Quarterly Report
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-Q

 


 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission File Number 1-71

 


HEXION SPECIALTY CHEMICALS, INC.

(Exact name of registrant as specified in its charter)

 


 

New Jersey   13-0511250
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
180 East Broad St., Columbus, OH 43215   614-225-4000
(Address of principal executive offices including zip code)   (Registrant’s telephone number including area code)

 


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.    Yes  ¨    No  x.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  ¨                Accelerated filer  ¨                Non-accelerated filer  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x.

Number of shares of common stock, par value $0.01 per share, outstanding as of the close of business on November 3, 2006: 82,556,847

 



Table of Contents

HEXION SPECIALTY CHEMICALS, INC.

INDEX

 

Item 1. Hexion Specialty Chemicals, Inc. Condensed Consolidated Financial Statements

  

Condensed Consolidated Statements of Operations and Comprehensive Loss, three months ended September 30, 2006 and 2005

   3

nine months ended September 30, 2006 and 2005

   4

Condensed Consolidated Balance Sheets, September 30, 2006 and December 31, 2005

   5

Condensed Consolidated Statements of Cash Flows, nine months ended September 30, 2006 and 2005

   7

Condensed Consolidated Statement of Common Stock and Other Shareholders’ Deficit, nine months ended September 30, 2006

   8

Notes to Condensed Consolidated Financial Statements

   9

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

   34

Item 3. Quantitative and Qualitative Disclosures about Market Risk

   53

Item 4. Controls and Procedures

   53

PART II – OTHER INFORMATION

  

Item 1. Legal Proceedings

   54

Item 1A. Risk Factors

   54

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

   54

Item 3. Defaults upon Senior Securities

   54

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

   54

Item 5. Other Information

   54

Item 6. Exhibits

   55

 

2


Table of Contents

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS (Unaudited)

HEXION SPECIALTY CHEMICALS, INC.

 

     Three Months ended September 30,  

(In millions, except for share and per share data)

   2006     2005  

Net sales

   $ 1,336     $ 1,125  

Cost of sales

     1,157       955  
                

Gross profit

     179       170  
                

Selling, general & administrative expense

     97       104  

Transaction costs (See Note 1)

     —         3  

Integration costs (See Note 1)

     21       3  

Other operating expense, net

     4       5  
                

Operating income

     57       55  
                

Interest expense, net

     61       55  

Other non-operating income, net

     (1 )     (3 )
                

(Loss) income from continuing operations before income tax, earnings from unconsolidated entities and minority interest

     (3 )     3  

Income tax expense

     11       8  
                

Loss from continuing operations before earnings from unconsolidated entities and minority interest

     (14 )     (5 )

Earnings from unconsolidated entities, net of tax

     1       —    

Minority interest in net income of consolidated subsidiaries

     —         (1 )
                

Loss from continuing operations

     (13 )     (6 )

Loss from discontinued operations (See Note 4)

     (1 )     —    
                

Net loss

     (14 )     (6 )

Accretion of redeemable preferred stock (See Note 8)

     —         12  
                

Net loss available to common shareholders

   $ (14 )   $ (18 )
                

Comprehensive loss

   $ (23 )   $ (2 )
                

Basic and Diluted Per Share Data

    

Loss from continuing operations

   $ (0.16 )   $ (0.22 )

Loss from discontinued operations

     (0.01 )     —    
                

Net loss available to common shareholders

   $ (0.17 )   $ (0.22 )
                

Common stock dividends declared

   $ 0.06     $ —    
                

Average number of common shares outstanding during the period – basic and diluted

     82,556,847       82,629,906  

See Notes to Condensed Consolidated Financial Statements

 

3


Table of Contents

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS (Unaudited)

HEXION SPECIALTY CHEMICALS, INC.

 

     Nine Months ended September 30,  

(In millions, except share and per share data)

   2006     2005  

Net sales

   $ 3,896     $ 3,301  

Cost of sales

     3,342       2,816  
                

Gross profit

     554       485  
                

Selling, general & administrative expense

     293       283  

Transaction costs (See Note 1)

     21       34  

Integration costs (See Note 1)

     45       8  

Other operating income, net

     (32 )     (4 )
                

Operating income

     227       164  
                

Interest expense, net

     171       149  

Loss on extinguishment of debt (See Note 6)

     52       17  

Other non-operating expense, net

     2       17  
                

Income (loss) from continuing operations before income tax, earnings from unconsolidated entities and minority interest

     2       (19 )

Income tax expense

     41       43  
                

Loss from continuing operations before earnings from unconsolidated entities and minority interest

     (39 )     (62 )

Earnings from unconsolidated entities, net of tax

     3       1  

Minority interest in net income of consolidated subsidiaries

     (4 )     (2 )
                

Loss from continuing operations

     (40 )     (63 )

Loss from discontinued operations (See Note 4)

     (14 )     (10 )
                

Net loss

     (54 )     (73 )

Redemption and accretion of redeemable preferred stock (See Note 8)

     33       18  
                

Net loss available to common shareholders

   $ (87 )   $ (91 )
                

Comprehensive loss

   $ (13 )   $ (127 )
                

Basic and Diluted Per Share Data

    

Loss from continuing operations

   $ (0.88 )   $ (0.98 )

Loss from discontinued operations

     (0.17 )     (0.12 )
                

Net loss available to common shareholders

   $ (1.05 )   $ (1.10 )
                

Common stock dividends declared

   $ 0.06     $ 6.66  
                

Average number of common shares outstanding during the period – basic and diluted

     82,591,905       82,629,906  

See Notes to Condensed Consolidated Financial Statements

 

4


Table of Contents

CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)

HEXION SPECIALTY CHEMICALS, INC.

 

(In millions)

   September 30,
2006
   

December 31,

2005

 

ASSETS

    

Current Assets

    

Cash and equivalents

   $ 69     $ 183  

Accounts receivable (less allowance for doubtful accounts of $20 and $19, respectively)

     760       589  

Inventories:

    

Finished and in-process goods

     322       287  

Raw materials and supplies

     201       146  

Other current assets

     98       131  

Assets of discontinued operations (See Note 4)

     —         39  
                
     1,450       1,375  
                

Other Assets

     93       103  
                

Property and Equipment

    

Land

     79       62  

Buildings

     238       205  

Machinery and equipment

     1,984       1,779  
                
     2,301       2,046  

Less accumulated depreciation

     (794 )     (655 )
                
     1,507       1,391  

Goodwill

     175       164  

Other Intangible Assets, net

     214       176  
                

Total Assets

   $ 3,439     $ 3,209  
                

See Notes to Condensed Consolidated Financial Statements

 

5


Table of Contents

CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)

HEXION SPECIALTY CHEMICALS, INC.

 

(In millions, except share and per share data)

   September 30,
2006
    December 31,
2005
 

LIABILITIES, REDEEMABLE PREFERRED STOCK, COMMON STOCK AND OTHER SHAREHOLDERS’ DEFICIT

    

Current Liabilities

    

Accounts and drafts payable

   $ 555     $ 493  

Debt payable within one year

     65       38  

Interest payable

     47       45  

Income taxes payable

     111       91  

Other current liabilities

     286       247  

Liabilities of discontinued operations (See Note 4)

     —         25  
                
     1,064       939  
                

Other Liabilities

    

Long-term debt

     2,784       2,303  

Long-term pension obligations

     183       167  

Non-pension postemployment benefit obligations

     111       119  

Deferred income taxes

     154       138  

Other long-term liabilities

     100       92  
                
     3,332       2,819  
                

Minority interest in consolidated subsidiaries

     13       11  

Commitments and Contingencies (See Note 7)

    

Redeemable Preferred Stock - $0.01 par value; liquidation preference $25 per share; 60,000,000 shares authorized, -0- and 14,781,959 issued and outstanding at September 30, 2006 and December 31, 2005, respectively (See Note 8)

     —         364  

Common Stock and Other Shareholders’ Deficit

    

Common stock - $0.01 par value; 300,000,000 shares authorized, 170,605,906 issued and 82,556,847 outstanding at September 30, 2006; 300,000,000 shares authorized, 170,678,965 issued and 82,629,906 outstanding at December 31, 2005

     1       1  

Paid-in capital

     482       515  

Treasury stock, at cost – 88,049,059 shares

     (296 )     (296 )

Accumulated other comprehensive loss

     (29 )     (70 )

Accumulated deficit

     (1,128 )     (1,074 )
                
     (970 )     (924 )
                

Total Liabilities, Redeemable Preferred Stock, Common Stock and Other Shareholders’ Deficit

   $ 3,439     $ 3,209  
                

See Notes to Condensed Consolidated Financial Statements

 

6


Table of Contents

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

HEXION SPECIALTY CHEMICALS, INC.

 

     Nine months ended
September 30,
 

(In millions)

   2006     2005  

Cash Flows from Operating Activities

    

Net loss

   $ (54 )   $ (73 )

Adjustments to reconcile net loss to net cash from operating activities:

    

Depreciation and amortization

     123       111  

Loss from discontinued operations

     14       —    

Gain on sale of businesses, net of taxes

     (34 )     —    

Write-off of deferred IPO costs

     15       —    

Write-off of deferred financing fees (See Note 6)

     9       11  

Minority interest in net income of consolidated subsidiaries

     4       2  

Stock based compensation expense

     5       10  

Deferred tax provision (benefit)

     14       (4 )

Impairments

     5       —    

Other non-cash adjustments

     21       12  

Net change in assets and liabilities:

    

Accounts receivable

     (112 )     (2 )

Inventories

     (22 )     62  

Accounts and drafts payable

     26       (91 )

Income taxes payable

     18       74  

Other assets

     25       (13 )

Other liabilities

     (50 )     4  

Net cash used in operating activities of discontinued operations (See Note 4)

     (3 )     —    
                
     4       103  
                

Cash Flows used in Investing Activities

    

Capital expenditures

     (85 )     (61 )

Capitalized interest

     (1 )     —    

Acquisition of businesses, net of cash acquired

     (181 )     (234 )

Proceeds from the sale of businesses, net of cash

     47       3  

Net cash used in investing activities of discontinued operations (See Note 4)

     —         (2 )
                
     (220 )     (294 )
                

Cash Flows from Financing Activities

    

Net short-term debt borrowings (repayments)

     18       (15 )

Borrowings of long-term debt

     2,654       1,194  

Repayments of long-term debt

     (2,158 )     (753 )

Payment of dividends on common stock

     (2 )     (523 )

Proceeds from issuance of preferred stock, net of issuance costs (See Note 8)

     —         334  

Repayment of preferred stock (See Note 8)

     (397 )     —    

Long-term debt and credit facility financing fees paid

     (17 )     (22 )

IPO related costs (See Note 1)

     (5 )     (8 )

Net cash from financing activities of discontinued operations (See Note 4)

     1       2  
                
     94       209  
                

Effect of exchange rates on cash and equivalents

     8       (6 )

(Decrease) increase in cash and equivalents

     (114 )     12  

Cash and equivalents at beginning of period

     183       152  
                

Cash and equivalents at end of period

   $ 69     $ 164  
                

Supplemental Disclosures of Cash Flow Information

    

Cash paid:

    

Interest, net

   $ 163     $ 134  

Debt redemption costs

     43       6  

Income taxes, net

     14       4  

Non-cash activity:

    

Settlement of note receivable from parent

   $ —       $ 581  

Unpaid common stock dividends declared

     3       27  

Redeemable preferred stock accretion (See Note 8)

     —         18  

See Notes to Condensed Consolidated Financial Statements

 

7


Table of Contents

CONDENSED CONSOLIDATED STATEMENT OF COMMON STOCK AND OTHER SHAREHOLDERS’ DEFICIT (Unaudited)

HEXION SPECIALTY CHEMICALS, INC.

 

(In millions)

   Common
Stock
   Paid-in
Capital
    Treasury
Stock
    Accumulated
Other
Comprehensive
Loss (a)
    Accumulated
Deficit
    Total  

Balance, December 31, 2005

   $ 1    $ 515     $ (296 )   $ (70 )   $ (1,074 )   $ (924 )
                                               

Net loss

     —        —         —         —         (54 )     (54 )

Change in unrealized loss on derivative instruments, net of tax

     —        —         —         (6 )     —         (6 )

Translation adjustments

     —        —         —         47       —         47  
                   

Comprehensive loss

     —        —         —         —         —         (13 )
                   

Stock based compensation expense

     —        5       —         —         —         5  

Redemption and accretion of redeemable preferred stock (See Note 8)

     —        (33 )     —         —         —         (33 )

Common stock dividends declared

     —        (5 )     —         —         —         (5 )
                                               

Balance, September 30, 2006

   $ 1    $ 482     $ (296 )   $ (29 )   $ (1,128 )   $ (970 )
                                               

(a) Accumulated other comprehensive loss at September 30, 2006 represents $69 net foreign currency translation gains, a $6 unrealized loss on derivative instruments, net of tax, and a $92 net loss relating to the Company’s minimum pension liability adjustment. Accumulated other comprehensive loss at December 31, 2005 represents $22 of net foreign currency translation gains and a $92 net loss relating to the Company’s minimum pension liability adjustment.

See Notes to Condensed Consolidated Financial Statements

 

8


Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

(In millions, except share data)

1. Background and Basis of Presentation

Hexion Specialty Chemicals, Inc. (“Hexion” or “the Company”) is engaged in the manufacture and marketing of resins, inks, coating and adhesive resins, formaldehyde, oil field products and other specialty and industrial chemicals worldwide. At September 30, 2006, the Company has 103 production and manufacturing facilities, of which 38 are located in the U.S.

Hexion was formed on May 31, 2005 upon the combination of three Apollo Management, L.P. (“Apollo”) controlled companies (the “Combinations”), Resolution Performance Products, LLC (“Resolution Performance”), Resolution Specialty Materials, Inc. (“Resoluton Specialty”) and Borden Chemical, Inc. (“Borden Chemical”). Upon consummation of the Combinations, Borden Chemical changed its name to Hexion Specialty Chemicals, Inc., and BHI Acquisition LLC (“BHI Acquisition”), Borden Chemical’s parent, changed its name to Hexion LLC. Prior to the Combinations, on April 29, 2005, a subsidiary of Borden Chemical completed the acquisition of Bakelite Aktiengesellschaft (“Bakelite” or the “Bakelite Acquisition”).

During the three and nine months ended September 30, 2005, the Company incurred costs totaling approximately $3 and $34, respectively, primarily for accounting, consulting, legal and contract termination fees in connection with the Combinations. As the Combinations transaction was considered a merger of entities under common control, in accordance with Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations, related costs have been expensed as incurred and are included in the Condensed Consolidated Statements of Operations and Comprehensive Loss as Transaction costs.

On April 25, 2005, the Company filed a registration statement with the U.S. Securities and Exchange Commission (the “SEC”) for a proposed initial public offering (“IPO”) of its common stock. The Company subsequently filed ten amendments to its registration statement from May 2, 2005 through June 19, 2006. On June 21, 2006, the Company announced that it was temporarily suspending its IPO due to adverse market conditions and issued a request to withdraw its registration statement with the SEC on October 12, 2006. For the nine months ended September 30, 2006, write-off of previously deferred accounting, legal, and printing costs associated with the Company’s proposed IPO of $15, as well as costs associated with terminated acquisition activities are included in Transaction costs on the Condensed Consolidated Statements of Operations and Comprehensive Loss.

