Annual Report
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-K

 


 

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

For the fiscal year ended December 31, 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 of incorporation)   (I.R.S. Employer Identification No.)

 

180 East Broad St., Columbus, OH 43215   614-225-4000
(Address of principal executive offices)   (Registrant’s telephone number)

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

 

Title of each class

 

Name of each exchange on which registered

None   None

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

NONE

 


Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x.

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes  x    No  ¨.

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  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.

At December 31, 2006, the aggregate market value of voting and non-voting common equity of the Registrant held by non-affiliates was zero.

Number of shares of common stock, par value $0.01 per share, outstanding as of the close of business on March 1, 2007: 82,556,847

Documents incorporated by reference. None

 



Table of Contents

HEXION SPECIALTY CHEMICALS, INC.

INDEX

 

PART I     
Item 1 – Business    3
Item 1A – Risk Factors    14
Item 1B – Unresolved Staff Comments    20
Item 2 – Properties    21
Item 3 – Legal Proceedings    22
Item 4 – Submission of Matters to a Vote of Security Holders    22
PART II     
Item 5 – Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities    23
Item 6 – Selected Historical Financial Data    24
Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations    25

Item 7A – Quantitative and Qualitative Disclosures About Market Risk

   43
Item 8 – Financial Statements and Supplementary Data    46
           Consolidated Financial Statements of Hexion Specialty Chemicals, Inc.   
           Consolidated Statements of Operations, years ended December 31, 2006, 2005 and 2004    47
           Consolidated Balance Sheets, December 31, 2006 and 2005    48
           Consolidated Statements of Cash Flows, years ended December 31, 2006, 2005 and 2004    50
           Consolidated Statement of Shareholder’s Deficit, years ended December 31, 2006, 2005 and 2004    52
           Notes to Consolidated Financial Statements    53
           Reports of Independent Registered Public Accounting Firms    93
Item 9 – Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    96
Item 9A – Controls and Procedures    96
Item 9B – Other Information    96
PART III   
Item 10 – Directors, Executive Officers and Corporate Governance    97
Item 11 – Executive Compensation    99
Item 12 – Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    111
Item 13 – Certain Relationships and Related Transactions, and Director Independence    112
Item 14 – Principal Accounting Fees and Services    114
PART IV   
Item 15 – Exhibits and Financial Statement Schedules    115
Financial Statement Schedules:   
           Schedule II—Valuation and Qualifying Accounts    95
Signatures      125
Consolidated Financial Statements of Hexion Specialty Chemicals Canada, Inc.   

 

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Table of Contents

PART I

(dollars in millions, except per share data)

ITEM 1 - BUSINESS

Overview

Hexion Specialty Chemicals, Inc., a New Jersey corporation with predecessors dating back to 1899 (which we may refer to as “we,” “us,” “our,” “Hexion” or the “Company”), is the world’s largest producer of thermosetting resins, or thermosets. Thermosets are a critical ingredient in virtually all paints, coatings, glues and other adhesives produced for consumer or industrial uses. We provide a broad array of thermosets and associated technologies, and have leading market positions in each of the key markets that we serve. Our breadth of related products provides our operations, technology and commercial service organizations with competitive advantages, while our scale provides us with significant efficiencies in our cost structure, allowing us to compete effectively throughout the value chain. Our value-added, technical service-oriented business model enables us to effectively participate in high-end specialty markets, while our scale enables us to capture value from higher volume applications.

Thermosets are developed to meet the performance characteristics required for each specific end use product. The type of thermoset used, and how it is formulated, applied and cured, determines its key attributes, such as durability, gloss, heat resistance, adhesion, or strength of the final product. We have the broadest range of thermoset resin technologies in our industry, with world class research, applications development and technical service capabilities. Our thermosets are sold under a variety of well-recognized brand names including BORDEN® (phenolic and amino resins), EPIKOTE® (epoxy resins), EPIKURE® (epoxy curatives), BAKELITE (phenolic and epoxy resins), LAWTER (inks) and CARDURA® (high-end automotive coatings).

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. We have a history of product innovation and success in introducing new products to new markets, as evidenced by more than 1,700 patents, the majority of which relate to the development of new products and processes for manufacturing.

As of December 31, 2006, we had 104 production sites around the world. Through our worldwide network of strategically located production facilities, we serve more than 11,000 customers in over 100 countries. We believe that our global scale provides us with significant advantages over many of our competitors. Where it is advantageous, we are able to internally produce strategic raw materials, providing us with a lower cost operating structure and security of supply. Where we are integrated downstream into product formulations, our technical know-how and market presence captures additional value. Our position in certain additives, complementary materials and services further enables us to leverage our core thermoset technologies and provide our customers a broad range of product solutions. As a result of our focus on innovation and a high level of technical service, we have cultivated long-standing customer relationships. Our global customers include leading companies in their respective industries, such as 3M, Ainsworth, Ashland Chemical, BASF, Bayer, DuPont, GE, Halliburton, Honeywell, Huntsman, Louisiana Pacific, Owens Corning, PPG Industries, Sumitomo, Sun Chemicals, Valspar and Weyerhaeuser.

Industry

The size of the global thermosetting resins market is approximately $34 billion in annual sales. Thermosetting resins include materials such as phenolic resins, epoxy resins, polyester resins, acrylic resins, alkyd resins and urethane resins. Thermosetting resins are used for a wide variety of applications due to their superior adhesion and bonding properties, heat resistance, and protective and aesthetic characteristics, compared to other materials. The key product areas of the global thermosetting resins market that we focus on, and in which we have leading market positions, is approximately $19 billion in annual sales. The thermosetting resins market has grown at an estimated annual volume rate of 4% over the past five years. We expect that certain segments of the thermosetting resins industry, including composites and UV resins, will grow at substantially faster rates.

Thermosets are sold to the global coatings, composites and adhesives markets, which have combined annual sales of over $100 billion. Thermosetting resins are generally considered specialty chemical products because they are sold primarily on the basis of performance, technical support, product innovation and customer service. Although the thermosetting resins market has consolidated in recent years, it remains fragmented with many small, non-core divisions of large chemical conglomerates and many small and medium-sized companies that provide a relatively high level of customization and service to their end markets. We believe we are the second largest North American-based specialty chemicals company.

The principal factors that contribute to success in the specialty chemicals market are (1) consistent delivery of high-quality products, (2) favorable process economics, (3) the ability to provide value to customers through both product attributes and strong technical service, and (4) a presence in large and growing markets.

 

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Table of Contents

Products and Market Applications

Our thermosetting resins are used in two primary applications: adhesive & structural and coating. Within each primary application we provide a diverse range of specialty chemical applications. Our primary products used in adhesive and structural applications include forest products resins, formaldehyde, specialty phenolic resins, epoxy resins, composite resins, phenolic encapsulated substrates and molding compounds. Our primary products for coating applications include epoxy coating resins, polyester resins, alkyd resins, acrylic resins, ink resins and versatic acids and derivatives.

Adhesive & Structural Products

Formaldehyde Based Resins and Intermediates

We are the leading producer of formaldehyde-based resins for the North American forest products industry with a 40% market share by volume and also hold significant positions in Europe, Latin America and Australia. In addition, we are the world’s largest producer of formaldehyde, a key building block used to manufacture thousands of products with a 15% global market share. We internally consume the majority of our formaldehyde production, giving us a significant competitive advantage versus our non-integrated competitors. Our forest products resins are used in a wide range of applications in the construction, remodeling and furniture industries.

We are also the world’s largest producer of specialty phenolic resins, which are used in applications that require extreme heat resistance and strength, such as automotive brake pads, engine filters, aircraft components and electrical laminates.

 

Products

  

Key Applications

Forest Products Resins   
Engineered Wood Resins    Softwood and hardwood plywood, oriented strand board (“OSB”), laminated veneer lumber, strand lumber and wood fiber resins, such as particleboard, medium density fiberboard and finished veneer lumber
Special Wood Adhesives    Laminated beams, structural and nonstructural fingerjoints, wood composite I-beams, cabinets, doors, windows, furniture, mold and millwork, and paper laminations
Wax Emulsions    Moisture resistance for panel boards
Formaldehyde Applications   
Formaldehyde    Herbicides and fungicides, fabric softeners, sulphur scavengers for oil and gas production, urea formaldehyde (“UF”), melamine formaldehyde (“MF”), phenol formaldehyde (“PF”), methyl diphenyl diisocyanate (“MDI”) and other catalysts
Phenolic Specialty Resins   
Composites and Electronic Resins    Aircraft components, brakes, ballistic applications, industrial grating, pipe, jet engine components, electrical laminates, computer chip encasement and photolithography
Automotive PF Resins    Acoustical insulation, engine filters, friction materials, interior components, molded electrical parts and assemblies

Construction PF Resins, UF

Resins, Ketone Formaldehyde and

Melamine Colloid

   Decorative laminates, fiberglass insulation, floral foam, lamp cement for light bulbs, molded appliance and electrical parts, molding compounds, sandpaper, fiberglass mat, laminates, coatings, crosslinker for thermoplastic emulsions and specialty wet strength paper

Epoxy Resins and Intermediates

We are the world’s largest supplier of epoxy resins, with a 34% global market share. Epoxy resins are the fundamental building blocks of many types of materials and are often used in the automotive, aerospace and electronics industries due to their unparalleled strength and durability. We also provide a variety of complementary products such as epoxy modifiers, curing agents, reactive diluents and specialty liquids. In addition, we are a major producer of bisphenol-A (“BPA”) and epichlorohydrin (“ECH”), key precursors in the manufacture of epoxy resins. We internally consume the majority of our BPA, and virtually all of our ECH, giving us a significant competitive advantage versus our non-integrated competitors.

 

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Table of Contents

Products

  

Key Applications

Civil Engineering    Bridge and canal construction, concrete enhancement and corrosion protection
Electrical Casting    Generators and bushings, transformers, medium- and high-voltage switch gear components, post insulators, capacitors and automotive ignition coils
Adhesives    Automotive: hem flange adhesives and panel reinforcement
   Construction: ceramic tiles, chemical dowels and marble
   Aerospace: metal and composite laminates
   Electronics: chip adhesives, solder masks and electronic inks
Electronic Resins    Unclad sheets, tube and molding, paper impregnation, cotton and glass filaments, printed circuit boards and electrical laminates

Composite Resins

We are a leading producer of resins that are used in composites. Composites are a fast-growing class of materials that are used in a wide variety of applications ranging from airframes and windmill blades to golf clubs. We supply composite epoxy resins to fabricators in the aerospace, sporting goods and pipe markets with a 44% market share in the United States and a 44% market share in Europe. Our leadership position in epoxy resins, along with our technology and service expertise, enables us to selectively forward integrate into custom formulations for specialty composites, such as turbine blades that are used in the wind energy market.

In addition to epoxy, we manufacture composite resins from unsaturated polyester resins (“UPR”), which are generally combined with fiberglass to produce cost-effective finished structural parts for applications ranging from boat hulls and recreational vehicles to bathroom fixtures.

 

Products

  

Key Applications

Composite Epoxy Resins    Automotive (structural interior), sports (ski, snowboard, golf), boats, construction, aerospace, wind energy and industrial applications
Reinforced UPR and Vinyl Ester Resins    Marine, transportation, construction, consumer products, recreational vehicles, spas, bath and shower surrounds
Non-reinforced UPR and Vinyl Ester Resins    Cultured marble, construction, gel coat and surface coating, and automotive putty

Phenolic Encapsulated Substrates

We are a leading producer of phenolic encapsulated sand and ceramic substrates that are used in oil field services and foundry applications. Our highly specialized compounds are designed to perform well under extreme conditions, such as intense heat, high-stress and corrosive environments, that characterize the oil and gas drilling and foundry industries. In the oil field services industry we have a 42% global market share in resin encapsulated proppants, used to enhance oil and gas recovery rates and extend well life. We are also the leading producer by volume of foundry resins in North America with a 48% market share. Our foundry resin systems are used by major automotive and industrial companies for precision engine block casting, transmissions, and brake and drive train components. In addition to encapsulated substrates, we provide phenolic resin systems and ancillary products used to produce finished metal castings.

 

Products

  

Key Applications

Oil Field Services Applications   
Resin Encapsulated Proppants    Oil and gas drilling
Foundry Applications   
Refractory Coatings    Thermal resistant coatings for ferrous and nonferrous applications
Resin Coated Sands and Binders    Sand cores and molds

 

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Molding Compounds

We are the leading producer of molding compounds (“MC”) in Europe, with an estimated market share of 64%. We formulate and produce a wide range of phenolic, polyester and epoxy molding compounds that are used to manufacture components requiring heat stability, electrical insulation, fire resistance and durability. Applications range from automotive underhood components to appliance knobs and cookware handles.

 

Products

  

Key Applications

Phenolic, Epoxy, Vinylester    Automotive ashtrays and under-hood components, heat resistant knobs and bases, switches and breaker components, and pot handles
Long Fiber Reinforced MC    High load, dimensionally stable automotive underhood parts and commutators
PBT, PET, PC, PC-ABS, PA6 and PA66    Connectors, switches, bobbins, wheel covers, power tool bodies and internal components

Coating Products

Epoxy Coating Resins

In addition to adhesive uses, epoxy resins are used for a variety of high-end coating applications that require the superior strength and durability of epoxy, such as protective coatings for industrial and domestic flooring, pipe, marine and construction applications, and appliance and automotive coatings. We also leverage our resin and additives position to supply custom resins to specialty coatings formulators.

 

Products

  

Key Applications

Electrocoat (Liquid Epoxy Resin (“LER”), Solid Epoxy Resin (“SER”), BPA)

   Automotive, general industry (such as heating radiators) and white goods (such as appliances)

Powder Coatings (SER, Performance Products)

   White goods, pipes for oil and gas transportation, general industry (such as heating radiators) and automotive (interior parts and small components)

Heat Cured Coatings (LER, SER)

   Metal packaging and coil-coated steel for construction and general industry
Floor Coatings (LER, Solutions, Performance Products)    Chemically resistant, antistatic and heavy duty flooring used in hospitals, the chemical industry, electronics workshops, retail areas and warehouses
Ambient Cured Coatings (LER, SER, Solutions, Performance Products)    Marine (manufacturing and maintenance), shipping containers and large steel structures (such as bridges, pipes, plants and offshore equipment)
Waterborne Coatings    Replacement of solvent-borne products in both heat cured and ambient cured applications

Polyester Resins

We are a leading supplier of polyester coatings resins in North America with a market share of 10% and are also a major producer of powder coatings in Europe with a market share of 10%. We provide liquid and powder custom polyester resins to customers for use in industrial coatings that require specific properties, such as gloss and color retention, resistance to corrosion and flexibility. Polyester coatings are typically used in transportation, automotive, machinery, appliances and metal office furniture.

 

Products

  

Key Applications

Powder Polyesters

   Outdoor durable systems for architectural window frames, facades and transport; indoor systems for domestic appliances and general industrial applications

Liquid Polyesters and Polyester Dispersions

   Automotive, coil and exterior can coating applications

 

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Alkyd Resins

We hold a leading position in alkyd resins in North America with a market share of 31%. We provide alkyd resins to customers who manufacture professional grade paints and coatings. Alkyd resins are formulated and engineered according to customer specifications, and can be modified with other raw materials to improve performance. Applications include industrial coatings (protective coatings used on machinery, metal coil, equipment, tools and furniture), special purpose coatings (highway-striping paints, automotive refinish coatings and industrial maintenance coatings) and decorative paints (house paint and deck stains). Our alkyd resins business shares an integrated production platform with our polyester resins business, which enables flexible sourcing, plant production balancing and improved economies of scale.

