company has the option to borrow an additional $250 million in the form of a term note under the Senior Credit Facility. If new indebtedness is added to the Companys current indebtedness levels, the risks described above could increase.
Fluctuations in interest and foreign currency exchange rates affect the Companys financial position and results of operations. The Company has used several strategies to actively hedge interest rate and foreign currency exposure and minimize the effect of such fluctuations on reported earnings and cash flow (see Foreign Currency Translation and Derivative Financial Instruments and Hedging in the Summary of Significant Accounting Policies and Note 24 to the Consolidated Financial Statements). Sensitivity of the Companys financial instruments to selected changes in market rates and prices, which are reasonably possible over a one-year period, are described below. The market values for interest rate risk are calculated by the Company utilizing a third-party software model that employs standard pricing models to determine the present value of the instruments based on the market conditions as of the valuation date.
The Companys derivative and other financial instruments subject to interest rate risk consist substantially of debt instruments (see Note 24 to the Consolidated Financial Statements). At December 31, 2004 and 2003, net market value of these combined instruments was a liability of $1.265 billion and $1.386 billion, respectively. The sensitivity analysis assumes an instantaneous 100-basis point move in interest rates from their levels, with all other variables held constant. A 100-basis point increase in interest rates at December 31, 2004 and 2003 would result in a $70 million and an $85 million decrease, respectively, in the net market value of the liability. A 100-basis point decrease in interest rates at December 31, 2004 and 2003 would result in a $74 million and a $68 million increase, respectively, in the net market value of the liability.
Our financial instruments subject to foreign currency exchange risk consist of foreign currency forwards and options and represent a net asset position of $0.6 million and $1.0 million at December 31, 2004 and 2003, respectively. The following sensitivity analysis assumes an instantaneous 10% change in foreign currency exchange rates from year-end levels, with all other variables held constant. A 10% strengthening of the U.S. dollar versus other currencies at December 31, 2004 and 2003 would result in a $0.6 million increase and a $0.1 million decrease, respectively, in the net asset position, while a 10% weakening of the dollar versus all currencies would result in a $0.8 million decrease and a $0.1 million increase, respectively, in the net asset position.
Foreign exchange forward and option contracts have been used to hedge the Companys firm and anticipated foreign currency cash flows. Thus, there is either an asset or cash flow exposure related to all the financial instruments in the above sensitivity analysis for which the impact of a movement in exchange rates would be in the opposite direction and substantially equal to the impact on the instruments in the analysis. There are presently no significant restrictions on the remittance of funds generated by the Companys operations outside the United States.
The Company has not designated any derivative as a hedge instrument under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133) and, accordingly, changes in the fair value of derivatives are recorded each period in earnings.
In the ordinary course of its business, the Company is subject to numerous environmental laws and regulations covering compliance matters or imposing liability for the costs of, and damages resulting from, cleaning up sites, past spills, disposals and other releases of hazardous substances. Changes in these laws and regulations may have a material adverse effect on the Companys financial position and results of operations. Any failure by the Company to adequately comply with such laws and regulations could subject the Company to significant future liabilities.
Environmental remediation expenses are funded from internal sources of cash. Such expenses are not expected to have a significant effect on the Companys ongoing liquidity. Environmental cleanup costs, including capital expenditures for ongoing operations, are a normal, recurring part of operations and are not significant in relation to total operating costs or cash flows (see Item 3, Legal Proceedings and Notes 11 and 12 to the Consolidated Financial Statements).
Hercules is a defendant in numerous lawsuits arising out of, or incidental to, the conduct of its business. Such litigation typically falls within the following broad categories: environmental (discussed above); antitrust; commercial; intellectual property; labor and employment; personal injury; property damage; product liability; and toxic tort. While it is not feasible to predict the outcome of all pending matters, the ultimate resolution of one or more of these matters could
have a material effect upon the Companys financial position, results of operations and/or cash flows for any annual, quarterly or other period (see Item 3, Legal Proceedings and Note 12 to the Consolidated Financial Statements).
The assets and liabilities associated with the Companys defined benefit plans are subject to interest rate and market risk. A 100-basis point decrease or increase in the discount rate has approximately a plus or minus $157 million impact on the ABO. A 100-basis point decrease or increase in the discount rate has approximately a plus or minus $163 million impact on the projected benefit obligation. A 100-basis point decrease or increase in the assumed rate of return has approximately a plus or minus $11 million impact on the U.S. pension and postretirement expense estimated for 2005 (see Note 8 to the Consolidated Financial Statements).