In addition, the Company has incurred costs totaling approximately $3 and $8 during the three and nine months ended September 30, 2005, respectively, and $21 and $45 during the three and nine months ended September 30, 2006, respectively, primarily related to redundancy and plant rationalization costs and incremental administrative costs associated with integration programs as a result of the Combinations and recent acquisitions. These costs include the implementation of a single, company wide, management information and accounting system. These costs are included in the Condensed Consolidated Statements of Operations and Comprehensive Loss as Integration costs.

Basis of Presentation—Prior to the Combinations, Resolution Performance, Resolution Specialty and Borden Chemical were considered entities under the common control of Apollo affiliates as defined in Emerging Issues Task Force Issue No. 02-5, Definition of Common Control in Relation to FASB Statement of Financial Accounting Standards No. 141, “Business Combinations”. As a result of the Combinations, the financial statements of these entities are presented retroactively on a consolidated basis in a manner similar to a pooling of interests, and include the results of operations of each business only from the date of acquisition by the Apollo affiliates.

In the opinion of management, all adjustments, consisting only of normal, recurring adjustments considered necessary for a fair presentation, have been included. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These unaudited Condensed Consolidated Financial Statements should be read in conjunction with the financial statements, accounting policies and notes included in the Company’s audited financial statements for the year ended December 31, 2005. Results for the interim periods are not necessarily indicative of results for the full year.

 

9


Table of Contents

2. Summary of Significant Accounting Policies

The following is an update of the significant accounting policies followed by the Company:

Principles of Consolidation—The Condensed Consolidated Financial Statements include the accounts of the Company and its majority-owned subsidiaries, in which minority shareholders hold no substantive participating rights, after elimination of intercompany accounts and transactions. The Company’s share of the net earnings of 20% to 50% owned companies, for which it has the ability to exercise significant influence over operating and financial policies (but do not control), are included in income on an equity basis. Investments in the other companies are carried at cost. The Company has recorded a minority interest for the equity interests in subsidiaries that are not 100% owned by the Company.

Earnings Per Share – At the date of the Combinations, the Company’s capital structure consisted of 82,629,906 shares outstanding. For purposes of calculating earnings per share, 82,629,906 was used as the number of weighted average shares outstanding for the three and nine months ended September 30, 2005 as no new shares were issued as a result of the legal merger of Resolution Performance, Resolution Specialty and Borden Chemical. This presentation reflects the post-merger capital structure of the Company for all periods on a consistent basis. For the three and nine months ended September 30, 2006, the number of weighted average shares reflects the cancellation of 73,059 shares that were contributed by the Company’s parent in May 2006. The Company did not have any potentially dilutive instruments outstanding for any periods.

Stock-Based Compensation—Effective January 1, 2005, the Company elected to adopt SFAS No. 123(R) (revised 2004), Share-Based Payment. Under the provisions of SFAS No. 123(R), stock-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the requisite service period. As the Company was considered a nonpublic entity, at the date of adoption, that used the minimum value method for pro forma disclosures under SFAS No. 123, Accounting for Stock-Based Compensation, the Company is required to apply the prospective transition method. As such, the Company applies the statement to any new awards and to any awards modified, repurchased or cancelled since January 1, 2005.

Reclassifications—Where appropriate, the prior period financial statements reflect reclassifications to conform to the current period presentation. Such reclassifications with regard to the Condensed Consolidated Statements of Operations and Comprehensive Loss for the three and nine months ended September 30, 2005, largely consisted of a breakout between Transaction costs and Integration costs to allow for a more meaningful presentation, and did not have an impact on total Operating income.

Recently Issued Accounting Standards

In June 2006, the FASB issued Interpretation (“FIN”) No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109. This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken, or expected to be taken, in a tax return. This interpretation is effective for fiscal years beginning after December 15, 2006. The Company is currently assessing the impact of the Interpretation on its consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This statement establishes a standard definition for fair value, establishes a framework under generally accepted accounting principles for measuring fair value and expands disclosure requirements for fair value measurements. This statement is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company is currently assessing the impact of the statement on its consolidated financial statements.

In September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106 and 132(R). This statement requires an employer to recognize the overfunded or underfunded status of defined benefit pension and postretirement plans as an assets or liabilities in its statement of financial position. Under SFAS No. 158, unrecognized actuarial gains and losses, prior service costs and credits and any remaining unrecognized transition amounts, net of their related income tax effect, will be reported as a component of Accumulated other comprehensive income. Incremental changes in these amounts not recognized in the statements of operations in the same year they arise are recognized in the year in which

 

10


Table of Contents

the changes occur as changes in other comprehensive income. The statement also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position. The requirement to recognize the funded status of defined benefit pension and postretirement plans is effective for fiscal years ending after December 15, 2006 for companies with publicly traded stock, and June 15, 2007 for all other companies. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position is effective for the fiscal years ending after December 15, 2008. While the Company currently measures plan assets and benefit obligations at each fiscal year-end, the Company is evaluating the impact that the other aspects of this Statement will have on its consolidated financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of prior-year uncorrected misstatements should be considered when quantifying misstatements in the current year financial statements. SAB 108 requires registrants to quantify misstatements using both an income statement (“rollover”) and balance sheet (“iron curtain”) approach and evaluate whether either approach results in a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. If prior year errors that had been previously considered immaterial now are considered material based on either approach, no restatement is required so long as management properly applied its previous approach and all relevant facts and circumstances were considered. If prior years are not restated, a cumulative effect adjustment is recorded in opening accumulated earnings (deficit) as of the beginning of the fiscal year of adoption. SAB 108 is effective for fiscal years ending on or after November 15, 2006, with earlier adoption encouraged. The Company is currently assessing the impact of SAB 108 on its consolidated financial statements.

3. Acquisitions and Divestitures

Acquisitions

The Company accounts for acquisitions using the purchase method of accounting. Accordingly, results of operations of the acquired entities have been included from the date of acquisition, and any excess of purchase price over the sum of amounts assigned to identified assets and liabilities has been recorded as goodwill. Fair values are based upon preliminary appraisals, internal studies and analyses and are subject to final adjustments.

On January 31, 2006, the Company completed the purchase of the decorative coatings and adhesives business unit of The Rhodia Group (the “Coatings Acquisition”). The business generated 2005 sales of approximately $200, with eight manufacturing facilities in Europe and Asia Pacific. On March 1, 2006, the Company acquired the global wax compounds business of Rohm and Haas (the “Wax Compound Acquisition”). The business generated 2005 sales of approximately $10. The purchase included Rohm and Haas’ wax compounds technology and product lines, manufacturing equipment and other business assets. On June 1, 2006, the Company acquired the ink and adhesive resins business of Akzo Nobel (the “Inks Acquisition”). The business generated 2005 sales of approximately $215 and includes ten manufacturing facilities in Europe, Asia Pacific, North America and South America. The aggregate purchase price, net of cash acquired, for the three acquisitions, including related direct costs, was $181. The proforma effects of the acquisitions are not material. On October 20, 2006 an application was filed by certain of our customers with the Court of First Instance to annul the European Commission’s decision permitting the Inks Acquisition. The Commission has asked the Company to intervene and support the defense of its decision permitting the acquisition.

Divestitures

On March 31, 2006, the Company sold Alba Adesivos Industria e Comercio Ltda. (“Alba Adesivos”), a consumer adhesives company based in Boituva, Brazil (the “Brazilian Consumer Divestiture”). Alba Adesivos is a producer of branded consumer and professional grade adhesives. The company generated 2005 sales of $38 and has approximately 140 employees. Due to the Company’s significant continuing involvement in the operations of Alba Adesivos as a result of a tolling agreement, the sale does not qualify for presentation as a discontinued operation. On March 31, 2006, the Company also completed the sale of its remaining 10% interest in Japan Epoxy Resin Co., Ltd., to its joint venture partner. The joint venture interest was accounted for using the cost method. On June 1, 2006, the Company completed the sale of an additional 5% interest in HA-International, LLC (“HAI”), a joint venture between the Company and Delta-HA, Inc. At September 30, 2006, the Company’s remaining economic interest in HAI is 60%. The Company recognized gains totaling $40 related to these divestitures ($31 million on an after tax basis) that are included in Other operating income, net for the nine months ended September 30, 2006.

 

11


Table of Contents

4. Discontinued Operations

On August 1, 2006, the Company sold its Taro Plast S.p.A. business (“Taro Plast”), which was acquired in the Bakelite Acquisition and formerly reported in the Epoxy and Phenolic Resins segment. Accordingly, Taro Plast has been reported as discontinued operations for all periods presented. The aggregate carrying value of the discontinued business was a net asset of $14 at December 31, 2005. Taro Plast has been classified separately in the Condensed Consolidated Balance Sheet at December 31, 2005 as discontinued operations. The major classes of assets and liabilities of discontinued operations included in the Consolidated Balance Sheet at December 31, 2005 are summarized as follows:

 

     December 31,
2005

Assets:

  

Accounts receivable (less allowance for doubtful accounts)

   $ 16

Inventories

     12

Other current assets

     1

Property and equipment, net

     5

Goodwill and Other intangible Assets, net

     5
      

Total assets of discontinued operations

   $ 39
      

Liabilities:

  

Accounts and drafts payable

   $ 9

Debt payable within one year

     13

Other current liabilities

     1

Other long-term liabilities

     2
      

Total liabilities of discontinued operations

   $ 25
      

Loss from discontinued operations in the Condensed Consolidated Statements of Operations and Comprehensive Loss for the three months ended September 30, 2006 and 2005 related to the Taro Plast sale are as follows:

 

     2006     2005

Net sales

   $ 4     $ 9

Loss from discontinued operations

     (1 )     —  

Loss from discontinued operations in the Condensed Consolidated Statements of Operations and Comprehensive Loss for the nine months ended September 30, 2006 and 2005 related to the Taro Plast sale are as follows:

 

     2006     2005

Net sales

   $ 28     $ 16

Loss from discontinued operations

     (14 )     —  

Loss from discontinued operations for the nine months ended September 30, 2006 includes an impairment charge of $13, which represents the amount by which the carrying amount of the net assets of Taro Plast exceeded the estimated fair value of the business less its estimated costs to sell. As the Company is party to a participation exemption, there is no tax benefit on the capital loss for the three or nine months ended September 30, 2006.

In 1998, pursuant to a merger and recapitalization transaction sponsored by The Blackstone Group (“Blackstone”) and financing arranged by The Chase Manhattan Bank (“Chase”), Borden Decorative Products Holdings, Inc. (“BDPH”), a wholly owned subsidiary of the Company, was acquired by Blackstone, which subsequently merged with Imperial Wallcoverings to create Imperial Home Décor Group (“IHDG”). Blackstone

 

12


Table of Contents

provided $85 in equity, a syndicate of banks provided $198 of senior secured financing and $125 of senior subordinated notes were privately placed. The Company received approximately $309 in cash and 11% of IHDG common stock for its interest in BDPH. On January 5, 2000, IHDG filed for reorganization under Chapter 11 of the U.S. Bankruptcy Code. IHDG emerged from bankruptcy in April 2001. The IHDG Litigation Trust (the “Trust”) was created pursuant to the plan of reorganization in the IHDG bankruptcy to pursue preference and other avoidance claims on behalf of the unsecured creditors of IHDG. In November 2001, the Trust filed a lawsuit against the Company and certain of its affiliates seeking to have the IHDG transaction voided as a fraudulent conveyance and asking for a judgment to be entered against the Company for $314 plus interest, costs and attorney fees. On June 8, 2005, the Company reached an agreement with the parties to settle and release all claims against the Company. The Company’s portion of the claim payment is $15. As the settlement directly relates to a divested business, which was accounted for as a discontinued operation in 1997, the Company has included the settlement cost in Loss from discontinued operations in its Financial Statements for the three and nine months ended September 30, 2005.

In 1996 and 1997, the Company sold its Dairy and Foods businesses. Both disposals were accounted for as discontinued operations in those years. In 2005, the Company received $5 million as settlement from a class action suit related to raw material purchases by the divested businesses between July 21, 1991 and June 30, 1995. As the settlement directly relates to the previously divested businesses, the Company has included the settlement proceeds in Loss from discontinued operations in its Financial Statements for the three and nine months ended September 30, 2005.

Typically, losses from discontinued operations are recorded in the financial statements net of tax; however, the Company has a full valuation allowance on its domestic deferred tax assets and is unable to realize an income tax benefit from these losses, thus the corresponding benefit of the Loss from discontinued operations for the three and nine months ended September 30, 2005 has been offset by a full valuation allowance.

5. Related Party Transactions

Administrative Service, Management and Consulting Arrangements

In connection with their respective acquisitions by Apollo, Resolution Performance, Resolution Specialty and Borden Chemical entered into certain management, consulting and transaction fee agreements with Apollo and its affiliates for the provision of certain structuring and advisory services. These agreements allowed Apollo and its affiliates to provide certain advisory services to the companies for terms up to ten years. The companies also agreed to indemnify Apollo and its affiliates and their directors, officers and representatives for potential losses relating to the services contemplated under these agreements. Prior to the Combinations, on May 31, 2005, Resolution Performance and Resolution Specialty terminated their agreements with Apollo, thereby releasing any and all obligations and liabilities by all parties under the respective agreements. In consideration of the terminations, Resolution Performance and Resolution Specialty paid Apollo $4 and $7, respectively. These amounts are included within Transaction costs in the Company’s Consolidated Statements of Operations and Comprehensive Loss for the nine months ended September 30, 2005.

At the time of the Combinations, the Company entered into a seven-year, amended and restated version of the former Borden Chemical management consulting agreement with Apollo (the “Amended Management Consulting Agreement”). The terms of the Amended Management Consulting Agreement currently provide for annual fees of approximately $3 and provide for a lump-sum settlement equal to the net present value of the remaining annual management fees payable under the remaining term of the agreement in connection with a sale of the Company or an IPO.

Pursuant to the agreements in effect, during the three months ended September 30, 2006 and 2005, the Company expensed fees of $1 and less than $1, respectively. For the nine months ended September 30, 2006 and 2005, the Company expensed fees of $2 and $3, respectively. These amounts are included within Other operating (income) expense, net in the Company’s Consolidated Statements of Operations and Comprehensive Loss.

In connection with the Bakelite Acquisition, in exchange for deal structuring and negotiating provided by Apollo, the Company made payments to Apollo in the amount of $4. These amounts are considered direct costs of the acquisition and have been capitalized as part of the purchase price.

 

13


Table of Contents

Other Transactions and Arrangements

The Company sells finished goods to a former unconsolidated joint venture of the Company and certain Apollo affiliates. These sales totaled $2 and $7 for the three months ended September 30, 2006 and 2005, respectively, and totaled $8 and $20 for the nine months ended September 30, 2006 and 2005, respectively. Accounts receivable from these affiliates totaled $1 and $2 at September 30, 2006 and December 31, 2005, respectively. The Company also purchases raw materials and services from certain Apollo affiliates. These purchases totaled $3 and less than $1 for the three months ended September 30, 2006 and 2005, respectively, and totaled $7 and $4 for the nine months ended September 30, 2006 and 2005, respectively. At September 30, 2006 and December 31, 2005, the Company had accounts payable to Apollo and affiliates of less than $1 related to these purchases.