 

Products

  

Key Applications

Alkyd and Alkyd Emulsions

   Architectural Markets: Exterior enamels, interior semi-gloss and trim, interior/exterior stains and wood primers
   Industrial Markets: Metal primers, general metal, transportation, machinery and equipment, industrial maintenance and marine, metal containers and wood furniture

Alkyd Copolymer

   Architectural Markets: Stain blocking primer, sanding sealers and aerosols
   Industrial Markets: Machinery and equipment, transportation, general metal and drywall coating

Urethane Modified

   Architectural Markets: Clear varnishes and floor coatings
   Industrial Markets: Wood coatings

Silicone Alkyd

   Industrial Markets: Industrial maintenance and marine and heat resistant coatings

Acrylic Resins

We are a supplier of solvent and water-based acrylic resins in North America and Europe. Acrylic resins are used in interior trim paints and exterior applications where weathering protection, color and gloss retention are critical. In addition, we produce a wide range of specialty acrylic resins for marine and maintenance paints, and automotive topcoats. We are also a low-cost producer of acrylic monomer, the key raw material in our acrylic resins. This ability to internally produce key raw materials gives us a cost advantage over our competitors and ensures us adequate supply.

 

Products

  

Key Applications

Acrylic Dispersions

   Architectural Markets: Interior semi-gloss and high gloss, interior and exterior paints, stains and sealers, drywall primer, masonry coatings and general purpose
   Industrial Markets: Automotive original equipment manufacturing (“OEM”), packaging, general metal, wood, plastic coatings, traffic marking paint, industrial maintenance and transportation, adhesives and textiles

Solutions Acrylics

   Architectural Markets: Aerosols, masonry and tile sealers
   Industrial Markets: Transportation, packaging, aerosols, automotive OEM, appliance, industrial maintenance, marine and road marking

Ink Resins and Additives

We are the world’s largest producer of ink resins and associated products, with a market share of 16%. Ink resins are used to apply ink to a variety of different substrates, including paper, cardboard, metal foil and plastic. We provide resins, liquid components and additives, sold primarily under the globally recognized Lawter brand name, to customers who formulate inks for a variety of substrates and printing processes. Our products offer performance enhancements such as durability, printability, substrate application, drying speed and security. Typical end-use applications include brochures, newspapers, magazines, food packages, beverage cans and flexible packaging. We are also a provider of formulated UV-cure coatings and inks.

 

Products

  

Key Applications

Resins

   Graphic arts, commercial, publication and packaging

Vehicles and Waxes

   Sheet-fed, heatset, gloss and wetting vehicles, and wax products

Liquid Inks

   Polymer films, paper and corrugated boards

 

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Table of Contents

Versatic Acids and Derivatives

We are the world’s largest producer of versatic acids and derivatives, with a market share of 77%. Versatic acids and derivatives are specialty monomers that provide significant performance advantages for finished coatings, including superior adhesion, flexibility and ease of application. Our products include basic versatic acids and derivatives sold under the Versatic, VEOVA® and CARDURA® names. Applications for versatic acids include decorative, automotive and protective coatings as well as other uses, such as pharmaceuticals and personal care products. We manufacture versatic acids and derivatives using our integrated manufacturing sites and our internally produced ECH.

 

Products

  

Key Applications

CARDURA®    Automotive repair/refinishing, automotive OEM and industrial coating
Versatic Acids and Derivatives    Chemical building blocks, peroxides, pharmaceuticals and agrochemicals
VEOVA®    Architectural coatings and construction

Segments

Our business is organized based on the products that we offer and the markets that we serve. At December 31, 2006, we had four reportable segments: Epoxy and Phenolic Resins, Formaldehyde and Forest Products Resins, Coatings and Inks, and Performance Products. A summary of the major products and primary applications of our reportable segments follows:

Epoxy and Phenolic Resins

 

2006 Net Sales    $2,152
Major Products:    Primary Application:

Epoxy Resins and Intermediates

  

Adhesive & Structural

Composite Resins

  

Adhesive & Structural

Molding Compounds

  

Adhesive & Structural

Formaldehyde Based Resins and Intermediates:

  

•     Phenolic Specialty Resins

  

Adhesive & Structural

Epoxy Coating Resins

  

Coating

Versatic Acids and Derivatives

  

Coating

Formaldehyde and Forest Products Resins

 

2006 Net Sales

   $1,385

Major Products:

   Primary Application:

Formaldehyde Based Resins and Intermediates:

  

•     Forest Products Resins

  

Adhesive & Structural

•     Formaldehyde Applications

  

Adhesive & Structural

Coatings and Inks

 

2006 Net Sales

   $1,254

Major Products:

   Primary Application:

Polyester Resins

  

Coating

Alkyd Resins

  

Coating

Acrylic Resins

  

Coating

Ink Resins and Additives

  

Coating

Performance Products

 

2006 Net Sales

   $414

Major Products:

   Primary Application:

Phenolic Encapsulated Substrates

  

Adhesive & Structural

For additional information about our segments see footnote 16 in Item 8 of Part II of this Annual Report on Form 10-K.

 

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Table of Contents

Marketing And Customers

Our products are sold to industrial users worldwide through a combination of a direct sales force that services our larger customers, and third-party distributors that more cost effectively serve our smaller customers. Our customer service and support network is made up of key regional customer service centers. We have global account teams that serve the major needs of our global customers for technical service and supply and commercial term requirements. Where operating and regulatory factors vary from country to country, these functions are managed locally.

In 2006, our largest customer accounted for less than 3% of our sales and our top ten customers accounted for approximately 17% of our sales. Neither our business nor any of our reporting segments depend on any single customer, or a particular group of customers, the loss of which would have a material adverse effect on either the reporting segment or the Company as a whole. Our primary customers are manufacturers, and the demand for our products is generally not seasonal.

Foreign Operations

Our international operations accounted for approximately 55% of our sales in 2006 and 49% in 2005. While our international operations may be subject to a number of additional risks such as exposure to foreign currency exchange risk, we do not believe that our foreign operations, on the whole, carry greater risk than our operations in the United States. Information about sales by geographic region for the past three years and long-lived assets by geographic region for the past two years can be found in footnote 16 in Item 8 of Part II of this Annual Report on Form 10-K. More information about our programs to manage exchange risk and interest rate risk can be found in Item 7A of Part II of this Annual Report on Form 10-K.

Raw Materials

Raw material costs account for approximately 85% of our cost of sales. In 2006, we purchased approximately $4 billion of raw materials. The three largest raw materials that we use are phenol, methanol and urea, which represented 50% of our total raw material expenditures. The majority of raw materials that we use to manufacture our products are available from more than one source and are readily available in the open market. We have long-term purchase agreements for our primary and many other raw materials that ensure the availability of adequate supply. These agreements generally have periodic price adjustment mechanisms and do not have minimum annual purchase requirements. Smaller quantity materials that are single sourced generally have long-term supply contracts to maximize supply reliability. Prices for our main feedstocks are generally driven by underlying petrochemical benchmark prices and energy costs, which are subject to price fluctuations. Although we seek to offset increases in raw material prices with increases in our product prices, we may not always be able to do so, and there may be periods when price increases lag behind raw material price increases.

Competition

We compete with a variety of companies in each of our product lines, including large global chemical companies and small specialty chemical companies. In addition, we face competition from a number of other products that are potential substitutes for formaldehyde-based resins. The principal competitive factors in our industry include technical service, breadth of product offering, product innovation and price. Some of our competitors are larger and have greater financial resources and less debt than we do, and, as a result, may be better able to withstand changes in industry conditions, including pricing, and the economy as a whole. We are able to compete with smaller niche specialty chemical companies due to our investment in research and development and our customer service model, which provides for on-site value-added technical service for our customers. In addition, our size and scale provides us significant efficiencies in our cost structure.

 

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We believe that no single company competes with us across all of our existing product lines. Following are our principal competitors by market application.

Adhesive & Structural Products

 

Major Products

       

Principal Competitors

Forest Products Resins       Dynea International, Georgia-Pacific and Kronospan
Formaldehyde Applications       Dynea International and Georgia-Pacific
Phenolic Specialty Resins       Dynea International, Occidental Petroleum, Schenectady, Ashland and PA Resins
Epoxy Resins and Intermediates       Huntsman, Dow Chemical, Nan Ya and the Formosa Plastics Group, Chang Chun Polymers and Thai Epoxy
Composite Resins       Huntsman, Dow Chemical, Ashland, AOC, Reichhold and CCP/Atofina
Phenolic Encapsulated Substrates       Ashland, Carbo Ceramics and Santrol
Molding Compounds       FAR and Sumitomo

Coating Products

 

Major Products

      

Principal Competitors

Epoxy Coating Resins      Dow Chemical, Huntsman, Nan Ya and the Formosa Plastics Group, Leuna and Kuk-do
Polyester Resins      DSM, Cytec, Cray Valley/CCP, Reichhold, Nuplex and EPS (owned by Valspar)
Alkyd Resins      Reichhold, CCP/Atofina/Cray Valley, DSM, Nuplex and EPS (owned by Valspar)
Acrylic Resins      BASF, Dow Chemical, Cognis and DSM (Neoresins)
Ink Resins and Additives      Mead Westvaco, Arizona Chemical, Resinall, Arakawa and Harima
Versatic Acids and Derivatives      ExxonMobil and Tianjin Shield

 

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Research and Development

Our research and development activities are geared to developing and enhancing products, processes, applications and technologies so that we can maintain our position as the world’s largest producer of thermosetting resins. We focus on:

 

   

developing new or improved applications based on our existing product lines and identified customer needs;

 

   

developing new resin products and applications for customers to improve their competitive advantage and profitability;

 

   

providing premier technical service for customers of specialty products;

 

   

providing technical support for manufacturing locations and assisting in optimizing our manufacturing processes;

 

   

ensuring that our products are manufactured consistent with our global environmental, health and safety policies and objectives;

 

   

developing lower cost manufacturing processes globally; and

 

   

expanding our production capacity.

In 2006, 2005 and 2004, our research and development and technical services expense was $69, $61 and $30, respectively. We take a customer-driven approach to discover new applications and processes and provide excellent customer service through our technical staff. Through regular direct contact with our key customers, our research and development associates can become aware of evolving customer needs in advance and can anticipate their requirements to more effectively plan customer programs. We also focus on continuous improvement of plant yields and production capacity and reduction of fixed costs. These continuous integrated streams are characterized by exceptional product consistency, low cost economics and high quality resin that is valued by our customers for their demanding applications.

We have over 700 scientists and technicians worldwide. Our research and development facilities include a broad range of synthesis, testing and formulating equipment, and small-scale versions of customer manufacturing processes for applications development and demonstration. In addition, we have an agreement with a not-for-profit research center to assist in research projects and new product development initiatives.

Patents and Trademarks

We own, license or have rights to over 1,700 patents, over 2,300 trademarks, and various patent and trademark applications and technology licenses around the world, which we hold for use or currently use in our operations. A majority of our patents relate to developing new products and processes for manufacturing and will expire between 2007 and 2027. We renew our trademarks on a regular basis. While we view our patents and trademarks to be valuable, because of the broad scope of our products and services, we do not believe that the loss or expiration of any single patent or trademark would have a material adverse effect on our results of operations, financial position or the continuation of our business.

Industry Regulatory Matters

Domestic 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, including the European inventory of existing commercial chemical substances and the European list of notified chemical substances, the United States, including the Toxic Substances Control Act inventory, and China are the most significant to our business. Chemicals that are on one or more of these lists can usually be registered and imported without requiring additional testing in other countries, although additional administrative hurdles may exist.

The European Commission has enacted a new regulatory system, known as Registration, Evaluation and Authorization of Chemicals, or REACH, which requires manufacturers, importers and consumers of certain chemicals to register these chemicals and evaluate their potential impact on human health and the environment. Under REACH, significant market restrictions could be imposed on the current and future uses of chemical products that we use as raw materials or that we sell as finished products in the European Union.

We also actively petition the U.S. Food and Drug Administration to sanction the use of certain specialty chemicals that we produce that we believe are safe for use by our customers to manufacture products that will come in direct or indirect contact with food.

 

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Environmental Regulations

Our operations involve the use, handling, processing, storage, transportation and disposal of hazardous materials and are subject to extensive environmental regulation at the federal, state and international level and are exposed to the risk of claims for environmental remediation or restoration. Our production facilities require operating permits that are subject to renewal or modification. Violations of environmental laws or permits may result in restrictions being imposed on operating activities, substantial fines, penalties, damages or other costs. In addition, 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. Other laws permit individuals to seek recovery of damages for alleged personal injury or property damage due to exposure to hazardous substances and conditions at our facilities or to hazardous substances otherwise owned, sold or controlled by us. Therefore, notwithstanding our commitment to environmental management, environmental health and safety, we may incur liabilities in the future, and these liabilities may result in a material adverse effect on our business, financial condition, results of operations or cash flows.

Although our environmental policies and practices are designed to ensure compliance with international, federal and state laws and environmental regulations, future developments and increasingly stringent regulation could require us to make additional unforeseen environmental expenditures. In addition, our former operations, including our ink, wallcoverings, film, phosphate mining and processing, thermoplastics, and food and dairy operations, may give rise to claims relating to our period of ownership. We cannot assure you that, as a result of former, current or future operations, there will not be some future impact on us as the result of new regulations or additional environmental remediation or restoration liabilities.

We have adopted and implemented health, safety and environmental policies, which include systems and procedures that govern environmental emissions, waste generation, process safety management, handling, storage and disposal of hazardous substances, worker health and safety requirements, emergency planning and response, and product stewardship. We expect to incur future costs for capital improvements and general compliance under environmental laws, including costs to acquire, maintain and repair pollution control equipment. In 2006, we incurred related capital expenditures of $18. We estimate that capital expenditures in 2007 for environmental controls at our facilities will be between $25 and $30. This estimate is based on current regulations and other requirements, but it is possible that a material amount of capital expenditures, in addition to those we currently anticipate, could be necessary if these regulations or other requirements change.

Employees

At December 31, 2006, we had approximately 6,900 employees. Approximately 40% of our employees are members of a labor union or are represented by workers’ councils that have collective bargaining agreements. Most of our European employees are represented by workers’ councils. We believe that relations with our union and non-union employees are good.

Formation and History of Hexion

Hexion was formed on May 31, 2005 by combining three Apollo Management, L.P. (“Apollo”) controlled companies: Resolution Performance Products, LLC (“Resolution Performance”), Resolution Specialty Materials, Inc. (“Resolution Specialty”), and Borden Chemical, Inc. (“Borden Chemical”), including Bakelite Aktiengesellschaft (“Bakelite”). We refer to this combination as the “Hexion Formation.”

Resolution Performance, a worldwide manufacturer and developer of epoxy resins and a leading global manufacturer of versatic acids and derivatives, was acquired by an affiliate of Apollo on November 14, 2000 from Shell Chemical L.P.

Resolution Specialty, a producer of coating resins, inks, composite polymers, textile chemicals and acrylic monomers, was acquired by an affiliate of Apollo from Eastman Chemical Company (“Eastman”) on August 2, 2004 (the “Resolution Specialty Transaction”).

Borden Chemical, a worldwide manufacturer of forest products and industrial resins, formaldehyde, oil field products and other specialty chemicals, was acquired by an affiliate of Apollo on August 12, 2004 (the “Borden Transaction”). On April 29, 2005, prior to the Hexion Formation, Borden Chemical acquired Bakelite, a leading European producer of phenolic and epoxy composite resins and molding compounds (the “Bakelite Transaction”).