In connection with the sale of certain assets or businesses, the Company has indemnified respective buyers against certain liabilities that may arise in connection with the sales transactions and business activities prior to the ultimate closing of the sale. These indemnifications typically pertain to environmental, tax, employee and/or product-related matters. If the indemnified party were to incur a liability or have a liability increase as a result of a successful claim, pursuant to the terms of the indemnification, the Company would be required to reimburse the buyer. These indemnifications are generally subject to threshold amounts, specified claim periods and other restrictions and limitations. As of December 31, 2004, the Company has recorded indemnifications totaling $40 million. Although it is possible that future payments may exceed amounts accrued, due to the nature of indemnified items, it is not possible to make a reasonable estimate of the maximum potential loss or range of loss.
As described in greater detail in Note 12 to the Consolidated Financial Statements, the Company has entered into comprehensive settlement agreements with each of its asbestos insurance carriers. Under the terms of these agreements and in exchange for payments made and to be received from the insurance carriers, the Company has released and indemnified the released insurers from any past, present and future claims asserted under its cancelled policies.
Recent Accounting Pronouncements
On October 22, 2004, President Bush signed The American Jobs Creation Act of 2004 (the Act). The Act included some of the most significant changes to corporate taxation since 1996 and, among other things eliminates the Extraterritorial Income Regime (ETI) over a two-year phase out period beginning in 2005. However, the phase out will still allow the Company to obtain 80% of the ETI benefit for 2005 and 60% for 2006. The Act provides for a special one-time tax deduction of 85% of certain foreign earnings that are repatriated in either an entitys last tax year that began before the enactment date or the first tax year that begins during the one-year period beginning on the date of enactment. Additionally, the Act provides for a deduction for U.S. domestic manufacturers beginning in 2005. This new deduction begins at 3% of the U.S. domestic manufacturers income for 2005 and 2006, increasing to 6% for 2007 through 2009 and achieves its maximum rate of 9% after 2009.
As a result of the accounting implications associated with the Act, the FASB issued Staff Positions FAS 109-1, Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004 (FSP 109-1) and FAS 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 (FSP 109-2) in December 2004. FSP 109-1 clarifies that the domestic manufacturing deduction should be accounted for as a special deduction to be recognized as earned, as opposed to a rate reduction, under Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. The Company is currently investigating the impact of FSP 109-1. Due to the complex nature of the ETI and foreign earnings repatriation provisions of the Act, it is anticipated that Congress or the Treasury Department will provide clarifying regulations in the near future. Accordingly, FSP 109-2 allows entities additional time beyond the financial reporting period in which the Act was enacted to evaluate the impact upon their financial statements. Both FSP 109-1 and FSP 109-2 became effective upon their issuance in December 2004. It is anticipated that FSP 109-2 will not have a material impact on the consolidated financial position, results of operations or cash flows as the Company currently repatriates all available foreign earnings. Accordingly, the special one-time tax deduction regarding certain foreign earnings, as referenced above, will not be available.
In November 2004, the FASB issued Statement of Financial Accounting Standards No. 151, Inventory Costs an amendment of ARB No. 43 (SFAS 151). SFAS 151 was one of a number of projects by the FASB to converge U.S. accounting standards to International Accounting Standards. SFAS 151 requires abnormal amounts of idle facility expenses, freight, handling costs and spoilage to be recognized as current period charges. In addition, the allocation of fixed manufacturing overhead costs to the costs of conversion is required to be based on the normal capacity of the manufacturing facilities. SFAS 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company does not expect SFAS 151 to have a material impact on its consolidated financial position, results of operations or cash flows as its current inventory and conversion cost methodologies are generally consistent with that required by the new standard.
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 153, Exchanges of Nonmonetary Assets an amendment of APB Opinion No. 29 (SFAS 153). SFAS 153 was also a result of the FASBs project to converge U.S. accounting standards to International Accounting Standards. The guidance in APB Opinion No. 29, Accounting for Nonmonetary Transactions, includes certain exceptions to the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. SFAS 153 eliminates the exception for similar productive assets and replaces it with a general exception for exchanges on nonmonetary assets that do not have commercial substance. SFAS 153 defines a nonmonetary exchange as having commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS 153 will be effective for fiscal periods beginning after June 15, 2005. The Company does not expect SFAS 153 to have a material impact on its consolidated financial position, results of operations or cash flows.