6. Debt

Debt outstanding at September 30, 2006 and December 31, 2005 is as follows:

 

     September 30, 2006    December 31, 2005
     Long-Term    Due Within
One Year
   Long-Term    Due Within
One Year

Revolving Credit Facilities

   $ 50    $ —      $ —      $ —  

Senior Secured Notes:

           

8% Senior secured notes due 2009 (includes $1 of unamortized debt premium at December 31, 2005) (a)

     —        —        141      —  

9.5% Senior second secured notes due 2010 (includes $2 of unamortized debt premium at December 31, 2005)(a)

     —        —        202      —  

9% Second-priority senior secured notes due 2014

     325      —        325      —  

Floating rate second-priority senior secured notes due 2010 (includes $1 of unamortized debt discount at September 30, 2006 and $2 at December 31, 2005)

     299      —        298      —  

Credit Agreement: term loans due 2013

     1,608      16      493      5

Debentures:

           

9.2% debentures due 2021

     115      —        115      —  

7.875% debentures 2023

     247      —        247      —  

Sinking fund debentures: 8.375% due 2016

     78      —        78      —  

13.5% Senior subordinated notes due 2010 (includes $8 of unamortized debt premium at December 31, 2005) (a)

     —        —        336      —  

Other:

           

Industrial Revenue Bonds due 2009

     34      —        34      —  

Other

     17      6      23      7

Capital Leases

     11      1      11      1
                           

Total current maturities of long-term debt

        23         13

Short-term debt (primarily foreign bank loans)

     —        42      —        25
                           

Total debt

   $ 2,784    $ 65    $ 2,303    $ 38
                           

(a) December 31, 2005 balance includes purchase accounting adjustments as a result of the acquisition of minority interests. These adjustments have been reflected as unamortized debt premiums.

At September 30, 2006 and December 31, 2005, the Company was in compliance with the material covenants and restrictions in all of the Company’s credit facilities and indentures.

Senior Secured Credit Facilities

In May 2006, the Company amended and restated its senior secured credit facilities. The seven-year $1,625 term loan facility, seven-year $50 synthetic letter of credit facility (“LOC”), and five-year $225 revolving credit facility (the “New Senior Secured Credit Facilities”), are each subject to an earlier maturity date, on any date that there is greater than $200 in the aggregate principal amount of certain of the Company’s indebtedness that will mature within 91 days of such date. Repayment of 1% total per annum of the term loan and LOCs must be made (in the case of the term loan

 

14


Table of Contents

facility, quarterly, in the case of the LOC, annually) with the balance payable upon the final maturity date. Further, the Company may be required to make additional repayments on the term loan beginning in 2008 if excess cash flow is generated and upon specified events.

The interest rates with respect to term loans to the Company under the New Senior Secured Credit Facilities are based on, at the Company’s option, (a) adjusted LIBOR plus 2.00% or (b) the higher of (i) JPMorgan Chase Bank, N.A.’s (JPMCB) prime rate or (ii) the Federal Funds Rate plus 0.50%, in each case plus 0.50%. Term loans to the Netherlands subsidiary are at the Company’s option, (a) EURO LIBOR plus 2.00% or (b) the rate quoted by JPMCB as its base rate for such loans plus 0.50%. The foregoing margins are subject to reduction if certain corporate credit ratings are achieved. The weighted average interest rate on the term loans in effect at September 30, 2006 was approximately 7.5%.

The New Senior Secured Credit Facilities have commitment fees (other than with respect to the LOC) equal to 0.50% per annum of the unused line plus a fronting fee of 0.25% of the aggregate face amount of outstanding letters of credit. The LOC has a commitment fee of 0.10% per annum.

Certain of the Company’s subsidiaries, excluding HAI, guarantee the obligations under the New Senior Secured Credit Facilities. The New Senior Secured Credit Facilities are secured by substantially all the assets of the Company and the subsidiary guarantors, subject to certain exceptions.

The credit agreement contains, among other provisions, restrictive covenants regarding indebtedness, payments and distributions, mergers and acquisitions, asset sales, affiliate transactions, capital expenditures and the maintenance of a certain financial ratio. Payment of borrowings under the New Senior Secured Credit Facilities may be accelerated if there is an event of default. Events of default include the failure to pay principal and interest when due, a material breach of representation or warranty, covenant defaults, events of bankruptcy and a change of control.

Upon entering into these New Senior Secured Credit Facilities, the Company repaid all amounts outstanding under its existing term loan and synthetic letter of credit facilities.

Senior Secured Notes, Senior Subordinated Notes and Series A Preferred Stock

On April 20, 2006, the Company made tender offers to repurchase all of its outstanding 8% Senior Secured Notes, 9.5% Senior Second Secured Notes and 13.5% Senior Subordinated Notes. As of the expiration of the tender offers on May 17, 2006, the Company accepted tenders from holders of 100% of the outstanding principal amount of the 8% Senior Secured Notes, 99.9% of the outstanding principal amount of the 9.5% Senior Second Secured Notes and 89.0% of the outstanding principal amount of the 13.5% Senior Subordinated Notes. On June 18, 2006, the Company redeemed all of its 9.5% Senior Second Secured Notes and 13.5% Senior Subordinated Notes that remained outstanding with available cash.

On May 12, 2006, the Company redeemed all of its outstanding Series A Preferred Stock with the proceeds of borrowings under its New Senior Secured Credit Facilities (See Note 8).

Upon completion of the tender and amendment of the senior secured credit facilities, for the nine months ended September 30, 2006, the Company recognized a loss on the extinguishment of debt of $52, consisting of redemption costs net of debt premiums and the write-off of deferred financing costs. The Company incurred financing costs of $17 related to the New Senior Secured Credit Facilities. These costs are included within Other assets on the Condensed Consolidated Balance Sheet and will be amortized over the life of the related debt.

On November 3, 2006, the Company amended and restated its New Senior Secured Credit Facilities, issued new Second-Priority Senior Secured Notes, repaid certain existing debt and paid a dividend on its common stock (collectively, the “Hexion Recapitalization”) (See Note 13).

Interest Rate Swap Agreements

On May 10, 2006, the Company entered into interest rate swap agreements with two counterparties. The swaps are three-year agreements designed to offset cash flow variability associated with interest rate fluctuations on the Company’s variable rate debt. The initial aggregate notional amount of the swaps is $1,000, which amortizes on a quarterly basis based on expected payments on the Company’s term loan in order to maintain a fixed to variable debt ratio of approximately 70% fixed to 30% variable. Under the interest rate swaps, the Company pays a fixed rate equal

 

15


Table of Contents

to approximately 7.37% and receives a variable rate based upon the terms of the underlying debt. The Company accounts for the swaps as qualifying cash flow hedges in accordance with SFAS No. 133, as amended by SFAS No. 138 and SFAS No. 149. As such, the effective portion of the change in fair value of the derivatives is recorded as a component of Accumulated other comprehensive loss and will be recognized in the income statement when the hedged cash flows affect earnings.

7. Commitments and Contingencies

Environmental Matters

Because the Company’s operations involve the use, handling, processing, storage, transportation and disposal of hazardous materials, the Company is subject to extensive environmental regulation at the Federal, state and local levels as well as foreign laws and regulations, and therefore is exposed to the risk of claims for environmental remediation or restoration. In addition, violations of environmental laws or permits may result in restrictions being imposed on operating activities, substantial fines, penalties, damages or other costs, any of which could have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows.

Accruals for environmental matters are recorded following the guidelines of Statement of Position 96-1, “Environmental Remediation Liabilities,” when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. Environmental accruals are reviewed on an interim basis and as events and developments warrant.

The Company has recorded liabilities, relating to 67 locations (70 at December 31, 2005), of approximately $39 and $40 at September 30, 2006 and December 31, 2005, respectively, for all probable environmental remediation, indemnification and restoration liabilities. These amounts include estimates of unasserted claims the Company believes are probable of loss and reasonably estimable. Based on the factors discussed below, and currently available information and analysis, the Company believes that it is reasonably possible that costs associated with such sites may fall within a range of $25 to $76, in the aggregate, at September 30, 2006. This estimate of the range of reasonably possible costs is less certain than the estimates upon which the liabilities are based, and in order to establish the upper end of such range, assumptions less favorable to the Company among the range of reasonably possible outcomes were used. As with any estimate, if facts or circumstances change, the final outcome could differ materially from these estimates.

Following is a more detailed discussion of the Company’s environmental liabilities and related assumptions at September 30, 2006:

BCP Geismar Site—The Company formerly owned a basic chemicals and polyvinyl chloride business which was taken public as Borden Chemicals and Plastics Operating Limited Partnership (“BCPOLP”) in 1987. Borden Chemical retained a 1% interest and the general partner interest, which were held by its subsidiary, BCP Management (“BCPM”). Borden Chemical also retained the liability for certain environmental matters after BCPOLP’s formation. Under a Settlement Agreement approved by the United States Bankruptcy Court for the District of Delaware among Borden Chemical, BCPOLP, BCPM, the United States Environmental Protection Agency and the Louisiana Department of Environmental Quality, Borden Chemical agreed to perform certain of BCPOLP’s obligations with respect to environmental conditions at BCPOLP’s Geismar, Louisiana site. These obligations are related to soil and groundwater contamination at the Geismar site. The Company bears the sole responsibility for these obligations, as there are no other potentially responsible parties (“PRPs”) or third parties from which the Company can seek reimbursement, and no additional insurance recoveries are expected.

A groundwater pump and treat system for the removal of contaminants is operational, and natural attenuation studies are proceeding. The Company has performed extensive soil and groundwater testing. Regulatory agencies are reviewing the current findings and remediation efforts. If closure procedures and remediation systems prove inadequate, or if additional contamination is discovered, this could result in the costs approaching the higher end of the range of possible outcomes discussed below.

The Company has recorded a liability of approximately $19 and $20 at September 30, 2006 and December 31, 2005, respectively, related to the BCP Geismar site. Based on currently available information and analysis, the

 

16


Table of Contents

Company believes that it is reasonably possible that costs associated with this site may fall within a range of $11 to $30, depending upon the factors discussed above. Due to the long-term nature of the project, the reliability of the timing of remediation payments and the ability to estimate remediation payments, a portion of this liability was recorded at its net present value, assuming a 3% discount rate and a time period of thirty years. The range of possible outcomes is discounted similarly. The undiscounted liability is approximately $24 over thirty years with payments of $7 to be paid ratably between 2006 and 2010.

Superfund Sites / Offsite Landfills—The Company is currently involved in environmental remediation activities at 31 sites (29 at December 31, 2005) in which it has been notified that it is, or may be, a PRP under the United States Comprehensive Environmental Response, Compensation and Liability Act or similar state “superfund” laws. The Company has recorded a liability of approximately $9 at September 30, 2006 and December 31, 2005 related to these sites. The Company anticipates approximately 50% of this liability will be paid within the next five years, with the remaining payments occurring over the next twenty-five years. Based on currently available information and analysis, the Company believes that it is reasonably possible that costs associated with such sites may be as low as $6 or as high as $16, in the aggregate. The Company generally does not bear a significant level of responsibility for these sites, and therefore, has little control over the costs and timing of cash flows. At 18 of the 31 superfund / offsite landfill sites, the Company’s share is less than 1%. At the remaining 13 sites, where the Company’s share exceeds 1%, the Company’s recorded liability was $8 and $7 at September 30, 2006 and December 31, 2005, respectively. In estimating both its current reserves for environmental remediation at these sites and the possible range of additional costs, the Company has not assumed that it will bear the entire cost of remediation of every site to the exclusion of other known PRPs who may be jointly and severally liable. The Company has limited information to assess the viability of other PRPs and their probable contribution on a per site basis. The range of possible outcomes also takes into account the maturity of each project, which results in a more narrow range as the project progresses. The Company’s ultimate liability will depend on many factors including its volumetric share of waste, the financial viability of other PRPs, the remediation methods and technology used, the amount of time necessary to accomplish remediation, and the availability of insurance coverage. The Company’s insurance provides very limited, if any, coverage for these environmental matters.

Sites Under Current Ownership—The Company is conducting environmental remediation at 12 locations (15 at December 31, 2005) currently owned by the Company, of which 3 sites are no longer operating. There are no other parties responsible for remediation at these sites. Much of the remediation is being performed by the Company on a voluntary basis; therefore, the Company has greater control over the costs to be incurred and the timing of cash flows. The Company has accrued approximately $7 at September 30, 2006 and December 31, 2005 for remediation and restoration liabilities at these locations. The Company anticipates approximately $3 of these liabilities will be paid within the next three years, with the remaining amounts being paid over the next ten years. Based on currently available information and analysis, the Company believes that it is reasonably possible that costs associated with such sites may fall within a range of $5 to $13, in the aggregate. The factors influencing the ultimate outcome include the methods of remediation to be elected, the conclusions and assessment of site studies remaining to be completed and the time period required to complete the work.

Other Sites—The Company is conducting environmental remediation at 10 locations that it formerly owned. The Company has accrued approximately $2 and $3 at September 30, 2006 and December 31, 2005, respectively, for remediation and restoration liabilities at these locations. Based on currently available information and analysis, the Company believes that it is reasonably possible that costs associated with such sites may fall within a range of $2 to $13, in the aggregate. The primary drivers in determining the final costs to the Company on these matters are the method of remediation selected and the level of participation of third parties.

In addition, the Company is responsible for 12 sites (14 at December 31, 2005) that require monitoring where no additional remediation is expected and has also established accruals for other related costs, such as fines and penalties. The Company has accrued approximately $2 and $1 at September 30, 2006 and December 31, 2005, respectively, related to these sites. Based on currently available information and analysis, the Company believes that it is reasonably possible that costs associated with such sites may fall within a range of $1 to $4 in the aggregate. Payment of these liabilities is anticipated to occur over the next ten years. The ultimate cost to the Company will be influenced by any variations in projected monitoring periods or by findings that are better or worse than anticipated findings.

 

17


Table of Contents

The Company formerly operated the Smith Douglass fertilizer business, which included a phosphate processing operation in Manatee County, Florida and an animal food processing operation in Hillsborough County, Florida. Both operations were sold in 1980. The EPA sent the Company and another former owner of the Manatee County facility a request for $0.1 relating to oversight costs incurred when the site was abandoned by its current owner. The Company is disputing the charge. The Company is aware that state and Federal environmental agencies have taken measures to prevent the off-site release of water from rainfall that accumulated in the drainage ditches and lagoons surrounding the gypsum piles located on this site. The Company is aware that the current owner of the Hillsborough County site ceased operations in March 2004 and is working with governmental agencies to effect closure of that site. At this time, the Company has received an information request from the EPA but has not received any demands from any governmental agencies or others regarding the closure and environmental cleanup at this site, which the Company believes is the responsibility of the current owner. While it is reasonably possible some costs could be incurred related to these sites, the Company has inadequate information to enable it to estimate a potential range of liability, if any.

As a result of the Bakelite Acquisition, the Company acquired a site in Duisburg, Germany with significant soil and groundwater contamination beneath a facility that is shared with Rütgers Chemicals AG (“Rütgers”). Rütgers is in discussions with the local authorities concerning a proposed remediation plan; however, the scope and extent of that plan and the costs of its possible implementation are not yet reasonably estimable. Rütgers has contractually agreed to provide indemnifications to the Company with respect to this matter until 2025, subject to certain exceptions and limitations. Management believes that it is unlikely that the Company will have to take extensive actions for remediation. While it is reasonably possible some costs could be incurred related to these sites, the Company has inadequate information to enable it to estimate a potential range of liability, if any.