 

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We have consolidated the management teams and centralized corporate functions of these four predecessor companies under the leadership of the current Hexion management team. We have implemented plans that we believe will provide us with additional growth opportunities through global product line management, as well as opportunities to further improve operational efficiencies, reduce fixed costs, optimize manufacturing assets and improve capital spending efficiency.

Acquisitions and Divestitures.

Following are our significant acquisitions and divestitures that we have made since the Hexion Formation.

On January 31, 2006, we acquired the decorative coatings and adhesives business unit of The Rhodia Group (the “Coatings Acquisition”). This business generated 2005 sales of approximately $200, and includes eight manufacturing facilities in Europe, Australia, Thailand and Brazil. This acquisition is in our Coatings and Inks segment.

On March 31, 2006, we sold Alba Adesivos, our branded consumer adhesives company based in Boituva, Brazil (the “Brazilian Consumer Divestiture”). This business generated 2005 sales of $38 and was included in our Formaldehyde and Forest Product Resins segment.

On June 1, 2006, we acquired the global ink and adhesive resins business of Akzo Nobel (the “Inks Acquisition”). This business manufactures resins that are used to manufacture inks for commercial printing and packaging, digital inks for laser and photocopying printing, and pressure sensitive adhesives that are used in tape and labeling applications. This business generated 2005 sales of approximately $215, and includes ten manufacturing facilities in Europe, North America, Argentina, Asia and New Zealand. This acquisition is in our Coatings and Inks segment.

On August 1, 2006, we sold our Italian-based engineering thermoplastics business, Taro Plast, S.p.A. (“Taro Plast”) which was acquired in the Bakelite Transaction (the “Thermoplastics Divestiture”). This business generated 2005 sales of $28 and is presented as a discontinued operation in our consolidated financial statements and was included in our Epoxy and Phenolic Resins segment.

On February 1, 2007, we acquired the adhesives and resins business of Orica Limited (the “Orica Acquisition”). This business manufactures formaldehyde and formaldehyde-based binding resins used primarily in the forest products industry. This business generated 2006 sales of approximately $85, and includes three manufacturing facilities in Australia and New Zealand. This acquisition will be included in our Formaldehyde and Forest Products segment.

Where You Can Find More Information

The public may read and copy any materials that we file with the Securities and Exchange Commission (“SEC”) at the SEC’s Public Reference Room at 100 F Street, NW, Washington, DC 20549. The public may obtain information about the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. In addition, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to these reports are available free of charge to the public through our internet website at www.hexion.com under “Investor Relations - SEC Filings” or on the SEC’s website at www.sec.gov.

 

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ITEM 1A - RISK FACTORS

Following are our principal risks. These factors may or may not occur, and we cannot express a view on the likelihood that any of these may occur. Other factors may exist that we do not consider to be significant based on information that is currently available or that we are not currently able to anticipate. Any of the following risks could materially adversely affect our business, financial condition or results of operations and prospects.

Resolution Performance, Resolution Specialty, Borden Chemical and Bakelite have a limited history of working together as a single company. We have a history of losses and we may fail to achieve cost savings and synergies from the Hexion Formation.

Our limited operating history, and the challenge of integrating previously independent businesses, make evaluating our business and our future financial prospects difficult. Primarily as a result of transactions and integration activities, we had a net loss available to common shareholders of $142, $117 and $105 for the years ended December 31, 2006, 2005 and 2004, respectively. Our potential for future business success and operating profitability must be considered in light of the risks, uncertainties, expense and difficulties typically encountered by recently organized or combined entities. In addition, we may not successfully achieve the cost savings and synergies that we anticipate from integrating the legacy operations of Resolution Performance, Resolution Specialty, Borden Chemical and Bakelite. A significant element of our business strategy is to improve our operating efficiencies and reduce our operating costs. We are currently targeting $175 in initial synergies from the Hexion Formation. During the year ended December 31, 2006 we achieved synergies of $50 and cumulative synergy cost savings from the Hexion Formation through December 31, 2006 of $70. A variety of factors could cause us not to achieve our $175 in expected cost savings by the end of 2007, or at all. In this case, our results of operations and profitability would be negatively impacted. Additional risk factors associated with our integration include:

 

   

delays in implementing more advanced worldwide IT systems;

 

   

higher than expected or unanticipated costs to implement the plan and to operate the business;

 

   

inadequate resources to implement the plan and to operate the business;

 

   

our inability to optimize manufacturing processes among the companies;

 

   

our inability to obtain lower raw material prices;

 

   

our inability to utilize new geographic distribution channels; and

 

   

our inability to reduce corporate and administrative expenses.

We may not generate sufficient cash flows from operations to meet our debt service payments and our interest expense could increase if interest rates increase. In addition, our substantial indebtedness could adversely affect our ability to raise additional capital to fund our operations and limit our ability to react to changes in the economy or our industry.

We are a highly leveraged company. As of December 31, 2006, we have $3,392 of outstanding indebtedness. In 2007, based on the amount of indebtedness outstanding at December 31, 2006, our cash debt service is expected to be approximately $350 (including $66 of short term maturities) based on current interest rates, of which $107 represents debt service on fixed-rate obligations (including variable rate debt subject to interest rate swap agreements). We may not generate sufficient cash flow from operations to meet our debt service and other obligations. If we are unable to meet our expenses and debt service obligations, we may need to refinance all or a portion of our indebtedness on or before maturity, sell assets or raise equity capital. We may not be able to refinance any of our indebtedness, sell assets or raise equity capital on commercially reasonable terms or at all, which could cause us to default on our obligations and impair our liquidity. An inability to generate sufficient cash flows to satisfy our debt obligations, or to refinance our obligations on commercially reasonable terms would have a material adverse impact on our business, financial condition and results of operations.

Our interest expense could increase if interest rates increase because 37% of our outstanding borrowings at December 31, 2006, including the impact of outstanding interest rate swap agreements, are at variable interest rates. While we have interest rate swaps in place to hedge a portion of the risk, an increase of 1% in the interest rate payable on our variable rate indebtedness would increase our 2007 estimated debt service requirements by approximately $13.

Our substantial level of indebtedness could have other consequences on our financial position and results of operations, including:

 

   

it may limit our flexibility to plan for, or react to, changes in our operations or business;

 

   

we are more highly leveraged than some of our competitors, which may place us at a competitive disadvantage;

 

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it may make us more vulnerable to downturns in our business or in the economy;

 

   

a substantial portion of our cash flow provided by operations will be used to repay our debt and will not be available for other purposes; and

 

   

it may restrict us from making strategic acquisitions, introducing new technologies or exploiting business opportunities.

The terms of our senior secured credit facilities and other debt may restrict our current and future operations, in particular our ability to respond to changes in our business or to take certain actions.

Our senior secured credit facilities and other debt contain a number of restrictive covenants that can impose significant operating and financial restrictions on our ability to, among other things:

 

   

incur or guarantee additional debt;

 

   

pay dividends and make other distributions to our shareholders;

 

   

create or incur certain liens;

 

   

make certain loans, acquisitions, capital expenditures or investments;

 

   

engage in sales of assets and subsidiary stock;

 

   

enter into sale/leaseback transactions;

 

   

enter into transactions with affiliates; and

 

   

transfer all or substantially all of our assets or enter into merger or consolidation transactions.

In addition, our senior secured credit facilities require us to not exceed a senior secured bank leverage ratio. As a result of these covenants and this ratio, we are limited in how we may conduct our business, and we may be unable to engage in favorable business activities or finance future operations or capital needs. While we are currently in compliance with all of the terms of our outstanding indebtedness, including the financial covenants, a downturn in our business could cause us to fail to comply with the covenants in our senior secured credit facilities. A failure to comply with the covenants contained in our senior secured credit facilities or our other debt could result in default, which if not cured or waived, could have a material adverse affect on our business, financial condition and results of operations. In the event of any default under our senior secured credit facilities or our other debt, the lenders:

 

   

will not be required to lend any additional amounts to us;

 

   

could elect to declare all borrowings that are outstanding, together with accrued and unpaid interest and fees, to be due and payable; or

 

   

require us to apply all of our available cash to repay these borrowings.

If the debt under our senior secured credit facilities or our other debt were to be accelerated, our assets may not be sufficient to repay such debt in full. Although we believe our assumptions are reasonable and correct and are consistent with the definition of Adjusted EBITDA under our senior secured credit facilities, investors should not place undue reliance on Adjusted EBITDA as an indicator of current and future performance.

Demand for many of our products is cyclical and we may experience prolonged depressed market conditions for our products, which may decrease our sales and profitability.

Demand for our products depends, in part, on general economic conditions. A decline in economic conditions in the industries that our customers serve may have a material adverse effect on our business. Our products are used in industries, some of which are cyclical in nature, such as the new home construction, automotive, oil and gas, intermediate chemicals and electronics industries. We sell our products to manufacturers in those industries who incorporate them into their own products. Sales to the construction industry are driven by trends in commercial and residential construction, housing starts and trends in residential repair and remodeling. Consumer confidence, mortgage rates, credit standards and income levels play a significant role in driving demand in the residential construction, repair and remodeling sector. A drop in consumer confidence or an increase in mortgage rates, credit

 

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standards or unemployment could cause a slowdown in the construction industry, and in particular the residential construction, repair and remodeling industry. Our products our used in numerous applications in the automotive industry. As a result, the level of new automotive production both in North America and internationally impacts the demand for our resins, molding compounds and versatic acids. Sales of our phenolic encapsulated substrates is impacted by the level of international natural gas and oil drilling activity. Downturns in these industries could cause a material decrease in our sales and profitability.

We face competition from other chemical companies and substitute products, which could force us to lower our prices, which would adversely affect our profitability and financial condition.

The markets that we operate in are highly competitive, and this competition could harm our business, results of operations, cash flow and financial condition. Our competitors include major international producers as well as smaller regional competitors. We believe that the most significant competitive factor that impacts demand for our products is selling price, and we may be forced to lower our selling price based on our competitors’ pricing decisions, which would reduce our profitability. In addition, we face competition from a number of products that are potential substitutes for formaldehyde resins. Growth in substitute products for formaldehyde-based resins could adversely affect our market share, net sales and profit margins. Furthermore, the movement towards substitute products could be exacerbated as a result of The International Agency for Research on Cancer (“IARC”) 2004 reclassification of formaldehyde from a “probable human carcinogen” to “carcinogenic to humans” based on studies that have linked formaldehyde exposure to nasopharyngeal cancer, and a possible causal association between leukemia and occupational exposure to formaldehyde.

Additional trends include current and anticipated consolidation among our competitors and customers which may cause us to lose market share as well as put downward pressure on pricing. There is also a trend in the chemical industry toward relocating manufacturing facilities to lower-cost regions, such as Asia, which may permit some of our competitors to lower their costs and improve their competitive position.

Some of our competitors are larger, have greater financial resources and have less debt than we do. As a result, those competitors may be better able to withstand a change in conditions within our industry and in the economy as a whole. If we do not compete successfully, our business, operating margins, financial condition, cash flows and profitability could be adversely affected.

We rely significantly on raw materials to manufacture our products. An inadequate supply of raw materials or fluctuations in raw material costs could have an adverse impact on our business.

Raw material costs make up approximately 85% of our cost of sales. During the past three years, the prices of our raw materials have been volatile. Although many of our contracts include competitive price clauses that allow us to buy outside the contract if market pricing falls below contract pricing, and many other contracts have minimum-maximum monthly volume commitments that allow us to take advantage of spot pricing, we may not be able to purchase raw materials at market prices. In addition, some of our customer contracts include selling price provisions that are indexed to publicly available indices for these materials; however, we may not be able to pass on raw material price increases to our customers immediately, if at all. Due to differences in timing of the pricing trigger points between our sales and purchase contracts, there is often a “lead-lag” impact that can negatively impact our margins in the short term in periods of rising raw material prices and positively impact them in periods of falling raw material prices. Raw material prices may not decrease from their currently high levels or, if they do, we may not be able to capitalize on these reductions in a timely manner, if at all. Future raw material prices may be impacted by new laws or regulations, suppliers’ allocations to other purchasers, interruptions in production by suppliers, natural disasters and changes in exchange rates. For example, we were subject to increased raw material prices and fuel surcharges as a result of Hurricanes Katrina and Rita in 2005, which negatively impacted our results by $27 million. If the cost of raw materials increases significantly and we are unable to offset the increased costs with higher selling prices, our profitability will decline.

Our manufacturing operations require adequate supplies of raw materials on a timely basis. We rely on long-term agreements with key suppliers for most of our raw materials. The loss of a key source or a delay in shipments could have an adverse effect on our business. Raw material availability may be subject to curtailment or change due to, among other things, new laws or regulations, suppliers’ allocations to other purchasers, interruptions in production by suppliers and natural disasters. Should any of our suppliers fail to deliver raw materials to us or should any key long-term supply contracts be cancelled, we may be forced to purchase raw materials in the open market. As a result, we may not be able to purchase these materials or purchase them at prices that would allow us to remain competitive. For example, during the third quarter of 2006 we were placed on allocation for methanol, a raw material that is used in the production of formaldehyde and formaldehyde-derived products, due to two major methanol producers declaring 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 this force majeure period, which ended on October 2, 2006.

One supplier provides over 10% of certain raw material purchases that we make, and we could incur significant time and expense if we had to replace this supplier. In addition, several of our feedstocks at various facilities are transported through a pipeline from one supplier. If we were unable to receive these feedstocks through these pipeline arrangements, we may not be able to obtain them from other suppliers at competitive prices or in a timely manner.

 

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Environmental obligations and liabilities could have a substantial negative impact on our financial condition, cash flows and profitability.

Our operations involve the use, handling, processing, storage, transportation and disposal of hazardous materials and are subject to extensive environmental laws and regulations at the national, state, local and international level. These environmental laws and regulations include some that govern the discharge of pollutants into the air and water, the management and disposal of hazardous materials and wastes, the cleanup of contaminated sites, and occupational health and safety. We have incurred, and will continue to incur, significant costs and capital expenditures to comply with these laws and regulations. In 2006, we incurred related capital expenditures of $18 to comply with environmental laws and regulations, and other environmental improvements. Violations of environmental laws or permits may result in restrictions being imposed on our operating activities or in our being subjected to substantial fines, penalties, criminal proceedings, third party property damage or personal injury claims or other costs. In addition, future developments or increasingly stringent regulations could require us to make additional unforeseen environmental expenditures.

Even if we fully comply with environmental laws, we are subject to liability associated with hazardous substances in soil, groundwater and elsewhere at a number of sites. These include sites that we formerly owned or operated, and sites where hazardous wastes and other substances from our current and former facilities and operations have been treated, stored or disposed of, as well as sites that we currently own or operate. Depending upon the circumstances, our liability may be joint and several, meaning that we may be held responsible for more than our proportionate share, or even all, of the liability involved. Environmental conditions at these sites can lead to claims against us for personal injury or wrongful death, property damages, and natural resource damage, as well as to claims and obligations for the investigation and cleanup of environmental conditions. The extent of any of these liabilities is difficult to predict.

We have been notified that we are or may be responsible for environmental remediation at a number of sites in the United States, Europe and South America. We are also performing a number of voluntary cleanups. The most significant site, making up approximately half of our remediation accrual, is a site formerly owned by us in Geismar, Louisiana. As the result of former, current or future operations, there may be additional environmental remediation or restoration liabilities or claims of personal injury by employees or members of the public due to exposure or alleged exposure to hazardous materials in connection with our operations, properties or products. Several sites, sold by us over 20 years ago, may have significant site closure or remediation costs. Actual costs at these sites, and our share, if any, are unknown to us at this time. In addition, we have been named in two tort actions relating to one of these sites. These environmental liabilities or obligations, or any that may arise or become known to us in the future, could have a material adverse effect on our financial condition, cash flows and profitability.