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (Revised 2004), Share-Based Payment (SFAS 123R), which is a revision of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123). SFAS 123R supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends Statement of Financial Accounting Standards No. 95, Statement of Cash Flows (SFAS 95). Generally, the approach in SFAS 123R is similar to the approach described in SFAS 123. However, SFAS 123R requires all share-based payments to employees, including grants of stock options, to be recognized in the income statement based on their fair values. The Company expects to adopt SFAS 123R effective July 1, 2005, as required. SFAS 123R permits public companies to adopt its requirements using one of two methods: (1) A modified prospective method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123R that remain unvested on the effective date; or (2) A modified retrospective method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under SFAS 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption. The Company plans to adopt SFAS 123R using the modified prospective method.
The Company previously adopted the fair-value-based method of accounting for share-based payments effective January 1, 2003 using the prospective method described in Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation Transition and Disclosure. Accordingly, the Company currently recognizes compensation cost associated with restricted stock awards and discloses the pro forma compensation cost of stock option awards. As SFAS 123R must be applied not only to new awards, but to previously granted awards, primarily stock options, that are not fully vested on the effective date, and because the Company adopted the prospective transition method, compensation cost for those previously granted awards that were not recognized under SFAS 123 will be recognized under SFAS 123R. This results from the prospective adoption of SFAS 123, which applied only to awards, principally restricted stock awards, granted, modified or settled after the adoption date of January 1, 2003. However, had the Company adopted SFAS 123R in prior periods, the impact would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net income and earnings per share in the Summary of Significant Accounting Policies. Beyond those restricted stock and stock option awards previously granted, the Company cannot predict with certainty the impact of SFAS 123R on the consolidated financial statements as such awards are determined on an annual basis and encompass a potentially wide range depending upon the incentive compensation philosophy advocated by the Human Resources Committee of the Companys Board of Directors. Compensation cost associated with previously granted stock option awards to be recognized in accordance with SFAS 123R during 2005 is expected to be less than $1 million.
SFAS 123R also requires the benefits of tax deductions in excess of compensation cost recognized in the financial statements to be reported as a financing cash flow, rather than as an operating cash flow as currently required under SFAS 95. This requirement, to the extent such benefits exist, will decrease net operating cash flows and increase net financing cash flows in periods subsequent to adoption. The Company cannot estimate what those amounts will be in the future, because they depend on, among other things, when employees exercise stock options. The amount of operating cash flows recognized in prior periods for such excess tax deductions was not material for 2004, 2003 and 2002 respectively, due to the minimal amount of options exercised during those periods.
Currently, the Company utilizes the Black-Scholes option pricing model to estimate the value of stock options granted to employees and expects to continue the use of this acceptable option valuation model upon the required adoption of SFAS 123R.
For discussion of quantitative and qualitative disclosures about market risk, see the caption Risk Factors under Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations.
INDEX TO CONSOLIDATED FINANCIAL
The management of Hercules is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. Hercules internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Because of the inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Hercules management assessed the effectiveness of the Companys internal control over financial reporting as of December 31, 2004. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on this assessment, management has concluded that, as of December 31, 2004, the Companys internal control over financial reporting was effective based on those criteria.
Managements assessment of the effectiveness of the Companys internal control over financial reporting as of December 31, 2004 has been audited by PricewaterhouseCoopers LLP, the Companys independent registered public accounting firm, as stated in their report, which appears herein.
To the Shareholders and Board of Directors
of Hercules Incorporated:
We have completed an integrated audit of Hercules Incorporateds 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Consolidated financial statements and financial statement schedule
In our opinion, the consolidated financial statements listed in the index appearing under Item 15 (a) (1) present fairly, in all material respects, the financial position of Hercules Incorporated and its subsidiaries at 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. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15 (a) (2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements 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 of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 5 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity on July 1, 2003.
As discussed in the Summary of Significant Accounting Policies, the Company adopted Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation Transition and Disclosure on January 1, 2003.
As discussed in Note 11 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations on January 1, 2003.
As discussed in Note 4 to the consolidated financial statements, the Company changed its accounting for goodwill and indefinite-lived intangible assets effective January 1, 2002, with the adoption of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets.
Internal control over financial reporting
Also, in our opinion, managements assessment, included in Managements Report on Internal Control Over Financial Reporting appearing under Item 8, that the Company maintained effective 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 (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control Integrated Framework issued by the COSO. The Companys management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on managements assessment and on the effectiveness of the Companys internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting 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 effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the
design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
The accompanying accounting policies and notes are an integral part of the consolidated financial statements.
The accompanying accounting policies and notes are an integral part of the consolidated financial statements.