For environmental conditions that existed at Resolution Performance sites prior to November 2000, the Royal Dutch/Shell Group of Companies (“Shell”) generally will indemnify the Company for environmental damages associated with environmental conditions that occurred or existed before the recapitalization in November 2000, subject to certain limitations. There have been no claims against Resolution Performance since November 2000 relating to such environmental matters; therefore, the Company has no accruals at September 30, 2006 and December 31, 2005 relating to Resolution Performance environmental matters.

According to the terms of the Resolution Specialty purchase agreement, Eastman Chemical Company retained the liability and indemnified Resolution Specialty for pre-existing unknown environmental conditions at facilities that were transferred to the Company, as well as for the pre-existing known environmental condition at the Roebuck, South Carolina facility, subject to certain limitations.

Non-Environmental Legal Matters

The Company has reserved approximately $11 and $12 at September 30, 2006 and December 31, 2005, respectively, relating to all non-environmental legal matters for legal defense and settlement costs that it believes are probable and estimable at this time.

Following is a discussion of non-environmental legal proceedings that are not in the ordinary course of business:

Brazil Tax Claim—In 1992, the State of Sao Paulo Administrative Tax Bureau issued an assessment against the Company’s primary Brazilian subsidiary claiming that excise taxes were owed on certain intercompany loans made for centralized cash management purposes, characterized by the Tax Bureau as intercompany sales. Since that time, management and the Tax Bureau have held discussions and the subsidiary has filed an administrative appeal seeking cancellation of the assessment. The Administrative Court upheld the assessment in December 2001. In 2002, the subsidiary filed a second appeal with the highest-level Administrative Court, again seeking cancellation of the assessment. Argument was made to the court in September 2004; the Company is awaiting its ruling. At September 30, 2006, the amount of the assessment, including tax, penalties, monetary correction and interest, is 57 million Brazilian reais, or approximately $26. The Company believes it has a strong defense against the assessment and will pursue the appeal vigorously, including appealing to the judicial level; however, there is no assurance that the assessment will not be upheld. At this time, the Company does not believe a loss is probable; therefore, only related legal fees have been accrued.

 

18


Table of Contents

CTA Acoustics—From the third quarter 2003 to the first quarter 2004, six lawsuits were filed against Borden Chemical in the 27th Judicial District, Laurel County Circuit Court, in Kentucky, arising from an explosion at a customer’s plant where seven plant workers were killed and other workers were injured. Lawsuits seeking recovery for wrongful death, emotional and personal injury and loss of consortium have been settled. The Company’s share of the settlement amounts was covered by insurance. The litigation also includes claims by the Company’s customer against the Company for property damage, which is due to be tried April 2007. The Company previously accrued and spent $5, the amount of its insurance deductible, relating to these actions and has insurance coverage expected to address legal fees or payments associated with CTA’s property damage claims.

Formosa Plant —Several lawsuits were filed in Sangamon County, Illinois in May 2006 against Hexion and its predecessor Borden Chemical on behalf of individuals injured or killed in an explosion at a Formosa Plastics Corporation (“Formosa”) plant in Illiopolis, Illinois that occurred on April 23, 2004. Borden Chemical divested the facility in 1987, and the facility was operated by BCPOLP until it was sold to Formosa out of BCPOLP’s bankrupt estate in 2002. At this time, the Company has inadequate information from which to estimate a potential range of liability, if any.

Hillsborough County —The Company is named in a lawsuit filed in Hillsborough County, Florida Circuit Court, relating to an animal feed supplement processing site formerly operated by Borden Chemical and sold in 1980. The lawsuit is filed on behalf of multiple residents of Hillsborough County living near the site and alleges various injuries related to exposure to toxic chemicals. At this time, the Company has inadequate information from which to estimate a potential range of liability, if any. The court dismissed a similar lawsuit brought on behalf of a class of plaintiffs in November 2005.

Louisville Class Action —The Company is named in a lawsuit filed in May 2006 in federal court in Louisville, Kentucky relating to odors and air emissions from its Louisville plant. The lawsuit is filed as a class action on behalf of plaintiffs living in Riverside Gardens, a community adjacent to the plant. At this time, the Company has inadequate information from which to estimate a potential range of liability, if any.

Other Legal Matters— The Company is involved in various product liability, commercial and employment litigation, personal injury, property damage and other legal proceedings, which are considered to be in the ordinary course of business. There has been increased publicity about asbestos liabilities faced by manufacturing companies. In large part, as a result of the bankruptcies of many asbestos producers, plaintiffs’ attorneys are increasing their focus on peripheral defendants, including the Company, and asserting that even products that contained a small amount of asbestos caused injury. Plaintiffs are also focusing on alleged harm caused by other products the Company has made or used, including those containing silica and vinyl chloride monomer. The Company does not believe that it has a material exposure relating to these claims and believes it has adequate reserves and insurance to cover currently pending and foreseeable future claims.

Other Commitments and Contingencies

The Company entered into contractual agreements with Shell and other third parties for the supply of site services, utilities, materials and facilities and for operation and maintenance services necessary to operate certain of the Company’s facilities on a stand-alone basis. The duration of the contracts range from less than one year to 20 years, depending on the nature of services. Such contracts may be terminated by either party under certain conditions as provided for in the respective agreements; generally, 90 days notice is required for short-term contracts and three years notice is required for longer-term contracts (generally those contracts in excess of five years). Contractual pricing generally includes a fixed and variable component.

In addition, the Company entered into contractual agreements with Shell and other third parties for the purchase of feedstocks. The terms of the agreements vary from three to ten years, extendable at the Company’s request and cancelable by either party as provided for in the respective agreements. Feedstock prices are based on market prices less negotiated volume discounts or cost input formulas.

 

19


Table of Contents

8. Redeemable Preferred Stock

In May 2005, Hexion Escrow Corp., a subsidiary of Hexion which merged into Hexion coincidental with the Combinations, offered 14 million shares of Redeemable Series A Floating Rate Preferred Stock, par value $0.01 per share, and a liquidation preference of $25 per share (the “Preferred Stock”). On May 12, 2006, the Company paid $397 from the proceeds it received from the New Senior Secured Credit Facilities (See Note 6) to redeem the Preferred Stock. The Company recorded preferred stock accretion of $18 for the nine months ended September 30, 2006 against Paid-in capital. In addition, for the nine months ended September 30, 2006, the Company recorded $15 of accretion related to the excess of the redemption price of the Preferred Stock over its carrying value at the date of redemption. The Company recorded preferred stock accretion of $12 and $18 for the three and nine months ended September 30, 2005, respectively.

9. Pension and Postretirement Expense

Following are the components of net pension and postretirement expense recognized by the Company for the periods ended September 30, 2006 and 2005:

 

     Pension     Postretirement  
     Three months ended
September 30,
    Three months ended
September 30,
 
     2006     2005     2006     2005  

Service cost

   $ 3     $ 5     $ —       $ —    

Interest cost

     7       6       —         —    

Expected return on plan assets

     (6 )     (7 )     —         —    

Amortization of prior service cost

     —         —         (3 )     (2 )

Recognized net actuarial loss (gain)

     3       2       —         (1 )
                                
   $ 7     $ 6     $ (3 )   $ (3 )
                                
     Pension     Postretirement  
     Nine months ended
September 30,
    Nine months ended
September 30,
 
     2006     2005     2006     2005  

Service cost

   $ 10     $ 11     $ —       $ —    

Interest cost

     20       17       1       1  

Expected return on plan assets

     (19 )     (20 )     —         —    

Amortization of prior service cost

     1       —         (9 )     (8 )

Recognized net actuarial loss (gain)

     9       6       (1 )     (2 )
                                
   $ 21     $ 14     $ (9 )   $ (9 )
                                

10. Income Taxes

Following is a comparison of income tax expense related to continuing operations for the three and nine months ended September 30, 2006 and 2005:

 

     Three months ended
September 30,
   Nine months ended
September 30,
     2006    2005    2006    2005

Income tax expense

   $ 11    $ 8    $ 41    $ 43

Effective tax rate

     N/M      N/M      N/M      N/M

Income tax expense for the three and nine months ended September 30, 2006 primarily reflects a higher portion of net income derived from foreign operations and the effect of lower tax rates in foreign jurisdictions. In addition, the three and nine months ended September 30, 2006 include an increase in income tax expense of $3 related to an

 

20


Table of Contents

adjustment of the tax impact of the Brazilian Consumer Divestiture, which occurred during the three months ended March 31, 2006. These expenses are offset by increases in domestic valuation allowances due to the inability to utilize net operating losses.

Income tax expense for the nine month period ending September 30, 2005 primarily reflects the impact of taxes on income in non-U.S. jurisdictions, the impact of a cumulative translation adjustment on the settlement of an intercompany loan that had been previously treated as permanently invested and the adjustment of an income tax reserve in the Netherlands. The Company has increased its valuation allowances in various tax jurisdictions, including the U.S., related primarily to net operating losses that may not be realized.

11. Segment Information

The Company’s organizational structure is based on the products the Company offers and the markets the Company serves. During the fourth quarter of 2005, the Company changed its reportable segments to better reflect the stage of the transition from the previous organization of the pre-merger companies to the Company’s organizational structure during the latter half of 2005. The transition provides greater alignment of the respective operating divisions and reporting segments. At September 30, 2006, the Company’s reporting structure consisted of four reportable segments: Epoxy and Phenolic Resins, Formaldehyde and Forest Products Resins, Coatings and Inks, and Performance Products. A brief summary of the Company’s reportable segments, is as follows:

 

    Epoxy and Phenolic Resins: Includes the operations primarily from the Resolution Performance and Bakelite legacy companies and the phenolic resin operation of the Borden Chemical legacy company. Major products include epoxy resins and intermediates, molding compounds, versatic acids and derivatives, specialty phenolic resins and epoxy coating resins.

 

    Formaldehyde and Forest Products Resins: Includes the formaldehyde and forest product operations primarily from the Borden Chemical legacy company. Major products include forest product resins and formaldehyde applications.

 

    Coatings and Inks: Includes the operations of the Resolution Specialty legacy company and the operations of the Coatings Acquisition and Inks Acquisition, since their respective dates of acquisition. Major products include composite resins, polyester resins, acrylic resins, alkyd resins and ink resins and additives.

 

    Performance Products: Includes the oil field products and foundry applications from the Borden Chemical legacy company. Major products include phenolic encapsulated substrates for oil field service applications and foundry applications.

All historical segment information included herein has been restated to conform with the Company’s current segment reporting. The changes to previously reported segment information are simply a reclassification of activity among the Company’s segments and they do not impact any of the Company’s previously reported consolidated results.

The Company began implementing additional refinements to its operating divisions in 2006 to more closely link similar products, minimize divisional boundaries and improve the Company’s ability to serve common customers from pre-merger legacy company relationships, which may result in additional refinements to the Company’s reporting segments.

 

21


Table of Contents

Operating Segments:

Following is a comparison of Net sales and Segment EBITDA by reportable segment for the three months and nine months ended September 30, 2006 and 2005. Segment EBITDA is defined as EBITDA adjusted to exclude certain non-cash and non-recurring expenses. Segment EBITDA is the primary performance measure used by the Company in the evaluation of its operating results and in determining allocations of capital resources among its segments. Segment EBITDA is also the profitability measure used to set management and executive incentive compensation. Corporate and Other primarily represents corporate general and administrative expenses that are not allocated to the segments.

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2006 (1)     2005 (2)     2006 (1)     2005 (2)  

Net Sales to Unaffiliated Customers (3)

        

Epoxy and Phenolic Resins

   $ 544     $ 491     $ 1,613     $ 1,376  

Formaldehyde and Forest Product Resins

     343       309       1,041       953  

Coatings and Inks

     343       225       928       676  

Performance Products

     106       100       314       296  
                                
   $ 1,336     $ 1,125     $ 3,896     $ 3,301  
                                

Segment EBITDA (3)

        

Epoxy and Phenolic Resins

   $ 63     $ 65     $ 205     $ 185  

Formaldehyde and Forest Product Resins

     40       35       110       114  

Coatings and Inks

     23       12       66       51  

Performance Products

     18       16       50       38  

Corporate and Other

     (10 )     (13 )     (34 )     (32 )

Depreciation and Amortization Expense

        

Epoxy and Phenolic Resins

   $ 24     $ 24     $ 68     $ 69  

Formaldehyde and Forest Product Resins

     8       8       21       22  

Coatings and Inks

     7       4       16       11  

Performance Products

     2       2       6       5  

Corporate and Other

     4       1       12       4  
                                
   $ 45     $ 39     $ 123     $ 111  
                                

(1) Net sales and Segment EBITDA in 2006 include the Coatings Acquisition, the Wax Compound Acquisition and the Inks Acquisition results from the dates of acquisition, January 31, March 1 and June 1, 2006, respectively. Epoxy and Phenolic Resins Net Sales to Unaffiliated Customers and Segment EBITDA in 2006 and 2005 excludes the operating results of the Taro Plast divestiture (See Note 4), which has been included in discontinued operations in the Condensed Consolidated Statement of Operations and Comprehensive Loss.

 

(2) Net sales and Segment EBITDA in 2005 include the Bakelite Acquisition results from the date of acquisition, April 29, 2005. Epoxy and Phenolic Resins Net Sales to Unaffiliated Customers and Segment EBITDA in 2006 and 2005 excludes the operating results of the Taro Plast divestiture (See Note 4), which has been included in discontinued operations in the Condensed Consolidated Statement of Operations and Comprehensive Loss.

 

(3) Intersegment sales and EBITDA are not significant and, as such, are eliminated within the selling segment.

 

22


Table of Contents

Reconciliation of Segment EBITDA to Net loss:

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2006     2005     2006     2005  

Segment EBITDA:

        

Epoxy and Phenolic Resins

   $ 63     $ 65     $ 205     $ 185  

Formaldehyde and Forest Product Resins

     40       35       110       114  

Coatings and Inks

     23       12       66       51  

Performance Products

     18       16       50       38  

Corporate and Other

     (10 )     (13 )     (34 )     (32 )

Reconciliation:

        

Items not included in Segment EBITDA

        

Transaction costs

     —         (3 )     (21 )     (34 )

Integration costs

     (21 )     (3 )     (45 )     (8 )

Non-cash charges

     (2 )     (3 )     (10 )     (20 )

Unusual items:

        

Gain on divestiture of business

     (1 )     —         40       —    

Purchase accounting effects/inventory step-up

     (1 )     (5 )     (3 )     (14 )

Discontinued operations

     (1 )     —         (14 )     (10 )

Business realignments

     (3 )     —         (4 )     (2 )

Other

     (2 )     (5 )     (7 )     (21 )
                                

Total unusual items

     (8 )     (10 )     12       (47 )
                                

Total adjustments

     (31 )     (19 )     (64 )     (109 )

Interest expense, net

     (61 )     (55 )     (171 )     (149 )

Loss on extinguishment of debt

     —         —         (52 )     (17 )

Income tax expense

     (11 )     (8 )     (41 )     (43 )

Depreciation and amortization

     (45 )     (39 )     (123 )     (111 )
                                

Net loss

   $ (14 )   $ (6 )   $ (54 )   $ (73 )
                                

Items not included in Segment EBITDA

For the three and nine months ended September 30, 2005, Transaction costs primarily represent accounting, consulting, legal and contract termination fees associated with the Combinations. For the three and nine months ended September 30, 2006, Transaction costs primarily represent the write-off of deferred accounting, legal, and printing costs as a result of the Company’s suspension of its IPO, as well as costs associated with terminated acquisition activities. For the three and nine months ended September 30, 2006 and 2005, Integration costs represent redundancy and plant rationalization costs and incremental administrative costs associated with integration programs as a result of the Combinations and recent acquisitions. These costs include the implementation of a single, company wide, management information and accounting system. For the three and nine months ended September 30, 2005, Non-cash charges primarily represent stock-based compensation expense and unrealized foreign currency exchange losses on debt instruments denominated in currencies other than the functional currency of the holder. For the three and nine months ended September 30, 2006, Non-cash charges primarily represent stock-based compensation expense and impairments of fixed assets.