Because we manufacture and use materials that are known to be hazardous, we are subject to comprehensive product and manufacturing regulations, for which compliance can be costly and time consuming. In addition, our production facilities are subject to significant operating hazards which could cause personal injury and loss of life, severe damage to, or destruction of, property and equipment, and environmental contamination.

We produce hazardous chemicals that require care in handling and use that are subject to regulation by many U.S. and non-U.S. national, supra-national, state and local governmental authorities. In some circumstances, these authorities must approve our products and manufacturing processes and facilities before we may sell some of these chemicals. We are subject to ongoing reviews of our products and manufacturing processes. For example, formaldehyde is extensively regulated, and various public health agencies continue to evaluate it. In 2004, IARC reclassified formaldehyde as “carcinogenic to humans,” a higher classification than previous IARC evaluations. It is possible that this reclassification will lead to further governmental review of existing regulations and may result in additional costly requirements. In addition, Bisphenol A (“BPA”), which is used as an intermediate at our Deer Park, Texas and Pernis, the Netherlands manufacturing facilities, and is also sold directly to third parties, is currently under evaluation as an “endocrine disrupter.” Endocrine disrupters are chemicals that have been alleged to interact with the endocrine systems of humans and wildlife and disrupt their normal processes. As required by EU regulation 793/93/EC, BPA producers are conducting an extensive toxicology testing program of this chemical. In the event that BPA is further regulated, additional operating costs would be likely in order to meet more stringent regulation of this chemical.

To obtain regulatory approval of certain new products, we must, among other things, demonstrate to the relevant authority that the product is safe for its intended uses and that we are capable of manufacturing the product in compliance with current regulations. The process of seeking approvals can be costly, time consuming and subject to unanticipated and significant delays. Approvals may not be granted to us on a timely basis, or at all. Any delay in obtaining, or any failure to obtain or maintain, these approvals would adversely affect our ability to introduce new products and to generate revenue from those products. New laws and regulations may be introduced in the future that could result in additional compliance costs, seizures, confiscation, recall or monetary fines, any of which could prevent or inhibit the development, distribution or sale of our products. For example, we manufacture resin-coated sand. Because sand consists primarily of crystalline silica, potential silica exposure exists, which is a recognized health hazard. The Occupational Safety and Health Administration, or OSHA, will likely propose a comprehensive occupational health standard for crystalline silica in 2007 for lower permissible exposure limits, exposure monitoring, medical surveillance and worker training. We may incur substantial additional costs to comply with any new OSHA regulations. In addition, the European Commission has enacted a new regulatory system, known as Registration, Evaluation and Authorization of Chemicals, or REACH, which requires

 

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manufacturers, importers and consumers of certain chemicals to register these chemicals and evaluate their potential impacts on human health and the environment. Under REACH, significant market restrictions could be imposed on the current and future uses of chemical products that we use as raw materials or sell as finished products in the European Union. As the scope of this potential regulation is not yet known, we cannot predict future compliance costs, which could be significant. If we fail to comply with applicable laws and regulations, we may be subject to civil remedies, including fines, injunctions, recalls or seizures, which would have an adverse effect on our financial condition, cash flows and profitability.

Our production facilities are subject to hazards associated with the manufacture, handling, storage and transportation of chemical materials and products, including pipeline leaks and ruptures, explosions, fires, inclement weather and natural disasters, mechanical failure, unscheduled downtime, labor difficulties, transportation interruptions and environmental hazards, such as spills, discharges or releases of toxic or hazardous substances and gases, storage tank leaks and remediation complications. These hazards can cause personal injury and loss of life, severe damage to or destruction of property and equipment, and environmental contamination and other environmental damage, and could have a material adverse effect on our financial condition. We may incur losses beyond the limits or coverage of our insurance policies for liabilities that are associated with environmental cleanup that may arise from these hazards. In addition, various kinds of insurance for companies in the chemical industry, such as coverage for silica claims, have not been available on commercially acceptable terms, or, in some cases, have been unavailable altogether. In the future, we may not be able to obtain coverage at current levels, and our premiums may increase significantly on coverage that we maintain.

We are subject to claims from our customers and their employees, environmental action groups and neighbors living near our production facilities.

We produce hazardous chemicals that require appropriate procedures and care to be used in handling or using them to manufacture other products. As a result of the hazardous nature of some of the products we use and produce, we may face claims relating to incidents that involve our customers’ improper handling, storage and use of our products. We have historically faced a substantial number of lawsuits, including class action lawsuits, that claim liability for death, injury or property damage caused by products that we manufacture or that contain our components. These lawsuits, and any future lawsuits, could result in substantial damage awards against us, which in turn could encourage additional lawsuits. In addition, the activities of environmental action groups could result in litigation or damage to our reputation.

The classification of formaldehyde as “carcinogenic to humans” by IARC could become the basis of product liability litigation, particularly if there would be any definitive studies that demonstrate a causal association with leukemia. In addition, in large part as the result of the bankruptcies of many producers of asbestos containing products, plaintiffs’ attorneys have increased their focus on peripheral defendants, including us, asserting that even products that contained small amounts of asbestos caused injury. Plaintiffs’ attorneys are also focusing on alleged harm caused by other products we have made or used, including silica-containing resin coated sands and vinyl chloride monomer, or VCM. For example, we have been named in four lawsuits claiming injuries related to benzene exposure even though benzene was not an ingredient in our products. While we cannot predict the outcome of pending suits and claims, we believe that we have adequate reserves to address currently pending litigation and adequate insurance to cover currently pending and foreseeable future claims. An unfavorable outcome in these litigation matters may cause our profitability, business, financial condition and reputation to decline.

Currency translation risk and currency transaction risk may negatively affect our sales and earnings, and could result in exchange losses.

We conduct our business and incur costs in the local currency of most of the countries in which we operate. In 2006, our sales outside the United States represented approximately 55% of our total sales. Our results of operations are reported in the relevant local currency and then translated to U.S. dollars at the applicable currency exchange rate for our financial statements. Changes in exchange rates between those foreign currencies and the U.S. dollar will affect our sales and earnings and may result in exchange translation losses. In addition to currency translation risks, we have currency transaction risk whenever one of our operating subsidiaries enters into either a purchase or a sales transaction using a different currency from the currency in which it receives revenues. We may engage in transactional exchange rate hedging activities to mitigate the impact of exchange rate fluctuations. However, the hedging transactions we enter into may not be effective or could result in foreign exchange hedging loss. The impact of future exchange rate fluctuations on our results of operations cannot be accurately predicted. Given the volatility of exchange rates, we may not be able to effectively manage our currency transaction and/or translation risks, and any volatility in currency exchange rates may have an adverse effect on our financial condition, cash flows and profitability.

We operate our business in countries that historically have been and may continue to be susceptible to recessions or currency devaluation, including Brazil and Malaysia. In addition, as we expand our business in emerging markets, particularly in China and Russia, the uncertain regulatory environment in these countries could have a negative impact on our operations there.

We rely on patents and confidentiality agreements to protect our intellectual property. Our failure to protect these intellectual property rights could adversely affect our future performance and growth.

Protection of our proprietary processes, methods and compounds, and other technology is important to our business. Failure to protect our existing intellectual property rights may result in the loss of valuable technologies or having to pay other companies for

 

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infringing on their intellectual property rights. We rely on patent, trade secret, trademark and copyright law as well as judicial enforcement to protect these technologies. The majority of our patents relate to developing new products and processes for manufacturing, and they expire at various times between 2007 and 2027. Some of our technologies are not covered by any patent or patent application. In addition, our patents could be challenged, invalidated, circumvented or rendered unenforceable. Furthermore, pending patent applications may not result in an issued patent, or if patents are issued to us, these patents may not provide meaningful protection against competitors or against competitive technologies.

Our production processes and products are specialized. However, we could face patent infringement claims from our competitors or others alleging that our processes or products infringe on their proprietary technology. If we were subject to an infringement suit, we may be required to change our processes or products, or stop using certain technologies or producing the infringing product entirely. Even if we ultimately prevail in an infringement suit, the existence of the suit could cause our customers to seek other products that are not subject to infringement suits. Any infringement suit could result in significant legal costs and damages and impede our ability to produce key products, which could have a material adverse effect on our business, financial condition and results of operations.

In addition, effective patent, trademark, copyright and trade secret protection may be unavailable or limited in some foreign countries. In some countries we do not apply for patent, trademark or copyright protection. We also rely on unpatented proprietary manufacturing expertise, continuing technological innovation and other trade secrets to develop and maintain our competitive position. While we generally enter into confidentiality agreements with our employees and third parties to protect our intellectual property, these confidentiality agreements are limited in duration and could be breached, and may not provide meaningful protection of our trade secrets or proprietary manufacturing expertise. Adequate remedies may not be available if there is an unauthorized use or disclosure of our trade secrets and manufacturing expertise. In addition, others may obtain knowledge about our trade secrets through independent development or by legal means. The failure of our patents or confidentiality agreements to protect our processes, apparatuses, technology, trade secrets and proprietary manufacturing expertise, methods and compounds could have an adverse effect on our business by jeopardizing critical intellectual property.

The Pension Benefit Guaranty Corporation has oversight for the funding of U.S. plans, and could require us to make significant contributions, or could terminate certain plans if we do not meet certain minimum funding requirements. Termination of these plans by the Pension Benefit Guaranty Corporation would increase our pension expense and could result in liens on material amounts of our assets.

On April 17, 2006, we notified the Pension Benefit Guaranty Corporation (“PBGC”) that a legacy Borden Chemical defined benefit pension plan (the “Borden Plan”) was underfunded by approximately $91 on a termination basis. IRS regulations require us to increase our contributions to the Borden Plan to reduce this underfunding. We contributed $24 to this plan during 2006. Based on current law, including the Pension Protection Act of 2006 (the “2006 PPA”) and plan provisions, we estimate that our total minimum funding required for the Borden Plan for the five years ended in 2011 will be approximately $43. However, our contributions during this period could exceed this projection, depending on the following factors:

 

   

the performance of the assets in the Borden Plan does not meet our expectations,

 

   

the PBGC requires additional contributions to the Borden Plan,

 

   

there are changes to IRS regulations or other applicable laws,

 

   

other actuarial assumptions, such as the discount rate, require modification.

The need to make these cash contributions may reduce the amount of cash that would be available to meet other obligations or the needs of our business. In addition, the PBGC could terminate the Borden Plan under a limited number of circumstances, including in the event the PBGC concludes that its risk may increase unreasonably if the Borden Plan continues. If the Borden Plan is terminated for any reason while it is underfunded, we could be required to make an immediate payment to the PBGC for all or a substantial portion of the underfunding as calculated by the PBGC using its own assumptions (which might result in a larger pension obligation than that based on the assumptions we have used to fund the Borden Plan). The PBGC could also assert a lien on a material amount of our assets.

We have a U.S. defined benefit plan that was converted to a cash balance plan prior to 2006. Under the 2006 PPA, cash balance plans are generally not considered to be discriminatory if certain requirements are met; however, plans converted prior to the effective date of the 2006 PPA, such as ours, are not grandfathered under the act. While there has not been any guidance issued regarding cash balance plans converted prior to the effective date of the 2006 PPA, it is possible that our cash balance plan may need to be modified for the period prior to 2006. Such a requirement may increase our obligations under the plan, but there is insufficient information at this time to assess the potential impact.

 

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Our majority shareholder’s interests may conflict with or differ from our interests.

Apollo beneficially owns or controls over 90% of our common stock. In addition, representatives of Apollo have the ability to prevent any transaction that requires the approval of directors. As a result, Apollo has the ability to substantially influence all matters that require shareholder approval, including the election of our directors and the approval of significant corporate transactions such as mergers, tender offers and the sale of all or substantially all of our assets. The interests of Apollo and its affiliates could conflict with or differ from our interests. For example, the concentration of ownership held by Apollo could delay, defer or prevent a change of control of our company or impede a merger, takeover or other business combination which may otherwise be favorable for us. Apollo may also pursue acquisition opportunities that may be complementary to our business, and as a result, those acquisition opportunities may not be available to us.

A major failure of our information systems could harm business.

We depend on integrated information systems to process orders, respond to customer inquiries, manage inventory, purchase, sell and ship goods on a timely basis, maintain cost-efficient operations, prepare financial information and reports, and operate our website. We may experience operating problems with our information systems as a result of system failures, viruses, computer “hackers” or other causes. Any significant disruption or slowdown of our systems could cause orders to be lost or delayed and could damage our reputation with our customers or cause our customers to cancel orders, which could adversely affect our results of operations.

Our internal control over financial reporting may not be effective and our independent auditors may not be able to certify as to their effectiveness, which could have a significant and adverse effect on our business and reputation.

We will be subject to the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 and the rules and regulations of the SEC thereunder (which we refer to as Section 404) as of December 31, 2007. Section 404 requires us to report on the design and effectiveness of our internal control over financial reporting. Our independent auditors will not be required to attest to our internal controls effectiveness until December 31, 2008. The ongoing integration activities, which include information system implementations, process changes and changes in roles and responsibilities, increase the risk of non-compliance. In the course of our ongoing Section 404 evaluation, we have identified areas of internal controls that need improvement. However, as the evaluation process is ongoing, we may identify additional areas that need improvement. We cannot be certain about the timing of completion of our evaluation, documentation, testing and any remediation actions or the impact of these actions on our operations. If our remediation actions are insufficient the chief financial officer or chief executive officer may conclude that our controls are ineffective for purposes of Section 404. As a result, there could be a negative reaction in the financial markets due to a loss of confidence in the reliability of our financial statement or our financial statements could change. In addition, we may be required to incur costs to improve our internal control system and hire additional personnel. This could negatively impact our results of operations.

ITEM 1B - UNRESOLVED STAFF COMMENTS

None.

 

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ITEM 2 - PROPERTIES

Our headquarters are in Columbus, Ohio and we have European executive offices in Hoogvliet, The Netherlands. Our major manufacturing facilities are primarily located in North America and Europe. As of December 31, 2006, we operated 39 domestic production and manufacturing facilities in 19 states and 65 foreign production and manufacturing facilities primarily in Australia, Brazil, Canada, the Czech Republic, China, France, Germany, Italy, Korea, Malaysia, the Netherlands, New Zealand, Spain and the United Kingdom.

The majority of our facilities are used for the production of thermosetting resins, and most of them manufacture more than one type of thermosetting resin, the nature of which varies by site. These facilities typically use batch technology, and range in size from small sites, with a limited number of reactors, to larger sites, with dozens of reactors. One exception to this is our plant in Deer Park, Texas, the only continuous-process epoxy resins plant in the world, which provides us with a cost advantage over conventional technology.

In addition, we have the ability to internally produce key intermediate materials such as formaldehyde, BPA, ECH, versatic acid, acrylic acid and gum rosin. This backward integration provides us with a cost advantage relative to our competitors and facilitates our adequacy of supply. These facilities are usually co-located with the thermosetting resin facilities they serve. As these intermediate materials facilities are often much larger than a typical resins plant, we can capture the benefits of manufacturing efficiency and scale by selling material to third parties that we do not use internally.