Unusual items not included in Segment EBITDA represent income (expenses) deemed by management to be non-recurring in nature. For the three and nine months ended September 30, 2005, these items principally consisted of purchase accounting/inventory step-up adjustments related to the Bakelite Acquisition, certain non-recurring litigation expenses primarily related to discontinued operations and business realignments. In addition, for the nine months ended September 30, 2005, these items included a realized foreign currency loss on an exchange rate hedge related to the Bakelite Acquisition. For the three months ended September 30, 2006, these items principally consisted of business realignments. For nine months ended September 30, 2006, these items principally consisted of a gain recognized on the Brazilian Consumer Divestiture, a charge related to the discontinued operations of Taro Plast, the gain from a litigation settlement, net of related legal fees, and business realignments.

 

23


Table of Contents

12. Guarantor/Non-Guarantor Subsidiary Financial Information

The Company and certain of its U.S. subsidiaries guarantee the debt issued by its wholly-owned subsidiaries Hexion Nova Scotia, ULC (“Nova Scotia, ULC”) and Hexion U.S. Finance Corporation, which includes the $325 second-priority notes due 2014 and the $298 floating rate second-priority senior secured notes due 2010. In addition, the Company, these same U.S. subsidiaries, and Hexion U.S. Finance Corporation also guaranteed the senior secured debt previously issued by Resolution Performance totaling $343 (“the Resolution Performance guaranteed debt”), which the Company repurchased during the second quarter of 2006 (See Note 6).

The following information contains the condensed consolidating financial information for the parent, Hexion, the subsidiary issuers (Hexion U.S. Finance Corporation, Nova Scotia, ULC and HSC Capital Corporation, formerly known as Resolution Performance Capital Corporation (“HSC Capital”)), the combined subsidiary guarantors (Borden Chemical Investments, Inc., Borden Chemical Foundry, Inc., Lawter International, Inc. (“Lawter”), Borden Chemical International, Inc., Hexion CI Holding Company (China LLC) and Oilfield Technology Group, Inc.) and the combined non-guarantor subsidiaries, which includes all of the Company’s foreign subsidiaries and HAI. Borden Service Company, a subsidiary guarantor, was merged into the Company in the fourth quarter of 2005, while three additional subsidiary guarantors, BDS Two, Inc., Bakelite North America Holding Company and Bakelite Epoxy Polymers Corporate, were merged into the Company on February 28, 2006; all of these former subsidiary guarantors are included in the parent for all periods presented. In addition, Lawter distributed the assets of its U.S. business to Hexion during the second quarter of 2006; its sole remaining assets are the shares of certain China subsidiaries, which are presented as equity investments in the combined subsidiary guarantors column. As a result, the presentation of prior periods has been reclassified to reflect the assets and results of operations of the Lawter U.S. business in the parent. The prior periods have also been restated to reflect the reclassification of discontinued operations (See Note 4).

All of the subsidiary issuers and subsidiary guarantors are 100% owned by Hexion. All guarantees are full and unconditional and are joint and several. There are no significant restrictions on the ability of the Company to obtain funds from its domestic subsidiaries by dividend or loan. While the Company’s Australian subsidiary and HAI are restricted in the payment of dividends and intercompany loans due to the terms of their credit facilities, there are no material restrictions on the Company’s ability to obtain cash from the remaining U.S. non-guarantor subsidiaries.

This information includes allocations of corporate overhead to the combined non-guarantor subsidiaries based on net sales. Income tax expense has been provided on the combined non-guarantor subsidiaries based on actual effective tax rates. All other tax expense is reflected in the parent.

 

24


Table of Contents

HEXION SPECIALTY CHEMICALS, INC.

THREE MONTHS ENDED SEPTEMBER 30, 2006

CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS (Unaudited)

 

     Hexion
Specialty
Chemicals,
Inc.
    Subsidiary
Issuers (1)
    Combined
Subsidiary
Guarantors
   Combined
Non-
Guarantor
Subsidiaries
    Eliminations     Consolidated  

Net sales

   $ 651     $ —       $ —      $ 872     $ (187 )   $ 1,336  

Cost of sales

     576       —         —        768       (187 )     1,157  
                                               

Gross profit

     75       —         —        104       —         179  
                                               

Selling, general & administrative expense

     43       —         —        54       —         97  

Integration costs

     12       —         —        9       —         21  

Other operating expense, net

     1       —         —        3       —         4  
                                               

Operating income

     19       —         —        38       —         57  
                                               

Interest expense, net

     38       17       —        6       —         61  

Intracompany interest expense (income)

     7       (19 )     —        12       —         —    

Other non-operating expense (income), net

     (3 )     2       —        —         —         (1 )
                                               

(Loss) income from continuing operations before income tax, earnings from unconsolidated entities and minority interest

     (23 )     —         —        20       —         (3 )

Income tax expense

     6       —         —        5       —         11  
                                               

(Loss) income from continuing operations before earnings from unconsolidated entities and minority interest

     (29 )     —         —        15       —         (14 )

Earnings from unconsolidated entities, net of tax

     15       —         2      1       (17 )     1  
                                               

(Loss) income from continuing operations

     (14 )     —         2      16       (17 )     (13 )

Loss from discontinued operations

     —         —         —        (1 )     —         (1 )
                                               

Net (loss) income

   $ (14 )   $ —       $ 2    $ 15     $ (17 )   $ (14 )
                                               

(1) Subsidiary issuers include Hexion U.S. Finance Corporation, HSC Capital and Nova Scotia, ULC. HSC Capital is also a subsidiary guarantor of the debt issued by Hexion U.S. Finance Corporation and Nova Scotia, ULC. The primary asset of the Hexion U.S. Finance Corporation is an intercompany receivable from Hexion (the parent) for $204, which is essentially offset by the debt payable. HSC Capital has no significant assets.

 

25


Table of Contents

HEXION SPECIALTY CHEMICALS, INC.

THREE MONTHS ENDED SEPTEMBER 30, 2005

CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS (Unaudited)

 

     Hexion
Specialty
Chemicals,
Inc.
    Subsidiary
Issuers (1)
    Combined
Subsidiary
Guarantors
    Combined
Non-
Guarantor
Subsidiaries
   Eliminations     Consolidated  

Net sales

   $ 551     $ —       $ —       $ 654    $ (80 )   $ 1,125  

Cost of sales

     482       —         —         552      (79 )     955  
                                               

Gross profit

     69       —         —         102      (1 )     170  
                                               

Selling, general & administrative expense

     46       —         —         58      —         104  

Transaction costs

     2       —         —         1      —         3  

Integration costs

     3       —         —         —        —         3  

Affiliated royalty expense (income)

     7       —         (7 )     —        —         —    

Other operating expense, net

     2       —         —         3      —         5  
                                               

Operating income

     9       —         7       40      (1 )     55  
                                               

Interest expense, net

     35       15       —         5      —         55  

Intracompany interest expense (income)

     6       (17 )     —         11      —         —    

Other non-operating expense (income), net

     (10 )     —         —         7      —         (3 )
                                               

(Loss) income from continuing operations before income tax, earnings from unconsolidated entities and minority interest

     (22 )     2       7       17      (1 )     3  

Income tax expense

     —         —         —         8      —         8  
                                               

(Loss) income from continuing operations before earnings from unconsolidated entities and minority interest

     (22 )     2       7       9      (1 )     (5 )

Earnings from unconsolidated entities, net of tax

     17       —         3       —        (20 )     —    

Minority interest in net income of consolidated subsidiaries

     (1 )     —         —         —        —         (1 )
                                               
                                               

Net (loss) income

   $ (6 )   $ 2     $ 10     $ 9    $ (21 )   $ (6 )
                                               

(1) Subsidiary issuers include Hexion U.S. Finance Corporation, HSC Capital and Nova Scotia, ULC. HSC Capital is also a subsidiary guarantor of the debt issued by Hexion U.S. Finance Corporation and Nova Scotia, ULC. The primary asset of the Hexion U.S. Finance Corporation is an intercompany receivable from Hexion (the parent) for $204, which is essentially offset by the debt payable. HSC Capital has no significant assets.

 

26


Table of Contents

HEXION SPECIALTY CHEMICALS, INC.

NINE MONTHS ENDED SEPTEMBER 30, 2006

CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS (Unaudited)

 

     Hexion
Specialty
Chemicals,
Inc.
    Subsidiary
Issuers (1)
    Combined
Subsidiary
Guarantors
    Combined
Non-
Guarantor
Subsidiaries
    Eliminations     Consolidated  

Net sales

   $ 1,786     $ —       $ —       $ 2,333     $ (223 )   $ 3,896  

Cost of sales

     1,563       —         —         2,002       (223 )     3,342  
                                                

Gross profit

     223       —         —         331       —         554  
                                                

Selling, general & administrative expense

     117       —         —         176       —         293  

Transaction costs

     21       —         —         —         —         21  

Integration costs

     20       —         —         25       —         45  

Affiliated royalty expense (income)

     6       —         (6 )     —         —         —    

Other operating income, net

     18       —         (5 )     (45 )     —         (32 )
                                                

Operating income

     41       —         11       175       —         227  
                                                

Interest expense, net

     102       48       —         21       —         171  

Loss on extinguishment of debt

     52       —         —         —         —         52  

Intracompany interest expense (income)

     22       (54 )     (1 )     33       —         —    

Other non-operating expense (income), net

     (8 )     5       —         5       —         2  
                                                

(Loss) income from continuing operations before income tax, earnings from unconsolidated entities and minority interest

     (127 )     1       12       116       —         2  

Income tax expense

     9       —         —         32       —         41  
                                                

(Loss) income from continuing operations before earnings from unconsolidated entities and minority interest

     (136 )     1       12       84       —         (39 )

Earnings from unconsolidated entities, net of tax

     86       —         7       3       (93 )     3  

Minority interest in net income of consolidated subsidiaries

     (4 )     —         —         —         —         (4 )
                                                

(Loss) income from continuing operations

     (54 )     1       19       87       (93 )     (40 )

Loss from discontinued operations

     —         —         —         (14 )     —         (14 )
                                                

Net (loss) income

   $ (54 )   $ 1     $ 19     $ 73     $ (93 )   $ (54 )
                                                

(1) Subsidiary issuers include Hexion U.S. Finance Corporation, HSC Capital and Nova Scotia, ULC. HSC Capital is also a subsidiary guarantor of the debt issued by Hexion U.S. Finance Corporation and Nova Scotia, ULC. The primary asset of the Hexion U.S. Finance Corporation is an intercompany receivable from Hexion (the parent) for $204, which is essentially offset by the debt payable. HSC Capital has no significant assets.

 

27


Table of Contents

HEXION SPECIALTY CHEMICALS, INC.

NINE MONTHS ENDED SEPTEMBER 30, 2005

CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS (Unaudited)

 

     Hexion
Specialty
Chemicals,
Inc.
    Subsidiary
Issuers (1)
    Combined
Subsidiary
Guarantors
    Combined
Non-
Guarantor
Subsidiaries
   Eliminations     Consolidated  

Net sales

   $ 1,692     $ —       $ —       $ 1,819    $ (210 )   $ 3,301  

Cost of sales

     1,494       —         —         1,529      (207 )     2,816  
                                               

Gross profit

     198       —         —         290      (3 )     485  
                                               

Selling, general & administrative expense

     133       —         —         150      —         283  

Transaction costs

     25       —         —         9      —         34  

Integration costs

     8       —         —         —        —         8  

Affiliated royalty expense (income)

     17       —         (19 )     2      —         —    

Other operating (income) expense, net

     (7 )     —         (1 )     4      —         (4 )
                                               

Operating income

     22       —         20       125      (3 )     164  
                                               

Interest expense, net

     101       40       —         8      —         149  

Loss on extinguishment of debt

     9       6       —         2      —         17  

Intracompany interest expense (income)

     12       (42 )     (1 )     31      —         —    

Other non-operating expense (income), net

     (5 )     1       —         21      —         17  
                                               

(Loss) income from continuing operations before income tax, earnings from unconsolidated entities and minority interest

     (95 )     (5 )     21       63      (3 )     (19 )

Income tax expense

     3       —         —         40      —         43  
                                               

(Loss) income from continuing operations before earnings from unconsolidated entities and minority interest

     (98 )     (5 )     21       23      (3 )     (62 )

Earnings from unconsolidated entities, net of tax

     37       —         7       1      (44 )     1  

Minority interest in net income of consolidated subsidiaries

     (2 )     —         —         —        —         (2 )
                                               

(Loss) income from continuing operations

     (63 )     (5 )     28       24      (47 )     (63 )

Loss from discontinued operations

     (10 )     —         —         —        —         (10 )
                                               

Net (loss) income

   $ (73 )   $ (5 )   $ 28     $ 24    $ (47 )   $ (73 )
                                               

(1) Subsidiary issuers include Hexion U.S. Finance Corporation, HSC Capital and Nova Scotia, ULC. HSC Capital is also a subsidiary guarantor of the debt issued by Hexion U.S. Finance Corporation and Nova Scotia, ULC. The primary asset of the Hexion U.S. Finance Corporation is an intercompany receivable from Hexion (the parent) for $204, which is essentially offset by the debt payable. HSC Capital has no significant assets.

 

28


Table of Contents

HEXION SPECIALTY CHEMICALS, INC.

SEPTEMBER 30, 2006

CONDENSED CONSOLIDATING BALANCE SHEET (Unaudited)

 

     Hexion
Specialty
Chemicals,
Inc.
    Subsidiary
Issuers (1)
    Combined
Subsidiary
Guarantors
    Combined
Non-
Guarantor
Subsidiaries
    Eliminations     Consolidated  

ASSETS

            

Current Assets

            

Cash and equivalents

   $ 7     $ —       $ —       $ 62     $ —       $ 69  

Accounts receivable, net

     248       —         —         512       —         760  

Inventories:

            

Finished and in-process goods

     139       —         —         183       —         322  

Raw materials and supplies

     78       —         —         123       —         201  

Other current assets

     16       —         —         82       —         98  
                                                
     488       —         —         962       —         1,450  
                                                

Other Assets

            

Investment in subsidiaries

     551       —         25       —         (576 )     —    

Other assets

     31       20       —         42       —         93  
                                                
     582       20       25       42       (576 )     93  
                                                

Property and Equipment, net

     669       —         —         838       —         1,507  

Goodwill

     115       —         —         60       —         175  

Other Intangible Assets, net

     90       —         —         124       —         214  
                                                

Total Assets

   $ 1,944     $ 20     $ 25     $ 2,026     $ (576 )   $ 3,439  
                                                

LIABILITIES, COMMON STOCK AND OTHER SHAREHOLDERS’ (DEFICIT) EQUITY

            

Current Liabilities

            

Accounts and drafts payable

   $ 226     $ —       $ —       $ 329     $ —       $ 555  

Interco accounts payable (receivable)

     18       (12 )     (7 )     1       —         —    

Debt payable within one year

     35       —         —         30       —         65  

Loans payable to (receivable from) affiliates

     135       (4 )     (12 )     (119 )     —         —    

Interest payable

     33       13       —         1       —         47  

Income taxes payable

     48       —         —         63       —         111  

Other current liabilities

     131       —         —         155       —         286  
                                                
     626       (3 )     (19 )     460       —         1,064  
                                                

Other Liabilities

            

Long-term debt

     1,841       625       —         318       —         2,784  

Intercompany loans payable (receivable)

     186       (674 )     —         488       —         —    

Long-term pension obligations

     51       —         —         132       —         183  

Non-pension post employment benefit obligations

     93       —         —         18       —         111  

Deferred income taxes

     27       —         —         127       —         154  

Other long-term liabilities

     81       —         —         19       —         100  
                                                
     2,279       (49 )     —         1,102       —         3,332  
                                                

Minority interest in consolidated subsidiaries

     9       —         —         4       —         13  

Common Stock and Other Shareholders’ (Deficit) Equity

     (970 )     72       44       460       (576 )     (970 )
                                                

Total Liabilities, Common Stock and Other Shareholders’ (Deficit) Equity

   $ 1,944     $ 20     $ 25     $ 2,026     $ (576 )   $ 3,439  
                                                

(1) Subsidiary issuers include Hexion U.S. Finance Corporation, HSC Capital and Nova Scotia, ULC. HSC Capital is also a subsidiary guarantor of the debt issued by Hexion U.S. Finance Corporation and Nova Scotia, ULC. The primary asset of the Hexion U.S. Finance Corporation is an intercompany receivable from Hexion (the parent) for $204, which is essentially offset by the debt payable. HSC Capital has no significant assets.

 

29


Table of Contents

HEXION SPECIALTY CHEMICALS, INC.

DECEMBER 31, 2005

CONDENSED CONSOLIDATING BALANCE SHEET

 

     Hexion
Specialty
Chemicals,
Inc.
    Subsidiary
Issuers (1)
    Combined
Subsidiary
Guarantors
    Combined
Non-
Guarantor
Subsidiaries
    Eliminations     Consolidated  

ASSETS

            

Current Assets

            

Cash and equivalents

   $ 8     $ —       $ —       $ 175     $ —       $ 183  

Accounts receivable, net

     219       —         —         370       —         589  

Inventories:

            

Finished and in-process goods

     139       —         —         148       —         287  

Raw materials and supplies

     65       —         —         81       —         146  

Other current assets

     96       —         —         35       —         131  

Assets of discontinued operations

     —         —         —         39       —         39  
                                                
     527       —         —         848       —         1,375  
                                                

Other Assets

            

Investment in subsidiaries

     471       —         26       —         (497 )     —    

Other assets

     3       22       —         78       —         103  
                                                
     474       22       26       78       (497 )     103  
                                                

Property and Equipment, net

     664       —         —         727       —         1,391  

Goodwill

     63       —         —         101       —         164  

Other Intangible Assets, net

     95       —         —         81       —         176  
                                                

Total Assets

   $ 1,823     $ 22     $ 26     $ 1,835     $ (497 )   $ 3,209  
                                                

LIABILITIES, REDEEMABLE PREFERRED STOCK, COMMON STOCK AND OTHER SHAREHOLDERS’ (DEFICIT) EQUITY

            

Current Liabilities

            

Accounts and drafts payable

   $ 226     $ —       $ —       $ 267     $ —       $ 493  

Intercompany accounts payable (receivable)

     (17 )     (4 )     (7 )     28       —         —    

Debt payable within one year

     13       —         —         25       —         38  

Loans payable to (receivable from) affiliates

     84       (17 )     (18 )     (49 )     —         —    

Interest payable

     24       20       —         1       —         45  

Income taxes payable

     45       —         —         46       —         91  

Other current liabilities

     159       —         —         88       —         247  

Liabilities of discontinued operations

     —         —         —         25       —         25  
                                                
     534       (1 )     (25 )     431       —         939  
                                                

Other Liabilities

            

Long-term debt

     1,368       625       —         310       —         2,303  

Intercompany loans payable (receivable)

     216       (652 )     —         436       —         —    

Long-term pension obligations

     51       —         —         116       —         167  

Non-pension post employment benefit obligations

     104       —         —         15       —         119  

Deferred income taxes

     26       —         —         112       —         138  

Other long-term liabilities

     76       —         —         16       —         92  
                                                
     1,841       (27 )     —         1,005       —         2,819  
                                                

Minority interest in consolidated subsidiaries

     8       —         —         3       —         11  

Redeemable Preferred Stock

     364       —         —         —         —         364  

Common Stock and Other Shareholders’ (Deficit) Equity

     (924 )     50       51       396       (497 )     (924 )
                                                

Total Liabilities, Redeemable Preferred Stock, Common Stock and Other Shareholders’ (Deficit) Equity

   $ 1,823     $ 22     $ 26     $ 1,835     $ (497 )   $ 3,209  
                                                

(1) Subsidiary issuers include Hexion U.S. Finance Corporation, HSC Capital and Nova Scotia, ULC. HSC Capital is also a subsidiary guarantor of the debt issued by Hexion U.S. Finance Corporation and Nova Scotia, ULC. The primary asset of the Hexion U.S. Finance Corporation is an intercompany receivable from Hexion (the parent) for $197, which is essentially offset by the debt payable. HSC Capital has no significant assets.

 

30


Table of Contents

HEXION SPECIALTY CHEMICALS, INC.

NINE MONTHS ENDED SEPTEMBER 30, 2006

CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS (Unaudited)

 

    

Hexion
Specialty

Chemicals,
Inc.

    Subsidiary
Issuers (1)
    Combined
Subsidiary
Guarantors
    Combined
Non-
Guarantor
Subsidiaries
    Eliminations    Consolidated  

Cash Flows from (used in) Operating Activities

   $ (34 )   $ 9     $ 4     $ 25     $ —      $ 4  
                                               

Cash Flows (used in) from Investing Activities

             

Capital expenditures

     (54 )     —         —         (31 )     —        (85 )

Capitalized interest

     (1 )     —         —         —         —        (1 )

Acquisition of businesses, net of cash acquired

     (30 )     —         —         (151 )     —        (181 )

Proceeds from the sale of businesses, net of cash

     —         —         5       42       —        47  
                                               
     (85 )     —         5       (140 )     —        (220 )
                                               

Cash flows from (used in) Financing Activities

             

Net short-term debt (repayments) borrowings

     10       —         —         8       —        18  

Borrowings of long-term debt

     2,224       —         —         430       —        2,654  

Repayments of long-term debt

     (1,733 )     —         —         (425 )     —        (2,158 )

Payment of dividends on common stock

     22       —         (16 )     (8 )     —        (2 )

Repayment of preferred stock

     (397 )     —         —         —         —        (397 )

Affiliated loan (repayments) borrowings

     14       (9 )     7       (12 )     —        —    

Long-term debt and credit facility financing fees paid

     (17 )     —         —         —         —        (17 )

IPO related costs

     (5 )     —         —         —         —        (5 )

Net cash from financing activities of discontinued operations

     —         —         —         1       —        1  
                                               
     118       (9 )     (9 )     (6 )     —        94  
                                               

Effect of exchange rates on cash and equivalents

     —         —         —         8       —        8  
                                               

Increase (decrease) in cash and equivalents

     (1 )     —         —         (113 )     —        (114 )

Cash and equivalents at beginning of period

     8       —         —         175       —        183  
                                               

Cash and equivalents at end of period

   $ 7     $ —       $ —       $ 62     $ —      $ 69  
                                               

(1) Subsidiary issuers include Hexion U.S. Finance Corporation, HSC Capital and Nova Scotia, ULC. HSC Capital is also a subsidiary guarantor of the debt issued by Hexion U.S. Finance Corporation and Nova Scotia, ULC. The primary asset of the Hexion U.S. Finance Corporation is an intercompany receivable from Hexion (the parent) for $204, which is essentially offset by the debt payable. HSC Capital has no significant assets.

 

31


Table of Contents

HEXION SPECIALTY CHEMICALS, INC.

NINE MONTHS ENDED SEPTEMBER 30, 2005

CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS (Unaudited)

 

    

Hexion
Specialty

Chemicals,
Inc.

    Subsidiary
Issuers(1,2)
    Combined
Subsidiary
Guarantors(2)
   

Combined

Non-

Guarantor
Subsidiaries

    Eliminations     Consolidated  

Cash Flows (used in) from Operating Activities

   $ (66 )   $ 37     $ 16     $ 116     $ —       $ 103  
                                                

Cash Flows from (used in) Investing Activities

            

Capital expenditures

     (33 )     —         —         (28 )     —         (61 )

Acquisition of businesses, net of cash accquired

     (4 )     —         —         (230 )     —         (234 )

Proceeds from the sale of businesses, net of cash

     —         —         3       —         —         3  

Investment in subsidiary

     5       —         —         —         (5 )     —    

Net cash used in investing activities of discontinued operations

     —         —         —         (2 )     —         (2 )
                                                
     (32 )     —         3       (260 )     (5 )     (294 )
                                                

Cash flows from (used in) Financing Activities

            

Net short-term debt borrowings (repayments)

     (8 )     —         —         (7 )     —         (15 )

Borrowings of long-term debt

     465       398       —         331       —         1,194  

Repayments of long-term debt

     (456 )     (250 )     —         (47 )     —         (753 )

Affiliated loan borrowings (repayments)

     232       (181 )     (12 )     (39 )     —         —    

Payment of dividends on common stock

     (508 )     —         (9 )     (106 )     100       (523 )

Proceeds from issuance of preferred stock, net

     334       —         —         —         —         334  

Long-term debt and credit facility financing fees paid

     (10 )     (4 )     —         (8 )     —         (22 )

Capital contributions (to) from affiliates

     (2 )     —         2       95       (95 )     —    

IPO related costs

     (8 )     —         —         —         —         (8 )

Net cash from financing activities of discontinued operations

     —         —         —         2       —         2  
                                                
     39       (37 )     (19 )     221       5       209  
                                                

Effect of exchange rates on cash and equivalents

     —         —         —         (6 )     —         (6 )
                                                

(Decrease) increase in cash and equivalents

     (59 )     —         —         71       —         12  

Cash and equivalents at beginning of period

     71       —         1       80       —         152  
                                                

Cash and equivalents at end of period

   $ 12     $ —       $ 1     $ 151     $ —       $ 164  
                                                

(1) Subsidiary issuers include Hexion U.S. Finance Corporation, HSC Capital and Nova Scotia, ULC. HSC Capital is also a subsidiary guarantor of the debt issued by Hexion U.S. Finance Corporation and Nova Scotia, ULC. The primary asset of the Hexion U.S. Finance Corporation is an intercompany receivable from Hexion (the parent) for $204, which is essentially offset by the debt payable. HSC Capital has no significant assets.

 

32


Table of Contents

13. Subsequent Events

Hexion Recapitalization

On November 3, 2006, the Company amended its senior secured credit facility pursuant to an amendment and restatement of the credit agreement governing this credit facility. The amended and restated credit agreement provides that its current seven-year $1,625 million term loan facility will remain outstanding, and also provides for an additional $375 million seven-year term loan facility, with the term of such facility beginning in May 2006. The amended and restated credit agreement also provides that the Company’s current seven-year $50 million synthetic letter of credit facility will remain outstanding, with the term of such facility beginning in May 2006. The Company continues to have access to the $225 million revolving credit facility.

In addition, the Company, through its wholly owned finance subsidiaries, Hexion U.S. Finance Corp. and Hexion Nova Scotia Finance, ULC, sold $200 million of Second-Priority Senior Secured Floating Rate Notes due 2014 (the “Floating Rate Notes”) and $625 million of 9.75% Second-Priority Senior Secured Notes due 2014 (the “Fixed Rate Notes” and, together with the Floating Rate Notes, the “Notes”). The Floating Rate Notes bear interest at a rate per annum, reset quarterly, equal to LIBOR plus 4.50%. The Company has entered into a Registration Rights Agreement and is subject to up to 1.00% of additional interest in the event of default under this agreement. Under the terms of the Indenture governing the Notes, the Company is subject to certain customary covenants, that, among other things, restrict its ability to create liens on its assets, incur debt at its subsidiaries or enter into sale leaseback transactions. These covenants are subject to certain qualifications and exceptions. In addition, the Indenture governing the Notes specifies certain events of default, including failure to pay principal and interest on the Notes, failure to comply with covenants, subject to a grace period in certain instances, and certain bankruptcy, insolvency or reorganization events.

In connection with these transactions, the Company has accepted for purchase and paid for its outstanding $299 principal amount Floating Rate Second-Priority Senior Secured Notes due 2010 and its outstanding $325 principal amount 9% Second-Priority Senior Secured Notes due 2014 issued by Hexion U.S. Finance Corp. and Hexion Nova Scotia Finance, ULC. In addition, the Company used $500 of the proceeds to fund a common stock dividend to its shareholders. As a result of these transactions, the Company expects to recognize a loss on the extinguishment of debt of approximately $69, consisting of redemption costs net of debt premiums and the write-off of deferred financing costs, and expects to incur financing costs of approximately $28. The financing costs will be deferred on the Company’s balance sheet and amortized over the life of the related debt.

 

33


Table of Contents
Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations (dollar amounts in millions)

Forward-Looking and Cautionary Statements

Certain statements in this quarterly report on Form 10-Q, including without limitation, statements made under the captions “Overview” and “Outlook,” are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended. In addition, the management of Hexion Specialty Chemicals, Inc. (which may be referred to as “Hexion,” “we,” “us,” “our” or the “Company”) may from time to time make oral forward- looking statements. Forward-looking statements may be identified by the words “believe,” “expect,” “anticipate,” “project,” “plan,” “estimate,” “will” or “intend” and similar expressions. The forward-looking statements contained herein reflect our current views with respect to future events and are based on our currently available financial, economic and competitive data and on current business plans. Actual results could vary materially depending on risks and uncertainties that may affect the Company’s operations, markets, services, prices and other factors as discussed in Item 1A-Risk Factors of the Company’s 2005 Form 10-K, filed with the Securities Exchange Commission on March 17, 2006. Important factors that could cause actual results to differ materially from those in the forward-looking statements include, but are not limited to: economic factors such as an interruption in the supply of or increased pricing of raw materials due to natural disasters, competitive factors such as pricing actions by our competitors that could affect our operating margins, and regulatory factors such as changes in governmental regulations involving our products that lead to environmental and legal matters as described in Item 3-Legal Proceedings of the Company’s 2005 Form 10-K.

Overview

We are the world’s largest producer of thermosetting resins, or thermosets. Thermosets are a critical ingredient for virtually all paints, coatings, glues and other adhesives produced for consumer or industrial uses. We are focused primarily on providing a broad array of thermosets and associated technologies, with leading market positions in all key markets served.

The global thermoset resins market is approximately $34 billion in annual sales, of which our primary markets represent approximately $19 billion in annual sales.

Our products are used in thousands of applications and are sold into diverse markets, such as forest products, architectural and industrial paints, packaging, consumer products and automotive coatings, as well as higher growth markets, such as composites, UV cured coatings and electrical laminates. As of September 30, 2006, we had 103 production sites globally and produce many of our key products locally in North America, Latin America, Europe and Asia. Through our worldwide network of strategically located production facilities, we serve more than 10,000 customers in 100 countries. We believe our global scale provides us with significant advantages over many of our competitors. In areas where it is advantageous, we are able to produce strategic raw materials, providing us a lower cost operating structure and security of supply. In other areas, where we can capitalize on our technical know-how and market presence to capture additional value, we are integrated downstream into product formulations. Our position in certain additives, complementary materials and services further enables us to leverage our core thermoset technologies and provide customers a broad range of product solutions. Our global customers include leading companies in their respective industries, such as 3M, Ainsworth, Ashland Inc., BASF, Bayer, DuPont, GE, Halliburton, Honeywell, Huntsman, Louisiana Pacific, Owens Corning, PPG Industries, Sumitomo, Sun Chemical, Valspar and Weyerhaeuser.