We believe our production and manufacturing facilities are well maintained and effectively utilized and are adequate to operate our business. Following are our more significant production and manufacturing facilities and executive offices:

 

Location

  

Nature of Ownership

   Reporting Segment
Deer Park, TX    Owned    Epoxy and Phenolic Resins
Duisburg-Meiderich, Germany    Owned/Leased    Epoxy and Phenolic Resins
Hoogvliet, The Netherlands†    Leased    Epoxy and Phenolic Resins
Iserlohn-Letmathe, Germany    Owned/Leased    Epoxy and Phenolic Resins
Lakeland, FL    Owned    Epoxy and Phenolic Resins
Louisville, KY    Owned    Epoxy and Phenolic Resins
Norco, LA*    Owned    Epoxy and Phenolic Resins
Pernis, the Netherlands*    Owned    Epoxy and Phenolic Resions
Geismar, LA    Owned    Formaldehyde and Forest Products
Gonzales, LA    Owned    Formaldehyde and Forest Products
Kitee, Finland    Owned    Formaldehyde and Forest Products
St. Romuald, QC, Canada    Owned    Formaldehyde and Forest Products
Edmonton, AB, Canada    Owned    Formaldehyde and Forest Products
Kallo, Belgium**    Owned    Coatings and Inks
Ribecourt, France    Owned    Coatings and Inks
Sokolov, Czech Republic    Owned    Coatings and Inks
Brady, TX    Owned    Performance Products
Columbus, OH†    Leased    Corporate and Other

* We own all of the assets at this location. The land is leased.
** The assets at this location are owned, except the land and building, which are occupied pursuant to a lease.
Executive offices.

 

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ITEM 3 - LEGAL PROCEEDINGS

Legal Proceedings

We are involved in various product liability, commercial litigation, personal injury, property damage and other legal proceedings in the ordinary course of our business. The following claims represent material proceedings that are not in the ordinary course of business.

The Sokolov, Czech Republic facility has soil and groundwater contamination which pre-dates privatization and acquisition of the facility by Eastman in 2000. The investigation phase of the site remediation project has been completed, and building demolition and removal of waste is underway. The National Property Fund has provided us a written commitment to reimburse all site investigation and remediation costs up to approximately $73 million. The current estimate for site remediation is significantly less than the maximum amount the National Property Fund has committed to the project.

On August 8, 2005, Governo Do Parana and the Environmental Institution of Paraná IAP, an environmental agency of the Brazilian government, provided Hexion Quimica Industria, our Brazilian subsidiary, with notice of a potential fine of up to $6 million in connection with alleged environmental damages to the Port of Paranagua caused in November 2004 by an oil spill by a shipping vessel carrying methanol purchased by Hexion. The investigation is ongoing and no final determination has been made with respect to damages or the liability of our Brazilian subsidiary. We are disputing this claim.

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

During the fourth quarter, no matters were submitted to a vote of security holders.

 

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PART II

(dollars in millions, except per share data)

ITEM 5 - MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

There is no established public trading market for our common stock. As of March 1, 2007, 82,556,847 common shares were held by our parent, Hexion LLC.

Other than the extraordinary dividends that we previously declared, we do not currently intend to pay any cash dividends on our common stock, and instead intend to retain earnings, if any, to fund future operations and to reduce our debt. Our senior secured credit facilities and the indentures that govern our notes impose restrictions on our ability to pay dividends. Therefore, our ability to pay dividends on our common stock will depend on, among other things, our level of indebtedness at the time of the proposed dividend and whether we are in default under any of our debt instruments. Our future dividend policy will also depend on the requirements of any future financing agreements to which we may be a party and other factors that our board of directors consider relevant. Any decision to declare and pay dividends in the future will be made at the discretion of our board of directors and will depend on, among other things, our results of operations, cash requirements, financial condition, business opportunities, provision of applicable law and other factors that our board of directors may consider relevant. For a discussion of our cash resources and needs, see Item 7 of Part II of this Annual Report on Form 10-K.

We have no compensation plans that authorize issuing our common stock to employees or non-employees. In addition, there have been no sales or repurchases of our equity securities during the past fiscal year. However, we have issued equity awards that are denominated in the common units of our parent, Hexion LLC. As the awards were granted in exchange for service to us these awards are included in our consolidated financial statements. For a discussion of these equity plans see footnote 14 in Item 8 and Item 11 of Part II and Part III, respectively, of this Annual Report on Form 10-K.

In 2006, we declared a dividend to our parent of $500 in connection with a debt refinancing. Approximately $480, funded from the proceeds of newly issued debt, was paid in 2006. We expect to pay the remaining on stock options, as they vest, through 2012. We declared and paid $5 in additional dividends to our parent during 2006.

In conjunction with our formation, we declared a dividend to our parent of $550, of which $523 was paid during 2005. The remaining $27 is expected to be paid on stock options, as they vest, through 2012. This dividend was funded through proceeds that we received from issuing preferred stock and from amounts that we borrowed under our credit facility.

 

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ITEM 6 - SELECTED FINANCIAL DATA

 

     Year ended December 31,  
     2006(1)     2005(2)     2004(3)     2003     2002  
     (dollars in millions, except per share data)  

Statements of Operations:

          

Net sales

   $ 5,205     $ 4,442     $ 2,019     $ 782     $ 740  

Cost of sales

     4,485       3,781       1,785       714       601  
                                        

Gross profit

     720       661       234       68       139  
                                        

Selling, general & administrative expense

     384       391       163       81       82  

Transaction costs

     20       44       56       —         —    

Integration costs

     57       13       —         —         —    

Other operating (income) expense(4)

     (27 )     5       6       10       16  
                                        

Operating income (loss)

     286       208       9       (23 )     41  
                                        

Interest expense, net

     242       203       117       77       65  

Loss on extinguishment of debt

     121       17       —         —         —    

Other non-operating expense

     3       16       5       —         —    
                                        

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

     (80 )     (28 )     (113 )     (100 )     (24 )

Income tax expense (benefit)

     14       48       —         (37 )     (10 )
                                        

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

     (94 )     (76 )     (113 )     (63 )     (14 )

Earnings from unconsolidated entities, net of taxes

     3       2       —         —         —    

Minority interest in net (income) loss of consolidated subsidiaries

     (4 )     (3 )     8       13       3  
                                        

Loss from continuing operations

     (95 )     (77 )     (105 )     (50 )     (11 )

Loss from discontinued operations(5)

     (14 )     (10 )     —         —         —    
                                        

Net loss

     (109 )     (87 )     (105 )     (50 )     (11 )

Redemption and accretion of redeemable preferred stock

     33       30       —         —         —    
                                        

Net loss available to common shareholders

   $ (142 )   $ (117 )   $ (105 )   $ (50 )   $ (11 )
                                        

Basic and Diluted Per Share Data:

          

Loss from continuing operations

   $ (1.55 )   $ (1.30 )   $ (1.27 )   $ (0.61 )   $ (0.13 )

Loss from discontinued operations(5)

     (0.17 )     (0.11 )     —         —         —    
                                        

Net loss available to common shareholders

   $ (1.72 )   $ (1.41 )   $ (1.27 )   $ (0.61 )   $ (0.13 )
                                        

Dividends declared per common share

   $ 6.12     $ 6.66     $ —       $ —       $ —    

Cash Flow Data:

          

Cash flows from (used in) operating activities

   $ 21     $ 171     $ (32 )   $ (43 )   $ 64  

Cash flows from (used in) investing activities

     (277 )     (354 )     (20 )     7       (45 )

Cash flows from (used in) financing activities

     128       219       148       80       (21 )

Balance Sheet Data (at end of period):

          

Cash and equivalents

   $ 64     $ 183     $ 152     $ 49     $ 5  

Working capital(6)

     367       467       433       177       99  

Total assets

     3,508       3,209       2,696       1,191       1,179  

Total long-term debt

     3,326       2,303       1,834       675       567  

Total net debt(7)

     3,328       2,158       1,698       634       572  

Total liabilities and minority interest

     4,922       3,769       3,005       1,039       949  

Redeemable preferred stock

     —         364       —         —         —    

Total shareholder’s (deficit) equity

     (1,414 )     (924 )     (309 )     152       230  

(1)

Includes data for the Coatings Acquisition and the Inks Acquisition since January 31, 2006 and June 1, 2006, their respective dates of acquisition.

(2)

Includes data for Bakelite from its date of acquisition, April 29, 2005.

(3)

Includes data for Resolution Specialty from August 2, 2004 and for Borden Chemical from August 12, 2004, their respective dates of acquisition by Apollo.

(4)

Other operating (income) expense for the year ended December 31, 2006 includes net gains of $39 recognized primarily on the Brazilian Consumer Divestiture.

(5)

Loss from discontinued operations for the year ended December 31, 2006 reflects the Thermoplastics Divestiture. Loss from discontinued operations for the year ended December 31, 2005 reflects litigation settlements related to previously divested businesses.

(6)

Working capital is defined as current assets less current liabilities.

(7)

Net debt is defined as long-term debt plus short-term debt less cash and equivalents.

 

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ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The purpose of the following discussion is to provide relevant information to investors who use our financial statements so they can assess our financial condition and results of operations by evaluating the amounts and certainty of cash flows from our operations and from outside sources. The three principal objectives of Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) are: to provide a narrative explanation of financial statements that enables investors to see our Company through the eyes of management; to enhance overall financial disclosure and provide the context within which financial information should be analyzed; and to provide information about the quality and potential variability of earnings and cash flows so that investors can judge the likelihood that past performance is indicative of future performance.

MD&A is presented in six sections: Forward-Looking and Cautionary Statements, Business Overview and Outlook, Results of Operations, Liquidity and Capital Resources, Critical Accounting Policies and Estimates, and Recently Issued Accounting Standards. MD&A should be read in conjunction with our financial statements and the accompanying notes that are contained in Item 8 of Part II of this Annual Report on Form 10-K.

Forward-Looking and Cautionary Statements

Certain statements in this Annual Report on Form 10-K including, without limitation, statements made under the caption “Business 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 about future events and are based on currently available financial, economic and competitive data and on our current business plans. Actual results could vary materially depending on risks and uncertainties that may affect our operations, markets, services, prices and other factors that are discussed in Item 1A of Part I of this Annual Report on Form 10-K. Important factors that could cause actual results to differ materially from those contained 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 discussed herein in Item 3 of Part I of this Annual Report on Form 10-K.

Business Overview and Outlook

We are the world’s largest producer of thermosetting resins, or thermosets. Thermosets are a critical ingredient in virtually all paints, coatings, glues and other adhesives produced for consumer or industrial uses. We provide a broad array of thermosets and associated technologies and have leading market positions in all of the key markets that we serve. The total 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. Major industry sectors that we serve include industrial/marine, construction, consumer/durable goods, automotive, electronics, architectural, civil engineering, repair/remodeling, graphic arts, and oil and gas field support. Key drivers of our business include general economic and industrial growth, housing starts, auto build rates and active gas drilling rigs. 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 that impact their industries could significantly affect our results.

As of December 31, 2006, we had 104 production sites around the world. Through our worldwide network of strategically located production facilities, we serve more than 11,000 customers in over 100 countries. Our global customers include leading companies in their respective industries, such as 3M, Ainsworth, Ashland Chemical, BASF, Bayer, DuPont, GE, Halliburton, Honeywell, Huntsman, Louisiana-Pacific, Owens Corning, PPG Industries, Sumitomo, Sun Chemicals, Valspar and Weyerhaeuser.

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 factors that drive competition.

We believe that the Hexion Formation provides us with significant opportunities for growth through global product line management, as well as considerable opportunities to increase our operational efficiencies, reduce fixed costs, optimize manufacturing assets and improve capital spending efficiency. We are focused on increasing our revenues, cash flows and profitability. We believe we can achieve these goals through the following strategies:

 

   

Providing our customers with a broad range of resins products on a global basis as the world’s largest producer of thermosetting resins. We have the opportunity to become a global, comprehensive solutions provider to our customers rather than simply offering a particular product, selling in a single geography or competing on price.

 

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Expanding our product offerings through internal innovation, joint research and development initiatives with our customers and research partnership formations.

 

   

Growing our business in the Asia-Pacific, Eastern Europe and Latin American markets, where the use of our products is increasing. We also expect to accelerate the penetration of our high-end, value-added products into new markets by combining sales and distribution infrastructures.

 

   

Continuing to improve our profitability by realizing cost savings opportunities as a result of the Hexion Formation.

Our business segments are based on the products that we offer and the markets that we serve. At December 31, 2006, we had four reportable segments: Epoxy and Phenolic Resins, Formaldehyde and Forest Products Resins, Coatings and Inks, and Performance Products. The major products of our reportable segments are as follows:

 

   

Epoxy and Phenolic Resins: epoxy resins and intermediates, molding compounds, versatic acids and derivatives, specialty phenolic resins and epoxy coating resins

 

   

Formaldehyde and Forest Products Resins: forest products resins and formaldehyde applications

 

   

Coatings and Inks: composite resins, polyester resins, acrylic resins, alkyd resins, and ink resins and additives

 

   

Performance Products: phenolic encapsulated substrates for oilfield and foundry applications

2006 Highlights

 

   

We made several strategic acquisitions during 2006 primarily in the Coatings and Inks segment. Specifically, the Coatings Acquisition and the Inks Acquisition, along with two smaller acquisitions, net of divestitures, contributed $331 in incremental sales.

 

   

We amended and restated our senior secured credit facilities and repaid, repurchased or redeemed certain debt. We used $397 of these proceeds to redeem our preferred stock and $480 of these proceeds to fund a common stock dividend to our shareholders.

 

   

We realized $50 of planned synergies in 2006 and are on pace to meet or exceed our planned $125 of synergies by the end of 2007. In addition, we identified an additional $50 of Phase II synergies.

 

   

Despite experiencing significant volatility in our raw material costs and finishing 2006 with phenol and methanol prices near record highs, we were able to pass along most of these increased costs in higher selling prices in many of our product lines.

 

   

Some of our key economic indicators, such as new housing and automotive builds, softened during 2006. However, due to our diversity of products we were able to maintain our overall volumes as a result of strong demand in our oilfield applications and our phenolic and epoxy specialty resins applications for the wind turbines, electronics and aeronautics end markets.

2007 Outlook

Our business is impacted by general economic and industrial growth, housing starts, automotive builds, oil and natural gas drilling activity and general industrial production. Our business has both geographic and end market diversity which reduces the impact of any one of these factors on our overall performance. We anticipate an increase in demand in 2007 in many of the markets that we serve in both industrialized and developing nations and we expect an upward trend in overall utilization rates for thermosetting resins. Specifically, we expect continued strength in North American oil and natural gas drilling activity, which would have a positive impact on our Performance Products segment’s volumes. In addition, we expect that epoxy demand will increase in 2007 due to market capacity constraints and strong sales in the electronics, wind turbines and aeronautics end markets. We expect these volume increases to be partially offset by lower volume expectations in several other key markets. We anticipate that continued softness in 2007 in North American automotive build rates will continue to place downward volume pressure on

 

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certain product lines that are included in our Epoxy and Phenolic Resins, Coatings and Inks and Performance Products segments. We also anticipate a continued trend in the first half of 2007 of lower housing starts in North America which would impact our 2007 volume primarily for our forest product resins, which is included in our Formaldehyde and Forest Product Resins segment, and our phenolic specialty resins, epoxy coating, polyester, alkyd and acrylic resin product lines, which are included in our Epoxy and Phenolic Resins and Coatings and Inks segments.