Industry Conditions. As is true for many industries, our results are impacted by the effect on our customers of economic upturns or downturns, as well as the impact on our own costs to produce, sell and deliver our products. Our customers use most of our products in their production processes; therefore, factors impacting their industries could significantly affect our results.

Major industry sectors served by us include industrial/marine, construction, consumer/durable goods, automotive, electronics, architectural, civil engineering, repair/remodeling, graphic arts and oil and gas field support. Key drivers for our business are general economic and industrial growth, housing starts, auto builds, furniture demand, active gas drilling rigs, print advertising demand and chemical intermediates sector operating conditions.

 

34


Table of Contents

Raw Material Costs. Raw material costs make up approximately 80% of our product costs. The three largest raw materials utilized in our production process are phenol, methanol and urea, which represents approximately half of our total raw material expenditures. Fluctuations in energy costs, such as volatility in the price of crude oil and related petrochemical products, as well as the cost of natural gas have translated into significant volatility in raw material costs. To help mitigate this volatility, we have purchase and sale contracts with many of our vendors and customers with periodic price adjustment mechanisms. Due to differences in timing of the pricing mechanism trigger points between our sales and purchase contracts there is often a “lead-lag” impact during which margins are negatively impacted for the short term in periods of rising raw material prices and positively impacted in periods of falling raw material prices. Since year-end 2005, the average index prices of methanol and phenol increased 7% and 24%, respectively, while the average index price of urea decreased 14% in the first three quarters of 2006. During the three months ended September 30, 2006, there was a $8 negative lead-lag impact on Segment EBITDA, and during the nine months ended September 30, 2006, there was a $24 negative lead-lag impact on Segment EBITDA. In addition, the pass through of raw material price changes can result in significant variances in sales comparisons from year to year. In the first nine months of 2006 and fiscal year 2005, we had a favorable impact on sales as continuing raw material price increases were passed through to customers, as allowed by contract.

During the three months ended September 30, 2006, we were placed on allocation for methanol, a raw material in the production of formaldehyde and formaldehyde derived products, as two major methanol producers declared force majeure. As a result of these raw material limitations, we allocated our available supply of formaldehyde and formaldehyde derived products in North America among our customers during the force majeure period, which ended on October 2, 2006.

Regulatory Environment. National and international laws regulate the production and marketing of chemical substances. Although almost every country has its own legal procedure for registration and import, laws and regulations in the European Union and the United States are most significant to our business, including the European inventory of existing commercial chemical substances, the European list of notified chemical substances, and the United States Toxic Substances Control Act inventory. Chemicals which are on one or more of the above lists can usually be registered and imported without additional testing in other countries, although additional administrative hurdles may exist.

We are also subject to extensive regulation under the environmental and occupational health and safety laws by Federal, state and local governmental entities and foreign authorities, such as the European Union. These laws are designed to protect workers and the public from exposure to certain hazardous chemicals and dangerous work conditions, to protect natural resources and to limit discharges of hazardous substances to the environment from ongoing operations. They provide for substantial fines and potential criminal sanctions for violations. They also establish requirements to remediate contamination. The laws are complex, change frequently and have tended to become more stringent over time.

For example, statutes such as the Federal Comprehensive Environmental Response, Compensation, and Liability Act and comparable state and foreign laws impose strict, joint and several liability for investigating and remediating the consequences of spills and other releases of hazardous materials, substances and wastes at current and former facilities, and at third-party disposal sites. Therefore, notwithstanding our commitment to environmental management, we cannot assure you that environmental, health and safety liabilities will not be incurred in the future, nor that such liabilities will not result in a material adverse effect on our financial condition, results of operations or business reputation.

Certain chemicals have been alleged to interact with the endocrine systems of humans and wildlife and disrupt normal processes. BPA, which is used as an intermediate at our Deer Park, Texas and Pernis, Netherlands manufacturing facilities and is also sold directly to third parties, is currently under evaluation as an “endocrine disrupter.” Pursuant to EU regulation 793/93/EC, BPA producers are currently conducting an extensive toxicology testing program of the chemical. In addition, new legislation in Europe took effect in 2005 and require that risk labels be used for BPA indicating “possible risk of impaired fertility.” In the event that BPA is further regulated, additional operating costs would likely be incurred to meet more stringent regulation of the chemical.

Various government agencies are conducting formaldehyde health assessments and evaluating the need for additional regulations. Although formaldehyde has been heavily regulated for several years, further regulation of

 

35


Table of Contents

formaldehyde could follow over time. In 2004, the International Agency for Research on Cancer (“IARC”) reclassified formaldehyde as “carcinogenic to humans,” a higher classification than previous IARC evaluations based principally on a study linking formaldehyde exposure to nasopharyngeal cancer, a rare form of cancer in humans. IARC also concluded that there was strong but not sufficient evidence for a finding of an association between leukemia and occupational exposure to formaldehyde, although IARC could not identify a mechanism for leukemia induction. We believe that our production facilities will be able to comply with any new workplace or environmental regulatory rules without any material impact on the business.

We support appropriate scientific research and risk-based policy decision-making, and we are working with industry groups, including the Formaldehyde Council, Inc. (“FCI”), to ensure that governmental assessments and regulations are based on sound scientific information. As part of that effort, the FCI is currently funding additional health research to supplement the existing science database. Results from some of this work will be available in 2006. We have leading product development technologies and credible stewardship programs in place to provide compliant and cost-effective resin systems to our customers.

We also actively petition the U.S. Food and Drug Administration to sanction the use of certain specialty chemicals produced by us, principally where we believe that these specialty chemicals will or may be used by our customers in the manufacture of products that will come in direct or indirect contact with food.

Competitive Environment. The chemical industry has been historically very competitive, and we expect this competitive environment to continue in the foreseeable future. We compete with companies of varying size, financial strength and availability of resources. Price, customer service and product performance are the primary areas in which we compete.

Other Factors Impacting Our Results. Other pressures on our profit margins include rising utility costs and increasing employee benefit, general insurance and legal costs. We are taking a number of steps to control these costs. In addition, we are continuing to analyze our business structure, consolidating plants and functions where we can realize significant cost savings and productivity gains. Future consolidations or productivity initiatives may include asset impairment charges and severance costs.

We believe that these factors will continue in the foreseeable future. These market dynamics will require us to continue to focus on productivity improvements and risk mitigation strategies to enhance and protect our margins.

Hexion Formation

The Combinations. On May 31, 2005, Resolution Performance Products, LLC (“Resolution Performance”) and Resolution Specialty Materials, Inc. (“Resolution Specialty”) were combined with and into Borden Chemical, Inc. (“Borden Chemical”) (the “Combinations”), all of which were controlled by Apollo Management, L.P. and its affiliates (“Apollo”). In connection with the Combinations, the minority interests in Resolution Performance and Resolution Specialty were eliminated. Upon the consummation of the Combinations, Borden Chemical changed its name to Hexion Specialty Chemicals, Inc. and BHI Acquisition LLC, Borden Chemical’s parent, changed its name to Hexion LLC. Apollo, through Hexion LLC, holds approximately 91.0% of the outstanding common stock of Hexion.

The Bakelite Transaction. On April 29, 2005, a subsidiary of Borden Chemical acquired Bakelite Aktiengesellschaft (“Bakelite” or the “Bakelite Acquisition”). Upon the consummation of the Bakelite Acquisition, Bakelite became an indirect, wholly-owned subsidiary of Hexion Specialty Chemicals Canada, Inc. (“Hexion Canada”). The Bakelite Acquisition was financed through a combination of available cash and borrowings under a bridge loan facility, which was refinanced with the proceeds of our second-priority senior secured floating rate notes issued on May 20, 2005 (the “New Floating Rate Notes”) and borrowings under our senior secured credit facilities (collectively the “Bakelite Financing”). The Bakelite Acquisition, the repayment or assumption of certain of Bakelite’s debt in connection therewith and the Bakelite Financing are collectively referred to as the “Bakelite Transaction.”

 

36


Table of Contents

2006 Completed Transactions

The Coatings Acquisition. On January 31, 2006, we acquired the decorative coatings and adhesives business unit of The Rhodia Group (the “Coatings Acquisition”). The business generated 2005 sales of approximately $200, with 8 manufacturing facilities in Europe and Asia Pacific. The acquisition was funded through a combination of available cash and existing credit lines.

The Wax Compound Acquisition. On March 1, 2006, we acquired the global wax compounds business of Rohm and Haas (the “Wax Compound Acquisition”). The business generated 2005 sales of approximately $10. The purchase included Rohm and Haas’ wax compounds technology and product lines, manufacturing equipment and other business assets. The acquisition was funded through available cash.

The Brazilian Consumer Divestiture. On March 31, 2006, we sold Alba Adesivos Industria e Comercio Ltda. (“Alba Adesivos”), a consumer adhesives company based in Boituva, Brazil (the “Brazilian Consumer Divestiture”). Alba Adesivos is a producer of branded consumer and professional grade adhesives. The company generated 2005 sales of $38 and has approximately 140 employees. The purchase price was paid in cash.

The Inks Acquisition. On June 1, 2006, we acquired the ink and adhesive resins business of Akzo Nobel (the “Inks Acquisition”). The business generated 2005 sales of approximately $215, and includes 10 manufacturing facilities in Europe, Asia Pacific, North America and South America. The acquisition was funded through a combination of available cash and existing credit lines. On October 20, 2006 an application was filed by certain of our customers with the Court of First Instance to annul the European Commission’s decision permitting the Inks Acquisition. The Commission has asked the Company to intervene and support the defense of its decision permitting the acquisition.

The Taro Plast Divestiture. On August 1, 2006, we sold our Taro Plast S.p.A. business (“Taro Plast”), which was acquired in the Bakelite Acquisition and formerly reported in the Epoxy and Phenolic Resins segment. Accordingly, Taro Plast has been reported as discontinued operations for all periods presented. The aggregate carrying value of the discontinued business was a net asset of $14 at December 31, 2005.

Matters Impacting Comparability of Results

Basis of Presentation. The Condensed Consolidated Financial Statements (the “Financial Statements”) include the accounts of the Company and its majority-owned subsidiaries, in which minority shareholders hold no substantive participating rights, after elimination of intercompany accounts and transactions. The Company’s share of the net earnings of 20% to 50% owned companies, for which it has the ability to exercise significant influence over operating and financial policies (but not control), are accounted for under the equity method. Investments in the other companies are carried at cost. The Company has recorded a minority interest for the equity interests in subsidiaries that are not 100% owned by the Company.

The results of the Bakelite Acquisition, the Coatings Acquisition, the Wax Compound Acquisition and the Inks Acquisition have been included since April 29, 2005, January 31, 2006, March 1, 2006 and June 1, 2006, their respective dates of acquisition.

Outlook

We expect free cash flow, defined as cash flow from operating activities less anticipated capital expenditures, to increase in the future due to improving operating characteristics, including the realization of synergies and the absence of one-time costs associated with the Hexion formation and debt refinancings. Our products are generally less capital intensive to manufacture than many other products in the chemical industry and, as a result, we have relatively low maintenance capital and moderate working capital requirements. Furthermore, due to our tax assets and other structuring considerations, we expect to have very low cash tax requirements for the foreseeable future.

Management is currently targeting $250 in synergies from the Hexion formation, of which $125 of net cost savings have been identified, which should further improve free cash flow. Management has developed detailed implementation plans to achieve the $125 of cost savings. We achieved cost savings of $20 in 2005 and $45 in the first

 

37


Table of Contents

nine months of 2006. We expect that approximately 60% of the $125 near term cost savings will be achieved by the end of 2006, with the remainder expected to be achieved in the following year.

Overview of Results

Three months ended September 30, 2006 vs. 2005

Our net sales increased to $1,336 in the third quarter of 2006 compared to $1,125 in the third quarter of 2005, an increase of $211. In 2006, the net impact of the acquisitions and divestitures added $117 in incremental net sales. Excluding the incremental impact of the acquisitions and divestiture, our net sales increased $94 in the third quarter of 2006, or approximately 8%. We were successful in driving volumes higher across several of our product lines, primarily in our base epoxy and specialty epoxy resins offset by lower volumes in our inks and coatings product lines. We also achieved stronger pricing, primarily in our formaldehyde, coatings and inks product lines, due to the partial pass through of higher raw material costs to customers. Net favorable currency translation of $14 also contributed to the increase primarily due to the strengthened Canadian dollar and Brazilian real as compared to the U.S. dollar.

Gross profit increased by $9, to $179, in the third quarter of 2006 compared to $170 in the third quarter of 2005. In 2006, the net impact of the Coatings Acquisition, the Inks Acquisition and the Brazilian Consumer Divestiture added $8 of gross profit. Excluding the incremental impact of the acquisitions and divestiture, our gross profit increased $1, or 1%. The increase is a result of the sales impact discussed above; in addition, the realization of synergies from the Combinations helped drive the increase, while rising raw material costs that could not be fully passed along to our customers resulted in a negative lead-lag impact of $8, which contributed to a decline in our gross margin.

Operating income increased by $2, to $57, in the third quarter of 2006 compared to $55 in the third quarter of 2005. The increase is due to the impact of the growth in gross profit discussed above, the absence of Transaction costs of $3 and the realization of synergies from the Combinations. These amounts were partially offset by increased Integration costs of $18. The increase in Integration costs is primarily due to additional redundancy and plant rationalization costs and incremental administrative costs associated with integration programs in 2006, including the implementation of a single, company wide, management information and accounting system.

We generated a net loss of $14 in the third quarter of 2006, an increase of $8 compared to the net loss of $6 reported in the third quarter of 2005. Increases in interest expense of $6, due to higher average debt levels and higher interest rates, and an increase in income tax expense of $3, primarily as a result of an increase in earnings from foreign operations, more than offset the improvements in operating income.

Nine months ended September 30, 2006 vs. 2005

Our net sales increased to $3,896 in the first nine months of 2006 compared to $3,301 in the first nine months of 2005, an increase of $595. In 2006, the net incremental effect from the acquisitions and divestiture was an increase in net sales of $464. Excluding the incremental impact of the acquisitions and divestiture, our net sales increased $131 in the first nine months of 2006, or approximately 4%. We were successful in driving volumes higher across several of our product lines, primarily our base and specialty epoxy and phenolic resins, forest product resins and oil field products, partially offset by volume decreases in the inks and coating product lines. We also achieved stronger pricing, primarily in our formaldehyde, resins, inks and coatings product lines. This was due primarily to the pass through of higher raw material costs to customers. Those positive pricing impacts were largely offset by competitive pricing pressures, primarily in our base epoxy resins and precursors. Year to date, relative to the U.S. dollar, the favorable effects of currency translation from the strengthened Canadian dollar and Brazilian real were partially offset by the translation effects from the weakened euro.

Gross profit increased $69, to $554, in the first nine months of 2006 compared to $485 in the first nine months of 2005. In 2006, the net impact of the Bakelite Acquisition, the Coatings Acquisition, the Inks Acquisition and the Brazilian Consumer Divestiture added $63 in gross profit. Excluding the incremental impact of the acquisitions and divestiture, our gross profit increased $6, or approximately 1%. The increase is a result of the sales impacts discussed above; in addition, the realization of synergies from the Combination helped drive the increase, while rising raw material costs that could not be fully passed along to our customers resulted in a negative lead-lag impact of $24, which contributed to a decline in our gross margin.

 

38


Table of Contents

Operating income increased by $63, to $227, in the first nine months of 2006 compared to $164 in the first nine months of 2005. The increase is due to the impact of growth in gross profit discussed above, an increase in Other operating income, net, of $28, primarily due to the gain on the Brazilian Consumer Divestiture and a decrease in Transaction costs of $13. These increases were offset by an increase in Selling, general & administrative expense of $10, primarily due to the incremental expense added by the Bakelite Acquisition and the Coatings Acquisition, and an increase in Integration costs of $37 due to additional redundancy and plant rationalization costs and incremental administrative costs associated with integration programs in 2006, including the implementation of a single, company wide, management information and accounting system.

We generated a net loss of $54 in the first nine months of 2006, an improvement of $19 compared to a net loss of $73 reported in the first nine months of 2005. The effects on operating income discussed above, as well as a decrease in Other non-operating expense, net, in 2006, as compared to 2005, due to the absence of an unrealized foreign exchange loss and the absence of a realized loss on the settlement of a contingent forward contract held by us relating to the Bakelite Transaction contributed to the improvement. These amounts were partially offset by an increase in interest expense of $22, due to higher average debt levels and higher interest rates, and an increase in debt extinguishment costs of $35 as a result of the refinancing that occurred in May 2006.

Results of Operations by Segment

Following is a comparison of Net sales and Segment EBITDA. Segment EBITDA is defined as EBITDA adjusted to exclude certain non-cash and non-recurring expenses. Segment EBITDA is the primary performance measure we use in the evaluation of our operating results and in determining allocations of capital resources among our segments. Segment EBITDA is also the profitability measure used to set management and executive incentive compensation. Corporate and Other primarily represents corporate general and administrative expenses that are not allocated to the segments.

 

    

Three months ended

September 30,

   

Nine months ended

September 30,

 
     2006 (1)     2005 (2)     2006 (1)     2005 (2)  

Net Sales to Unaffiliated Customers (3)

        

Epoxy and Phenolic Resins

   $ 544     $ 491     $ 1,613     $ 1,376  

Formaldehyde and Forest Product Resins

     343       309       1,041       953  

Coatings and Inks

     343       225       928       676  

Performance Products

     106       100       314       296  
                                
   $ 1,336     $ 1,125     $ 3,896     $ 3,301  
                                

Segment EBITDA (3)

        

Epoxy and Phenolic Resins

   $ 63     $ 65     $ 205     $ 185  

Formaldehyde and Forest Product Resins

     40       35       110       114  

Coatings and Inks

     23       12       66       51  

Performance Products

     18       16       50       38  

Corporate and Other

     (10 )     (13 )     (34 )     (32 )

(1) Net sales and Segment EBITDA in 2006 include the Coatings Acquisition, the Wax Compound Acquisition and the Inks Acquisition results from the dates of acquisition, January 31, March 1 and June 1, 2006, respectively. Epoxy and Phenolic Resins Net Sales to Unaffiliated Customers and Segment EBITDA in 2006 and 2005 excludes the operating results of the Taro Plast divestiture, which has been included in discontinued operations in the Condensed Consolidated Statement of Operations and Comprehensive Loss.

 

(2) Net sales and Segment EBITDA in 2005 include the Bakelite Acquisition results from the date of acquisition, April 29, 2005. Epoxy and Phenolic Resins Net Sales to Unaffiliated Customers and Segment EBITDA in 2006 and 2005 excludes the operating results of the Taro Plast divestiture, which has been included in discontinued operations in the Condensed Consolidated Statement of Operations and Comprehensive Loss.

 

(3) Intersegment sales and EBITDA are not significant and, as such, are eliminated within the selling segment.

 

39


Table of Contents

Three Months Ended September 30, 2006 vs. 2005 Segment Results

The chart below summarizes the percentage increase (decrease) in net sales to unaffiliated customers from the three months ended September 30, 2006 versus the three months ended September 30, 2005.

 

     Volume     Price/Mix     Currency
Translation
   

Acquisitions/

Divestitures

    Total  

Epoxy and Phenolic Resins

   7 %   3 %   1 %   —       11 %

Formaldehyde and Forest Product Resins

   5 %   5 %   3 %   (2 )%   11 %

Coatings and Inks

   (15 )%   12 %   1 %   54 %   52 %

Performance Products

   (1 )%   7 %   —       —       6 %

Epoxy and Phenolic Resins

In the third quarter of 2006, net sales of Epoxy and Phenolic Resins increased by $53, or 11%, to $544, compared to the third quarter of 2005. Improved volume contributed approximately $36 across all major product lines due to a new tolling agreement in our base epoxy business and continued strong demand in the electronics and wind energy sectors. In addition, increased pricing contributed approximately $13 along with $4 from favorable currency translation.

Segment EBITDA of Epoxy and Phenolic Resins decreased in the third quarter of 2006 by $2, to $63, compared to the third quarter of 2005. Improved volumes and lower costs, driven from synergy and cost reduction programs, were offset by higher raw material costs and negative product mix as well as startup and turnaround costs at certain manufacturing locations.

Formaldehyde and Forest Products Resins

Net sales of Formaldehyde and Forest Products Resins increased in the third quarter of 2006 by $34, or 11%, to $343, compared to the third quarter of 2005. Excluding the net incremental impact of the acquisitions and divestitures, net sales increased $39, or 13%. The increase was a result of an increase in volume of $14, an increase in pricing of $16 and favorable currency translation of $9. The volume increase is primarily due to the absence of the 2005 hurricane impact in North America and increases in demand for formaldehyde products. The increase in pricing, compared to 2005, primarily for our formaldehyde products in North America, is due to the partial pass through of higher costs to customers of phenol and methanol, net of competitive pricing pressures for our forest resin products. Favorable currency translation was a result of both the Canadian dollar and the Brazilian real strengthening versus the U.S. dollar.

Formaldehyde and Forest Products Resins’ Segment EBITDA increased in the third quarter of 2006 by $5, to $40, compared to the third quarter of 2005. The increase is primarily due to improved volumes discussed above and the absence of higher costs attributable to Hurricane Katrina, partially offset by increased raw material pricing.

Coatings and Inks

In the third quarter of 2006, net sales for Coatings and Inks increased by $118, to $343, compared to the third quarter of 2005. The Coatings Acquisition and Inks Acquisition contributed $122, of incremental net sales in 2006. Excluding the incremental impact of the acquisitions, net sales decreased by $4, or 2%. Primarily driving the decrease was decreased volumes of $33 due to lower demand of inks in Europe and a softening new housing market causing decreased volumes in coatings. This was partially offset by increased pricing of $27 due to the pass through of higher raw material costs to customers and a favorable currency translation of $2.

Coatings and Inks third quarter 2006 Segment EBITDA increased by $11, to $23, compared to the third quarter of 2005. The Coatings Acquisition and Inks Acquisition contributed $7 of incremental Segment EBITDA in 2006. Excluding the incremental impact of the acquisitions, Segment EBITDA increased by $4 primarily due to increased pricing.

 

40


Table of Contents

Performance Products

In the third quarter of 2006, net sales of Performance Products increased by $6, to $106, or 6%, compared to the third quarter of 2005. The increase was primarily a result of increased pricing of $7 in our foundry and oil field products due to the pass through of raw material price increases and improved product mix. This was partially offset by a decrease in volume of $1 in our foundry product line due to decreased volumes in the automotive related sector. These volume decreases were partially offset by an increase in oilfield volumes caused principally by increased demand in natural gas drilling activity, driven by increased natural gas prices, as well as the ability to satisfy customer demand out of our new Canadian production facility in Sturgeon.

Segment EBITDA in the third quarter of 2006 for Performance Products increased by $2, to $18, compared to the third quarter of 2005, primarily due to the factors discussed above.

Corporate and Other

Corporate and Other expenses were $10 in the third quarter of 2006, a decrease of $3 from the third quarter of 2005, primarily as a result of synergies related to the Combinations.

Nine Months Ended September 30, 2006 vs. 2005 Segment Results

The chart below summarizes the percentage increase (decrease) in net sales to unaffiliated customers from the nine months ended September 30, 2006 versus the nine months ended September 30, 2005.

 

     Volume     Price/Mix     Currency
Translation
   

Acquisitions/

Divestitures

    Total  

Epoxy and Phenolic Resins

   5 %   (2 )%   (1 )%   15 %   17 %

Formaldehyde and Forest Product Resins

   2 %   3 %   3 %   1 %   9 %

Coatings and Inks

   (5 )%   6 %   —       36 %   37 %

Performance Products

   1 %   5 %   —       —       6 %

Epoxy and Phenolic Resins

In the first nine months of 2006, net sales of Epoxy and Phenolic Resins increased by $237, to $1,613 compared to the first nine months of 2005. The Bakelite Acquisition contributed $222 of incremental net sales in 2006. Prior to the Bakelite Acquisition in 2005, Bakelite was a customer and accounted for sales of $14. Excluding the net incremental impact of these Bakelite transactions, net sales increased $29, or 2%. The increase is due to improved volumes of approximately $66 due to a new tolling agreement in our base epoxy business and continued strong demand in the electronics and wind energy sectors. These volume impacts were partially offset by unfavorable currency translation of approximately $11 as the euro weakened versus the U.S. dollar, as well as negative product mix and competitive pricing pressures of approximately $26, primarily in our base epoxy resins and intermediate products.

Segment EBITDA of Epoxy and Phenolic Resins increased in the first nine months of 2006 by $20, to $205, compared to the first nine months of 2005. The Bakelite Acquisition contributed $27 of incremental Segment EBITDA in the first nine months of 2006. Excluding the incremental impact of the Bakelite Acquisition, Segment EBITDA declined $7. The positive impacts from improved volumes and lower costs, driven from synergy and cost reduction programs, were substantially offset by increased raw material and energy costs.

Formaldehyde and Forest Products Resins

Net sales of Formaldehyde and Forest Products Resins increased in the first nine months of 2006 by $88, to $1,041, or 9%, compared to the first nine months of 2005. The net impact of the acquisitions and divestiture contributed $12 of incremental net sales in 2006. Excluding the net incremental impact of the acquisitions and divestiture, net sales increased $76, or 8%. The increase was a result of strong pricing of $27, a volume increase of $22 and favorable currency translation of $27. The strong pricing, compared to 2005, primarily for our North American formaldehyde products and North American resins, is due to the partial pass through of higher costs of phenol and methanol to our customers and favorable product mix, net of competitive pricing pressures. This was partially offset by pricing pressures in the Latin American formaldehyde-based products due to excess supply in this market. The

 

41


Table of Contents

increase in volume is due to increases across all product categories, offset by a decline in North American formaldehyde volume due to temporary production curtailments at a few large customers. Favorable currency translation was a result of both the Canadian dollar and the Brazilian real strengthening versus the U.S. dollar.

Segment EBITDA of Formaldehyde and Forest Products Resins decreased in the first nine months of 2006 by $4, to $110, compared to the first nine months of 2005. The Bakelite Acquisition contributed $2 of incremental Segment EBITDA in 2006. Excluding the incremental impact of the acquisition, Segment EBITDA declined $6 primarily due to negative lead lag resulting from phenol price increases that we have not yet been able to pass through to customers, as well as competitive pricing pressures.

Coatings and Inks

In the first nine months of 2006, net sales for Coatings and Inks increased by $252, to $928, compared to the first nine months of 2005. The Coatings Acquisition and Inks Acquisition contributed $244 of incremental net sales in 2006. Excluding the incremental impact of the acquisitions, net sales increased $8, or 1%. Primarily driving the increase was stronger pricing of approximately $43 across most of our product lines, except monomers; where pricing was lowered as industry capacity utilization decreased with the opening of new competitor manufacturing facilities in Asia. The stronger pricing effects were offset by an unfavorable currency translation of $2, primarily due to the weakened euro and decreased volumes of $33 due to softening demand of inks in Europe and a weakening new housing market causing decreased volumes in coatings.

Coatings and Inks first nine months of 2006 Segment EBITDA increased by $15, to $66, compared to the first nine months of 2005. The Coatings Acquisition and Inks Acquisition contributed $17 of incremental Segment EBITDA in 2006. Excluding the incremental impact of the acquisitions, Segment EBITDA declined $2 as stronger pricing was offset by significantly higher raw material costs for our inks and European coatings products and lower volumes.

Performance Products

In the first nine months of 2006, net sales in Performance Products increased by $18, to $314, or 6%, compared to the first nine months of 2005. The increase in net sales was a result of higher volumes of $2 and strong pricing of $16. Higher volumes, primarily in our oil field products, were due to increased demand due to an expansion in natural gas and drilling activity as well as the ability to satisfy customer demand out of our new Canadian production facility in Sturgeon. This volume increase was partially offset by lower volumes in foundry product line due to decreased volumes in the automotive industry. Increased pricing, primarily in our foundry and oil field products, resulted from the pass through of raw material price increases.

Segment EBITDA in the first nine months of 2006 for Performance Products increased by $12, to $50. The increase in Segment EBITDA is due to the increase in volume, pass through of raw material price increases and control over operational costs.

Corporate and Other

Corporate and Other expenses were $34 in the first nine months of 2006, an increase of $2 from the first nine months of 2005. The increase is primarily a result of the Combinations. Upon consummation of the Combinations, we began to consolidate the corporate functions of the four former legacy businesses, and certain corporate general and administrative expenses previously included in the business segments are now centralized and reported separately. In 2006, we have continued this consolidation of corporate functions.

 

42


Table of Contents

Reconcilliation of Segment EBITDA to Net Loss:

 

    

Three months ended

September 30,

   

Nine months ended

September 30,

 
     2006     2005     2006     2005  

Segment EBITDA:

        

Epoxy and Phenolic Resins

   $ 63     $ 65     $ 205     $ 185  

Formaldehyde and Forest Product Resins

     40       35       110       114  

Coatings and Inks

     23       12       66       51  

Performance Products

     18       16       50       38  

Corporate and Other

     (10 )     (13 )     (34 )     (32 )

Reconciliation:

        

Items not included in Segment EBITDA

        

Transaction costs

     —         (3 )     (21 )     (34 )

Integration costs

     (21 )     (3 )     (45 )     (8 )

Non-cash charges

     (2 )     (3 )     (10 )     (20 )

Unusual items:

        

Gain on divestiture of business

     (1 )     —         40       —    

Purchase accounting effects/inventory step-up

     (1 )     (5 )     (3 )     (14 )

Discontinued operations

     (1 )     —         (14 )     (10 )

Business realignments

     (3 )     —         (4 )     (2 )

Other

     (2 )     (5 )     (7 )     (21 )
                                

Total unusual items

     (8 )     (10 )     12       (47 )
                                

Total adjustments

     (31 )     (19 )     (64 )     (109 )

Interest expense, net

     (61 )     (55 )     (171 )     (149 )

Loss on extinguishment of debt

     —         —         (52 )     (17 )

Income tax expense

     (11 )     (8 )     (41 )     (43 )

Depreciation and amortization

     (45 )     (39 )     (123 )     (111 )