We expect that raw material cost volatility will likely continue through 2007 because of, among other things, volatility of key feedstock pricing. We anticipate that prices of our main raw materials will remain at or near their historical highs through much of 2007, but may begin to decline during the second half of 2007 or early 2008. In the second half of 2006, we were successful in raising prices across many of our product lines to recover higher raw material costs. We were able to mitigate raw material cost volatility by our monthly or quarterly pricing mechanisms and the value-added nature of many of our product lines. We will continue to focus on pricing in 2007 because we believe there are still opportunities in certain markets to pass through our raw material price increases.

We expect to generate higher free cash flow (which we define as cash flow from operating activities less anticipated capital expenditures) in 2007 due to improved sales volume and pricing, realizing planned synergies and lower one-time costs associated with the Hexion integration, and continued focus on reducing working capital. We plan to spend approximately $120 on capital expenditures in 2007. We will continue to focus on reducing debt and the resulting cash paid for interest in 2007 through increased free cash flow.

Matters Impacting Comparability of Results

Our audited Consolidated Financial Statements include the accounts of the Company and its majority-owned subsidiaries in which minority shareholders hold no substantive participating rights, after eliminating intercompany accounts and transactions. Our share of the net earnings of our 20% to 50% owned companies, where we have the ability to exercise significant influence, but do not control, over operating and financial policies, are included in income on an equity basis. Investments in companies with ownership of less than 20% are carried at cost.

Resolution Performance, Borden Chemical and Resolution Specialty were considered entities under the common control of Apollo as defined in EITF 02-5 Definition of Common Control in Relation to FASB Statement of Financial Accounting Standards No. 141, “Business Combinations.” As a result of combining these entities, our financial statements 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 Apollo.

Our financial data for the year ended December 31, 2004 includes:

 

   

The results of operations of Resolution Performance for the full year ended December 31, 2004,

 

   

The results of operations of Resolution Specialty since the acquisition of Resolution Specialty by Apollo on August 2, 2004; and

 

   

The results of operations of Borden Chemical since the acquisition of Borden Chemical by Apollo on August 12, 2004.

Our financial data for the year ended December 31, 2005 includes:

 

   

The results of operations of the former Resolution Performance, Resolution Specialty and Borden Chemical for the full year ended December 31, 2005, and

 

   

The results of operations of Bakelite since the completion of the Bakelite Transaction on April 29, 2005.

Our financial data for the year ended December 31, 2006 includes:

 

   

The results of operations of the Coatings Acquisition and the Inks Acquisition since January 31, 2006 and June 1, 2006, the respective acquisition dates.

Raw material costs make up approximately 85% of our cost of goods sold. The three largest raw materials that we use in our production processes are phenol, methanol and urea, which represent approximately half of our total raw material costs. 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 caused significant volatility in our raw material costs. Compared to the average prices in 2005, the average prices of phenol, methanol, and urea in North America increased (decreased) by approximately 28%, 23% and (13)%, respectively, in 2006. In 2005

 

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the average prices of phenol, methanol and urea increased by approximately 15%, 16% and 26%, respectively compared to the average prices in 2004. The majority of our methanol and urea purchases are made in North America. We purchase similar amounts of phenol for our North American and European businesses. European price increases in 2006 for phenol approximated 6%. To help mitigate this volatility, we have purchase and sale contracts with many of our vendors and customers that contain periodic price adjustment mechanisms. Due to differences in the timing of pricing mechanism trigger points between our sales and purchase contracts, there is often a lead-lag impact during which margins are negatively impacted in the short term when raw material prices increase and are positively impacted when raw material prices fall. During the year ended December 31, 2006, there was a $29 negative lead-lag impact on operating income. In addition, passing through raw material price changes can result in significant variances in sales comparisons from year to year. In 2006 and 2005, we had a favorable impact on sales from passing through raw material price increases to our customers, as allowed by our customer contracts.

During the third quarter of fiscal 2006 we were placed on allocation for methanol, a raw material that is used in the production of formaldehyde and formaldehyde-derived products, because 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. This resulted in the loss of some sales volume in the fourth quarter in our Formaldehyde and Forest Product Resins segment.

Our 2005 results were impacted by Hurricanes Katrina and Rita. Approximately $27 of lost sales as well as some incremental expenses associated with these hurricanes negatively impacted our operating income in the second half of 2005. These incremental expenses included higher costs for key raw materials, plant downtime, supply chain and other logistical disruptions, and dislocated employees.

Results of Operations

 

CONSOLIDATED STATEMENTS OF OPERATIONS

      

(amounts in millions)

      
     2006     2005     2004  

Net sales

   $ 5,205     $ 4,442     $ 2,019  

Cost of sales

     4,485       3,781       1,785  
                        

Gross profit

     720       661       234  

Selling, general & administrative expense

     384       391       163  

Transaction costs

     20       44       56  

Integration costs

     57       13       —    

Other operating (income) loss, net

     (27 )     5       6  
                        

Operating income

     286       208       9  
                        

Interest expense, net

     242       203       117  

Loss on extinguishment of debt

     121       17       —    

Other non-operating expense, net

     3       16       5  
                        

Total non-operating expenses

     366       236       122  
                        

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

     (80 )     (28 )     (113 )

Income tax expense

     14       48       —    
                        

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

     (94 )     (76 )     (113 )

Earnings from unconsolidated entities, net of tax

     3       2       —    

Minority interest in net (income) loss of consolidated subsidiaries

     (4 )     (3 )     8  
                        

Loss from continuing operations

     (95 )     (77 )     (105 )

Loss from discontinued operations

     (14 )     (10 )     —    
                        

Net loss

   $ (109 )   $ (87 )   $ (105 )
                        

Sales

        In 2006, our net sales increased by $763, or 17% compared with 2005. Acquisitions, net of divestitures added $559 in incremental net sales and organic growth added $204. We were successful in driving volumes higher across several of our product lines, including epoxy resins and intermediates, phenolic specialty resins, oil field services and international forest product resins and formaldehyde, due to strong worldwide demand for these products. These volume increases were partially offset by lower volumes in our North American forest products resins, U.S. coating products and North American foundry products. These decreases were primarily driven by softer housing and automotive markets during the second half of 2006. We were also successful in passing through price increases to customers for many of our product lines in 2006, including our North American forest products resins, formaldehyde, foundry, oilfield, and coatings businesses, and our worldwide phenolic specialty resins businesses. In addition, a net favorable currency translation of $55 contributed to the sales increase as a result of the strengthening of the Canadian dollar, Brazilian real and euro against the U.S. dollar.

 

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In 2005, our net sales increased by $2,423, or 120% compared with 2004. The Borden Transaction, the Resolution Specialty Transaction and the Bakelite Transaction accounted for $2,169 of this increase and organic growth added $254. Organic growth was primarily due to increased average selling prices, as the result of improved pricing, passing through higher raw material prices, and favorable product mix.

Gross Profit

In 2006, our gross profit increased by $59, or 9%, compared with 2005. The net impact of the acquisitions and divestiture added $66 of incremental gross profit, while gross profit in our legacy businesses declined by $7. Synergies that we realized from the Hexion Formation positively impacted gross profit, however, the continued rise in raw material costs that could not be fully passed along to our customers, more than offset the synergies.

In 2005, our gross profit increased by $427, or 182%, compared with 2004. The impact of acquisitions added $308 in incremental gross profit, while our legacy businesses generated a gross profit increase of $119. The impact of increased average selling prices and favorable product mix more than offset higher raw material prices and natural gas costs.

Operating Income

In 2006, our operating income increased $78 compared with 2005. This improvement was driven in part by the improvement in gross profit discussed above, which generated an additional $59 in operating income. In addition, Transaction costs fell by $24 in 2006. In 2006, these costs were primarily from suspending an initial public offering; while in 2005, these costs were primarily from the Hexion Formation. Also contributing to the increase in operating income was a gain of $39 from the Brazilian Consumer Divestiture. These increases were partially offset by higher Integration costs of $44. Integration costs primarily include redundancy and plant rationalization initiatives and incremental administrative costs from other integration programs, including the implementation of a single, company-wide, management information and accounting system. Selling, general and administrative expense decreased by $7 primarily as a result of synergies from the Hexion Formation.

In 2005, our operating income increased $199 compared with 2004. This improvement was primarily from the improvement in gross profit discussed above. Also contributing to this improvement was a $12 reduction in Transaction costs. Transaction costs in 2005 were from the Hexion Formation, while costs in 2004 were from the Borden Transaction and the Resolution Specialty Transaction. Offsetting lower Transaction costs was an increase in Integration costs of $13, as we moved from finalizing the formation of Hexion toward achieving full integration of the companies that were acquired in the Hexion Formation. Offsetting these improvements was an increase in Selling, general and administrative expense of $228. The Bakelite Transaction, the Borden Transaction and the Resolution Specialty Transaction accounted for $186 of this increase. We also recognized stock-based compensation expense of $12 in 2005 for the Hexion Formation.

Non-Operating Expenses

In 2006, our total non-operating expenses increased by $130 compared with 2005. Net interest expense increased by $39 from 2005 due to higher interest rates and higher average debt levels to fund acquisitions and the payment of dividends. In addition, we recognized a loss on extinguishment of debt of $121 as a result of the debt refinancing and recapitalizations in May and November 2006. Other non-operating expense, net, was $13 lower than 2005 due to the absence in 2006 of an unrealized foreign exchange loss and the absence of a realized loss from settling a contingent forward held by us relating to the Bakelite Transaction.

In 2005, our total non-operating expenses increased by $114 compared with 2004. Net interest expense increased by $86 from 2004 due to higher interest rates and higher average debt levels that resulted from the Borden Transaction, the Resolution Specialty Transaction, the Bakelite Transaction and refinancing our credit facilities. In 2005, we wrote-off deferred financing fees of $17. Included in other non-operating expense in 2005 was $9 of foreign exchange losses from settling a contingent forward contract that we held related to the Bakelite Transaction and an unrealized loss of $10 related to a U.S. dollar denominated $290 term loan on a Dutch subsidiary’s books.

Income Taxes

Although our loss from continuing operations before income tax, earnings from unconsolidated entities and minority interest was $80 in 2006, current year tax expense was $14. The federal income tax benefit on the Company’s domestic loss (computed at the federal statutory tax rate) as well as the reduction of the foreign deferred tax liabilities from enacted tax rate reductions in Canada, the Netherlands and Spain, was offset by an increase in the domestic valuation allowance and a provision for income taxes associated with the unrepatriated earnings of foreign subsidiaries.

 

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In 2005, despite a loss from continuing operations before income tax earnings, from unconsolidated entities and minority interest of $28, we had $48 of income tax expense. The federal income tax benefit on our domestic loss (computed at the federal statutory tax rate) and the release of foreign valuation allowances were more than offset by (i) an increase in the domestic valuation allowance, (ii) foreign income tax on a foreign currency exchange gain on the settlement of an intercompany loan, (iii) increases in accruals related to state and foreign tax contingencies, and (iv) nondeductible expenses, primarily related to the Hexion Formation.

In 2004, income tax expense reflects a federal income tax benefit computed at the federal statutory rate, offset by a provision for taxes associated with the unrepatriated earnings of foreign subsidiaries. This provision was based on management’s decision that foreign earnings could no longer be considered permanently invested after the Borden Transaction. This additional provision allowed us to release previously provided valuation allowances against our deferred tax assets. The provision also reflects a write-off of net operating losses, offset by the benefit from a change in a foreign enacted tax rate.

Loss from Discontinued Operations

In 2006, we sold Taro Plast in the Thermoplastics Divestiture. Taro Plast was acquired as part of the Bakelite Transaction and was formerly reported in the Epoxy and Phenolic Resins segment. Accordingly, Taro Plast is reported as a discontinued operation for all periods presented. In 2006, Loss from discontinued operations also included an impairment charge of $13 for the amount by which the carrying value of the net assets of Taro Plast exceeded the estimated fair value of the business, less estimated costs to sell.

In 2005, we settled a claim against us for $15 that was for a lawsuit resulting from a previously divested business. We also received a $6 settlement from a class action suit from raw material purchases on a formerly divested business. As both of these events were from contingencies at previously divested businesses that were treated as discontinued operations, we included these amounts in Loss from discontinued operations. In 2005, we also recognized a loss of $1 on the discontinued operations of Taro Plast.

 

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Results of Operations by Segment

Following is a summary of Net sales to unaffiliated customers and Segment EBITDA. Segment EBITDA is defined as Earnings Before Interest, Income Taxes, Depreciation and Amortization (“EBITDA”) that is adjusted to exclude certain non-cash and non-recurring expenses. Segment EBITDA is the primary performance measure used by our senior management and Board of Directors to evaluate operating results and to allocate capital resources among our segments. Segment EBITDA is also the profitability measure that is used in management and executive incentive compensation programs. Corporate and Other primarily represents certain corporate general and administrative expenses that are not allocated to the segments.

 

     Year Ended December 31,  
     2006     2005     2004  
     Amount     Change from
Prior Year
    Amount     Change from
Prior Year
    Amount  

Net Sales to Unaffiliated Customers (1)(2):

          

Epoxy and Phenolic Resins

   $ 2,152     14 %   $ 1,881     72 %   $ 1,096  

Formaldehyde and Forest Products Resins

     1,385     8 %     1,281     180 %     458  

Coatings and Inks

     1,254     42 %     886     173 %     325  

Performance Products

     414     5 %     394     181 %     140  

Segment EBITDA (2):

          

Epoxy and Phenolic Resins

   $ 271     11 %   $ 244     162 %   $ 93  

Formaldehyde and Forest Products Resins

     152     —         152     198 %     51  

Coatings and Inks

     81     29 %     63     142 %     26  

Performance Products

     65     25 %     52     225 %     16  

Corporate and Other

     (45 )   5 %     (43 )   330 %     (10 )

(1)

Intersegment sales are not significant and, as such, are eliminated within the selling segment.

(2)

Net sales and Segment EBITDA in 2006 include the Coatings Acquisition and the Inks Acquisition from January 31, 2006 and June 1, 2006, respectively, and exclude the results from the Brazilian Consumer Divestiture since March 31, 2006. Net sales and Segment EBITDA in 2005 include Bakelite results from the date of acquisition, April 29, 2005. Net sales and Segment EBITDA in 2004 include Resolution Specialty results from August 2, 2004 and Borden Chemical results from August 12, 2004, their respective dates of acquisition by Apollo.

2006 vs. 2005 Segment Results

The table below provides additional detail of the percentage change in sales by segment from 2005 to 2006.

 

     Volume     Price/Mix     Currency
Translation
   

Acquisitions/

Divestitures

    Total  

Epoxy and Phenolic Resins

   3 %   (1 )%   1 %   11 %   14 %

Formaldehyde and Forest Product Resins

   (1 )%   6 %   3 %   —       8 %

Coatings and Inks

   (4 )%   6 %   1 %   39 %   42 %

Performance Products

   (1 )%   6 %   —       —       5 %

Epoxy and Phenolic Resins

Epoxy and Phenolic Resins’ net sales increased in 2006 by $271, or 14%, compared with 2005. The Bakelite Transaction contributed $222 of incremental net sales in 2006. Prior to the Bakelite Transaction in 2005, Bakelite was a customer and accounted for sales of $14. Organic growth generated an increase in net sales of $63. This was a result of improved volumes due primarily to a new tolling agreement. In addition, volumes in the phenolic specialty resin and specialty epoxy businesses grew as a result of strong demand in the electronics and wind energy sectors, respectively. The positive impact of improved volume was partially offset by lower overall average selling prices that decreased sales by $22 from the prior year due to mix and competitive pricing pressures primarily in our versatic acids and derivatives business. We had a favorable currency translation impact of $15 as the euro strengthened against the U.S. dollar in the second half of the year.

Segment EBITDA of Epoxy and Phenolic Resins increased in 2006 by $27 compared with 2005. The Bakelite Transaction contributed $25 of incremental Segment EBITDA in 2006, while our legacy businesses had an increase in Segment EBITDA of $2. The positive impacts from improved volumes and lower costs, driven from synergy and cost reduction programs, were mostly offset by increased raw material costs, coupled with higher energy costs that in the short term could not be passed on to our customers.

 

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Formaldehyde and Forest Products Resins

Formaldehyde and Forest Products Resins’ net sales increased in 2006 by $104, or 8%, compared with 2005. The net impact of acquisitions and divestitures contributed $6 of incremental net sales, while organic growth contributed $98 in net sales in 2006. Strong pricing contributed $74 to the sales increase, primarily in our North American forest products resins and North American formaldehyde products, from passing through a portion of higher phenol and methanol costs to our customers. Higher volumes in our international forest product resins and formaldehyde products, due to new customers and increased demand in Latin America, were more than offset by lower volumes in our North American resins business as the result of a softer housing market. We also had lower volumes in our North American formaldehyde business due to weakening demand that temporarily curtailed certain customers’ production in the first half of 2006. Favorable currency translation of approximately $35 also contributed to higher sales, as both the Canadian dollar and the Brazilian real strengthened versus the U.S. dollar.

Segment EBITDA of Formaldehyde and Forest Products Resins in 2006 was consistent with 2005 as the positive impact of the increased net sales was offset by increased raw material costs and costs related to a supplier force majeure.

Coatings and Inks

Coatings and Inks’ net sales increased by $368, or 42%, in 2006 compared with 2005. The Coatings Acquisition and the Inks Acquisition accounted for $345 of incremental sales in 2006 and organic growth generated additional net sales of $23. Stronger pricing contributed approximately $57 to the sales increase and was seen across all of our products lines, except acrylic resins, where excess industry capacity, due to new competitors in Asia, resulted in lower prices. This was partially offset by a decrease of $39 primarily from lower volume in our coatings products and international inks product lines. Overall, coatings product volumes in the U.S. were negatively impacted by the softening housing market and international inks volume was impacted by lower demand late in 2006. Favorable currency translation of $5 also contributed to the increased sales as the euro strengthened against the U.S. dollar in the second half of 2006.

Segment EBITDA of Coatings and Inks increased by $18 in 2006 compared with 2005. The Coatings Acquisition and the Inks Acquisition contributed $20 of incremental Segment EBITDA in 2006. Our legacy businesses experienced a slight decrease in Segment EBITDA of $2 due to lower volumes in coating products and international inks, and increased raw material costs.

Performance Products

Performance Products’ net sales increased by $20, or 5%, in 2006 compared with 2005. Increased pricing contributed $22 in additional sales, primarily in our North American oil field and foundry product lines from passing through phenol price increases to customers. Increased pricing was offset by a slight decline in volumes driven by a customer outage in Australia and the North American auto slowdown. Volumes in our North American foundry business were down due to weakening demand in the automotive sector. The volume decrease in foundry products was offset by volume improvements in our oil field products as a result of increases in North American natural gas and drilling activities, as well as increased production capacity as a result of our new Canadian production facility.

Segment EBITDA of Performance Products increased by $13 in 2006 compared with 2005. The increase was primarily the result of strong volume development in our oil field products and our continued focus on controlling operating costs.

Corporate and Other

Corporate and Other expense increased by $2 in 2006 compared to 2005. As a result of the Hexion Formation in 2005, we began to consolidate certain corporate functions of the legacy companies, and some corporate general and administrative expenses that were previously included within those businesses are now included in Corporate and Other. Synergies captured from the Hexion Formation helped to offset inflationary increases.

 

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2005 vs. 2004 Segment Results

The table below provides additional detail of the percentage change in sales by segment from 2005 and 2004.

 

     Volume     Price/Mix     Currency
Translation
   

Acquisitions/

Divestitures

    Total  

Epoxy and Phenolic Resins

   —       17 %   —       55 %   72 %

Formaldehyde and Forest Product Resins

   (4 )%   5 %   4 %   175 %   180 %

Coatings and Inks

   —       13 %   (1 )%   161 %   173 %

Performance Products

   6 %   5 %   —       170 %   181 %

Epoxy and Phenolic Resins

Epoxy and Phenolic Resins’ net sales increased by $785, or 72%, in 2005 compared with 2004. The Bakelite Transaction and the Borden Transaction accounted for $602 of the sales increase. Organic growth increased net sales by $183 primarily as the result of increased average selling prices and favorable product mix. Overall average selling prices increased from the prior year primarily from pricing improvement initiatives. Overall volumes decreased slightly from the prior year from an emphasis on pricing improvement versus volume growth.

Segment EBITDA of Epoxy and Phenolic Resins increased by $151 in 2005 compared with 2004. The Bakelite Transaction and the Borden Transaction accounted for $61 of incremental Segment EBITDA in 2005, while our legacy businesses accounted for $90 of the increase as a result of increased average selling prices and favorable product mix, as discussed above. Hurricanes Katrina and Rita negatively impacted results by approximately $13 due to incremental costs from shutting down and restarting plants, and from higher utility and raw material costs.

Formaldehyde and Forest Products Resins

Formaldehyde and Forest Products Resins’ net sales increased by $823, or 180%, in 2005 compared with 2004. The Borden Transaction and the Bakelite Transaction contributed $802 of incremental net sales and organic growth provided an additional $21 of net sales. This was the result of strong pricing for our resins and formaldehyde products due to passing through raw material price increases. Favorable currency translation of approximately $16, as both the Canadian dollar and the Brazilian real strengthened versus the U.S. dollar, also contributed to the net sales increase. Partially offsetting these favorable items was a decrease in volumes primarily in our formaldehyde products caused by hurricane-related customer outages.

Segment EBITDA of Formaldehyde and Forest Products Resins increased by $101 in 2005 compared with 2004. The Borden Transaction and the Bakelite Transaction contributed $97 of incremental Segment EBITDA in 2005, while we generated increased Segment EBITDA of $4 from strong pricing for our resins and formaldehyde products due to passing through raw material price increases. In 2004, we experienced an unfavorable lead-lag impact on earnings as raw material prices increased, and we were not able to pass these price increases through to our customers at the same time. Hurricanes Katrina and Rita negatively impacted Segment EBITDA by approximately $10 in 2005 due to lost sales and incremental costs from shutting down and restarting plants, and from higher utility and raw material costs.

Coatings and Inks

Coatings and Inks’ net sales increased by $561, or 173%, in 2005 compared with 2004. The Resolution Specialty Transaction contributed $526 of incremental sales in 2005. Organic growth generated additional net sales of $35, the result of strong pricing across all of our product lines, as well as improved product mix.

Segment EBITDA of Coatings and Inks increased by $37 in 2005 compared with 2004. The Resolution Specialty Transaction contributed $42 of incremental Segment EBITDA in 2005, offset by a decline in Segment EBITDA of $5. Hurricanes Katrina and Rita negatively impacted 2005 Segment EBITDA by approximately $3 from higher utility and raw material costs.

 

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Performance Products

Performance Products’ net sales increased by $254, or 181%, in 2005 compared with 2004. The Borden Transaction contributed $239 of incremental sales in 2005, and organic growth provided additional net sales of $15. This increase was the result of increased volumes in our foundry products, improved pricing in Asia Pacific and favorable product mix in our oil field products. Improved foundry volumes were driven by higher non-automotive demand. Increased pricing in Asia Pacific was due to passing through raw material price increases.

Segment EBITDA of Performance Products increased by $36 in 2005 compared with 2004. The Borden Transaction contributed $28 of incremental Segment EBITDA in 2005. In addition, our Segment EBITDA increased by $8 due to the factors discussed above as well as lower processing costs in Asia Pacific. Hurricanes Katrina and Rita negatively impacted Segment EBITDA by approximately $1.

Corporate and Other

Corporate and Other expense increased by $33 in 2005 compared with 2004 as a result of the Borden Transaction and the Hexion Formation. Prior to the Hexion Formation, Resolution Performance and Resolution Specialty included their corporate and other expenses in their prior reportable segments’ earnings. When the Hexion Formation took place, we began to consolidate the corporate functions of the four former legacy businesses, resulting in certain corporate general and administrative expenses no longer being allocated to operating segments.

Reconciliation of Segment EBITDA to Net Loss

 

     Year Ended December 31,  
     2006     2005     2004  

Segment EBITDA:

      

Epoxy and Phenolic Resins

   $ 271     $ 244     $ 93  

Formaldehyde and Forest Products Resins

     152       152       51  

Coatings and Inks

     81       63       26  

Performance Products

     65       52       16  

Corporate and Other

     (45 )     (43 )     (10 )

Reconciliation:

      

Items not included in Segment EBITDA

      

Transaction costs

     (20 )     (44 )     (56 )

Integration costs

     (57 )     (13 )     —    

Non-cash charges

     (22 )     (30 )     (2 )

Unusual items:

      

Gain on divestiture of business

     39       —         —    

Purchase accounting effects/inventory step-up

     (3 )     (16 )     (10 )

Discontinued operations

     (14 )     (10 )     —    

Business realignments

     2       (9 )     (3 )

Other

     (10 )     (18 )     (7 )
                        

Total unusual items

     14       (53 )     (20 )
                        

Total adjustments

     (85 )     (140 )     (78 )

Interest expense, net

     (242 )     (203 )     (117 )

Loss on extinguishment of debt

     (121 )     (17 )     —    

Income tax expense

     (14 )     (48 )     —    

Depreciation and amortization

     (171 )     (147 )     (86 )
                        

Net loss

   $ (109 )   $ (87 )   $ (105 )
                        

Items not included in Segment EBITDA

In 2006, Transaction costs primarily represented the write-off of deferred accounting, legal and printing costs as the result of the Company’s suspension of its IPO, as well as costs from terminating acquisition activities. In 2005, Transaction costs primarily represented accounting, consulting, legal and contract termination fees from the Hexion Formation and expenses associated with terminated acquisition activities. In 2004, Transaction costs primarily represented costs related to the Borden Transaction and the Resolution Specialty Transaction.

 

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In 2006, Integration costs represented redundancy and plant rationalization costs and incremental administrative costs for integration programs resulting from the Hexion Formation, the Coatings Acquisition and the Inks Acquisition. In 2005, Integration costs were of a similar nature, primarily from the Hexion Formation. Included in both years are costs related to the implementation of a single, company-wide, management information and accounting system.

In 2006, Non-cash charges were primarily from stock-based compensation expense, impairments of property, plant and equipment and unrealized derivative and foreign exchange losses. In 2005, Non-cash charges were primarily from stock-based compensation costs and unrealized foreign currency exchange losses on debt instruments that were denominated in currencies other than the functional currency of the holder. In 2004, Non-cash charges were primarily from goodwill impairments.

Not included in Segment EBITDA are certain income or expenses that are deemed by management to be unusual or non-recurring in nature. For 2006, these items primarily consisted of a gain recognized on the Brazilian Consumer Divestiture, a charge related to the discontinued operations of Taro Plast, business realignments, and the impact of the announced exit from the European solvent coating resins business (the “Alkyds Divestiture”). For 2005, these items primarily consisted of purchase accounting/inventory step-up adjustments that were related to the Bakelite Transaction, a realized foreign currency loss on an exchange rate hedge related to the Bakelite Transaction, certain non-recurring litigation expenses related to discontinued operations and business realignments. For 2004, these items primarily consisted of purchase accounting/inventory step-up adjustments related to the Resolution Specialty Transaction, business realignments, incremental expenses from a mechanical failure at a Brazilian formaldehyde plant, and integration costs related to the Resolution Specialty Transaction.

Liquidity and Capital Resources

Sources and Uses of Cash

Our primary source of liquidity is cash flow generated from operations. We also have availability under our senior secured credit facilities, subject to certain conditions. Our primary liquidity requirements are working capital requirements, debt service, one-time synergy program-related obligations, contractual obligations and capital expenditures. We expect to have adequate liquidity to fund working capital requirements, contractual obligations and capital expenditures over the remainder of the term of our credit facilities from cash received from operations and amounts available under credit facilities.

Following are highlights from our Consolidated Statements of Cash Flows for the years ended December 31:

 

     2006     2005     2004  

Operating activities

   $ 21     $ 171     $ (32 )

Investing activities

     (277 )     (354 )     (20 )

Financing activities

     128       219       148  

Effect of exchange rates on cash flow

     9       (5 )     7  
                        

Net change in cash and equivalents

   $ (119 )   $ 31     $ 103  
                        

Operating Activities

In 2006, operations provided $21 of cash. The net loss of $109 included non-cash charges for depreciation and amortization of $180 (including amortization of deferred financing costs), a gain on sale of businesses, net of taxes, primarily related to the Brazilian Consumer Divestiture of $33, the write off of deferred financing costs that resulted from refinancing certain debt facilities in May and November of $27, and the write off of deferred costs as a result of the suspension of our IPO of $15. Increased sales levels at the end of the year, higher raw material costs compared with the prior year, and acquisitions, net of divestitures, drove higher accounts receivable, inventory and accounts and drafts payable levels. Additional significant cash flows items in 2006 included the receipt of $44, net of legal fees, from the settlement of a lawsuit, an insurance reimbursement of $33 related to payments made in 2005 for the settlement of litigation and pension and postretirement plan contributions of $34.

In 2005, our operations generated $171 of cash. The net loss of $87 included non-cash charges for depreciation and amortization of $156 (including amortization of deferred financing costs). Accounts receivable and inventory levels were down compared to the prior year as the result of improved working capital management. The positive impact of these lower levels was partially offset by an increase in accounts payable. We made net cash tax payments of $8 and contributed $31 to our pension plans.

In 2004, we used $32 in cash to fund operations. The Net loss of $105 included non-cash charges for depreciation and amortization of $91 (including amortization of deferred financing costs). In addition, costs associated with the Borden Transaction were $46. Increases in accounts receivables and inventories driven by higher sales levels, were offset by increases in accounts payable.

 

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Table of Contents

Investing Activities

In 2006, we used $277 for investing activities. We spent $125 for capital expenditures, primarily for plant expansions and improvements. We also used $201 for acquisitions and generated cash of $47 from divesting certain businesses.

In 2005, we used $354 for investing activities. We spent $252 for business acquisitions and $103 for capital expenditures, primarily for plant expansions and improvements.

In 2004, we used $20 for investing activities. We spent $57 for capital expenditures, primarily for plant expansions and implementing SAP software at Resolution Specialty. We paid $152 for the Resolution Specialty acquisition, net of cash acquired, and received $185 for cash that was held by Borden Chemical at the time of the Borden Transaction.

Financing Activities

In 2006, our financing activities provided cash of $128. We generated $1,051 of cash, primarily from refinancing our debt in May and November. Proceeds from the May refinancing were used to redeem our preferred stock for $397. Proceeds from our November refinancing were used to pay a $480 dividend to our common shareholders. We paid $17 and $21 of debt refinancing fees for the May and November refinancings, respectively. In addition, we paid $4 of IPO related costs, which were written off when we suspended our IPO.

In 2005, our financing activities provided cash of $219. Net cash generated by financing activities was primarily due to long-term debt borrowings of $1,193, consisting of the $150 senior secured notes, the $500 term loan under the Hexion Credit Facility and borrowings under a bridge facility for the Bakelite Transaction. These borrowings were partially offset by net debt repayment of $752 and debt financing fees of $22 from the financings. We paid a dividend of $523, which was funded through $334 of net proceeds that we received from issuing preferred stock and from amounts that we borrowed under our credit facility. We also made payments of $11 for costs related to our proposed IPO.

Our financing activities in 2004 provided cash of $148, primarily due to issuing debt of $121 to fund the Resolution Specialty Transaction, partially offset by net debt repayments by Resolution Performance and Borden Chemical totaling $23. We also received $60 as part of the Resolution Specialty Transaction.

At December 31, 2006, we had cash and equivalents of $64.

 

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Table of Contents

Outstanding Debt

Following is a summary of our outstanding debt and redeemable preferred stock, including $66 of short-term maturities at December 31, 2006:

 

     2006    2005

Revolving Credit Facilities

   $ 23    $ —  

Senior Secured Notes:

     

8% Senior secured notes due 2009

     —        141

9.5% Senior second secured notes due 2010

     —        202

9% Second-priority senior secured notes due 2014

     —        325

9.75% Second-priority senior secured notes due 2014

     625      —  

Floating rate second-priority senior secured notes due 2010

     —        298

Floating rate second-priority senior secured notes due 2014

     200      —  

Credit Agreements:

     

Floating rate term loans due 2012

     —        498

Floating rate term loans due 2013

     1,995      —  

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

     —        336

Other Borrowings:

     

Industrial Revenue Bonds due 2009

     34      34

Capital Leases

     11      12
     

Other

     64      55
             

Total debt

   $ 3,392    $ 2,341
             

Redeemable Preferred Stock

   $ —      $ 364
             

2006 Refinancing Activities

In May 2006, we amended and restated our senior secured credit facilities to provide for a seven-year $1,625 term loan facility and a seven-year $50 synthetic letter of credit facility and continued access to a $225 million revolving credit facility, which we refer to as the May 2006 Senior Secured Credit Facilities. When we entered into the May 2006 Senior Secured Credit Facilities, we repaid all of the amounts that were outstanding under our May 2005 term loan and synthetic letter of credit facilities. In addition, we repurchased or redeemed all of our outstanding 8% Senior secured notes, 9.5% Senior Second secured notes, 13.5% Senior subordinated notes and Redeemable Preferred Stock.

In November 2006, we amended and restated our May 2006 Senior Secured Credit Facilities, which provided a term loan increase of $375. We refer to the November amendment and restatement of our credit facilities as the New Senior Secured Credit Facilities. In addition, through our wholly owned finance subsidiaries, Hexion U.S. Finance Corp. and Hexion Nova Scotia Finance, ULC, we sold $200 of Floating rate second-priority senior secured notes due 2014 and $625 of 9.75% Second-priority senior secured notes due 2014. When we entered into the New Senior Secured Credit Facilities, we received the net proceeds from issuing the Floating rate second-priority senior secured notes due 2014 and the 9.75% Second-priority senior secured notes. We repurchased or redeemed all of our outstanding Floating rate second-priority notes dues 2010 and 9% Second-priority senior secured notes. We also used $480 of the proceeds to fund a common stock dividend to our parent.

See Note 8 to the Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for more information on our debt.

Revolving Credit Facilities

At December 31, 2006, we had additional borrowing capacity under our senior secured revolving credit facilities of $189.

We have additional credit facilities at certain domestic and international subsidiaries with various expiration dates through 2008. These facilities provide availability totaling $114 as of December 31, 2006, of which $56 was available to fund working capital needs and capital expenditures. While these facilities are primarily unsecured, portions are secured by inventory, accounts receivable, equipment or stock of the respective subsidiary. At December 31, 2006, the net book value of the collateral securing a portion of these facilities was $9.

 

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Interest Rate Swap Agreements

We are a party to various interest rate swap agreements that are designed to offset cash flow variability from interest rate fluctuations on our variable rate debt. The notional amount of the swap changes based on the expected payments on our term loan in order to maintain an effective fixed to variable debt ratio of approximately 65% fixed to 35% variable. As a result of the interest rate swaps, we pay a fixed rate equal to approximately 7.9% per year and receive a variable rate based on the terms of the underlying debt. See Item 7A – Quantitative and Qualitative Disclosures About Market Risk and the notes to the Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for more information on these agreements.

Covenant Compliance

Certain covenants contained in the credit agreement that govern our senior secured credit facilities and/or the indentures that govern our Second-Priority Senior Secured Notes (i) require the maintenance of a senior secured debt to Adjusted EBITDA ratio and (ii) restrict our ability to take certain actions such as incurring additional debt or making acquisitions if we are unable to meet such ratio and also a defined Adjusted EBITDA to Fixed Charges ratio. The covenant to incur additional indebtedness and the ability to make future acquisitions, requires an Adjusted EBITDA to Fixed Charges ratio (measured on a trailing four-quarter basis) of 2.0:1. Failure to comply with these covenants could limit our long-term growth prospects by hindering our ability to obtain future debt or grow through acquisitions.

Fixed charges are defined as interest expense excluding the amortization or write-off of deferred financing costs. Adjusted EBITDA is defined as EBITDA further adjusted to exclude certain non-cash, non-recurring and realized or expected future cost savings directly related to prior acquisitions and the Hexion Formation. As we are highly leveraged, we believe that including the supplemental adjustments that are made to calculate Adjusted EBITDA provides additional information to investors about our ability to comply with our financial covenants and our ability to obtain additional debt in the future. Adjusted EBITDA and Fixed Charges are not defined terms under accounting principles generally accepted in the United States of America. Adjusted EBITDA should not be considered an alternative to operating income or net income as a measure of operating results or an alternative to cash provided by operations as a measure of liquidity. Fixed Charges should not be considered an alternative to interest expense. At December 31, 2006, we were in compliance with all of the financial covenants and restrictions that are contained in the indentures that govern our notes and all of our credit facilities.

 

    

Year Ended

December 31, 2006

 

Reconciliation of Net Loss to Adjusted EBITDA

  

Net loss

   $ (109 )

Income taxes

     14  

Interest expense, net

     242  

Loss from extinguishment of debt

     121  

Depreciation and amortization expense

     171  
        

EBITDA

     439  

Adjustments to EBITDA

  

Acquisitions EBITDA (1)

     35  

Transaction costs (2)

     20  

Integration costs (3)

     57  

Non-cash charges (4)

     22  

Unusual items:

  

Gain on divestiture of business

     (39 )

Purchase accounting effects/inventory step-up

     3  

Discontinued operations

     14  

Business realignments

     (2 )

Other (5)

     10  
        

Total unusual items

     (14 )
        

In process Synergies (6)

     105  
        

Adjusted EBITDA (7)

   $ 664  
        

Fixed charges (8)

   $ 290  
        

Ratio of Adjusted EBITDA to Fixed Charges

     2.29  
        

(1) Represents the incremental EBITDA impact for the Coatings Acquisition, the Inks Acquisition, as well as two smaller acquisitions, and the Orica Acquisition which closed February 1, 2007, less EBITDA generated prior to the Brazilian Consumer Divestiture, as if they had taken place at the beginning of the period.

 

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(2) Represents the write-off of deferred accounting, legal and printing costs associated with the Company’s proposed IPO, as well as costs associated with terminated acquisition activities.
(3) Represents redundancy and plant rationalization costs and incremental administrative costs associated with integration programs. It also includes costs related to the implementation of a single, company-wide management information and accounting system.
(4) Includes non-cash charges for impairments of fixed assets, stock-based compensation and unrealized foreign exchange and derivative losses.
(5) Includes the impact of the announced Alkyds Divestiture, one-time benefit plan costs and management fees.
(6) Represents estimated net unrealized synergy savings resulting from the Hexion Formation.
(7) The Company is required to have an Adjusted EBITDA to Fixed Charges ratio of greater than 2.0 to 1.0 to incur additional indebtedness under our indenture for the Second Priority Senior Secured Notes. As of December 31, 2006, the Company was able to satisfy this covenant and incur additional indebtedness under this indenture.
(8) The fixed charges reflect pro forma interest expense as if the debt refinancing and Orica Acquisition, which occurred in November 2006 and February 2007, respectively, had taken place at the beginning of the period.

Contractual Obligations

The following table presents our contractual cash obligations at December 31, 2006. Our contractual cash obligations consist of legal commitments at December 31, 2006 that require us to make fixed or determinable cash payments, regardless of the contractual requirements of the specific vendor, to provide us with future goods or services. This table does not include information about most of our recurring purchases of materials that we use in our production because our raw material purchase contracts do not meet this definition since they generally do not require fixed or minimum quantities. Contracts with cancellation clauses are not included, unless a cancellation would result in a major disruption to our business. For example, we have contracts for information technology support that are cancelable, but this support is essential to the operation of our business and administrative functions; therefore, amounts payable under these contracts are included.

 

     Payments Due By Year

Contractual Obligations

   2007    2008    2009    2010    2011    2012 and
beyond
   Total

Long-term debt, including current maturities

   $ 66    $ 36    $ 55    $ 21    $ 43    $ 3,160    $ 3,381

Interest on fixed rate debt obligations

     107      103      102      98      98      525      1,033

Interest on variable rate debt obligations (a)

     177      178      178      169      173      255      1,130

Capital lease obligations

     —        1      —        3      —        7      11

Operating lease obligations

     29      22      18      13      9      29      120

Purchase obligations (b)

     92      81      75      30      18      99      395

Funding of pension and other postretirement obligations (c)

     30      33      30      30      30      —        153
                                                

Total

   $ 501    $ 454    $ 458    $ 364    $ 371    $ 4,075    $ 6,223
                                                

(a) Based on applicable interest rates in effect at December 31, 2006.
(b) Purchase obligations are comprised of the fixed or minimum amounts of goods and/or services under long-term contracts and assumes that certain contracts are terminated in accordance with their terms after giving the requisite notice which is generally two to three years for most of these contracts; however, under certain circumstances, some of these minimum commitment term periods could be further reduced which would significantly decrease these contractual obligations.
(c) Pension and other postretirement contributions have been included in the above table for the next five years. These amounts include estimated benefit payments to be made for unfunded foreign defined benefit pension plans as well as estimated contributions to our funded defined benefit plans. The assumptions used by our actuaries in calculating these projections included a weighted average annual return on pension assets of approximately 7% for the years 2007 – 2011 and the continuation of current law and plan provisions. These estimated payments may vary based on the actual return on our plan assets. See Note 12 to the Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for more information on our pension and postretirement obligations.

 

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This table excludes payments for income taxes and environmental obligations since, at this time, we cannot determine either the timing or the amounts of payments beyond 2006. We estimate that we will pay approximately $64 in 2007 for local, state and international income taxes, which includes $24 related to a settlement with the Netherlands’ tax authorities for the years 2003 through 2006. We expect environmental expenditures for 2007 through 2011 of approximately $16. See Notes 10 and 15 to the Consolidated Financial Statements in Item 8 of Part II of this Annual Report on 10-K for more information on these obligations.

Capital Expenditures

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 expenditure and moderate working capital requirements. We plan to spend approximately $120 on capital expenditures in 2007. We determined this amount through our budgeting and planning process, and it is subject to change at the discretion of our Board of Directors. We considered future product demand, existing plant capacity and external customer trends. Of these expenditures, we expect that approximately half will be used for maintenance and environmental projects. We expect that the remainder will be used to expand plant capacity as necessary to meet expected growth in demand. We plan to fund capital expenditures through operations and, if necessary, through available lines of credit. We have no material firm commitments for these anticipated capital expenditures at December 31, 2006.

Recent Developments

On February 1, 2007, we acquired the adhesives and resins business of Orica Limited in Australia and New Zealand to increase our formaldehyde-based resins capacity in the Asia-Pacific region. This business had 2006 sales of approximately $85 and has three manufacturing facilities. We paid a purchase price, not including transaction fees and expenses, of approximately $60. This purchase price is subject to certain post-closing adjustments that will be based on the amount of working capital as of the closing date. This acquisition and the related transaction fees and expenses were financed through borrowings by our Australian subsidiary. This acquisition will be included in the Formaldehyde and Forest Products Resins segment.

Off Balance Sheet Arrangements

We had no off-balance sheet arrangements as of December 31, 2006.

Critical Accounting Policies and Estimates

In preparing our financial statements in conformity with accounting principles generally accepted in the United States of America, we have to make estimates and assumptions about future events that affect the amounts of reported assets, liabilities, revenues and expenses, as well as the disclosure of contingent assets and liabilities in the financial statements and accompanying notes. Some of these accounting policies require the application of significant judgment by management to select the appropriate assumptions to determine these estimates. By their nature, these judgments are subject to an inherent degree of uncertainty; therefore, actual results may differ significantly from estimated results. We base these judgments on our historical experience, advice from experienced consultants, forecasts and other available information, as appropriate. Our significant accounting policies are more fully described in Note 2 to the Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K.

Our most critical accounting policies, which reflect significant management estimates and judgment to determine amounts in our audited Consolidated Financial Statements, are as follows:

Environmental Remediation and Restoration Liabilities

Accruals for environmental matters are recorded when we believe that it is probable that a liability has been incurred and we can reasonably estimate the amount of the liability. Our accruals are established following the guidelines of Statement of Position 96-1, Environmental Remediation Liabilities. We have accrued approximately $40 at December 31, 2006 and 2005 for all probable environmental remediation and restoration liabilities, which is our best estimate of these liabilities. Based on currently available information and analysis, we believe that it is reasonably possible that the costs associated with these liabilities may fall within a range of $25 to $75. This estimate of the range of reasonably possible costs is less certain than the estimates that we make to determine our reserves. To establish the upper limit of this range, we used assumptions that are less favorable to Hexion among the range of reasonably possible outcomes, but we did not assume that we would bear full responsibility for all sites to the exclusion of other potentially responsible parties.

Some of our facilities are subject to environmental indemnification agreements, where we are generally indemnified against damages from environmental conditions that occurred or existed before the closing date of our acquisition of the facility, subject to certain limitations.

 

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Income Tax Assets and Liabilities and Related Valuation Allowances

At December 31, 2006 and 2005, we had valuation allowances of $224 and $239, respectively, against all of our net federal, state and some of our net foreign deferred income tax assets. The valuation allowance was calculated in accordance with U.S. GAAP, which requires an assessment of both negative and positive evidence when measuring the need for a valuation allowance. In accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, evidence, such as operating results during the most recent three-year period, is given more weight than our expectations of future profitability, which are inherently uncertain. Our losses in the U.S. and certain foreign operations in recent periods represented sufficient negative evidence to require a full valuation allowance against our net federal, state and certain foreign deferred income tax assets. We intend to maintain a valuation allowance against the net deferred income tax assets until sufficient positive evidence exists to support the realization of such assets.

The calculation of our income tax liabilities involves dealing with uncertainties in the application of complex domestic and foreign income tax regulations. We recognize liabilities for anticipated income tax audit issues based on our estimate of whether, and the extent to which, additional income taxes will be due. If we ultimately determine that payment of these amounts is not necessary, we reverse the liability and recognize an income tax benefit during the period in which we determine that the liability is no longer necessary. We also recognize income tax benefits to the extent that it is probable that our positions will be sustained when challenged by the respective taxing authorities. To the extent we prevail in matters for which liabilities have been established, or are required to pay amounts in excess of our liabilities, our effective income tax rate in a given period could be materially impacted. An unfavorable income tax settlement would require the use of cash and result in an increase in our effective income tax rate in the year it is resolved. A favorable income tax settlement would be recognized as a reduction in the effective income tax rate in the year of resolution.

Pensions

The amounts that we recognize in our financial statements for pension benefit obligations are determined by actuarial valuations. Inherent in these valuations are certain assumptions, the more significant of which are:

 

   

The weighted average rate to use for discounting the liability;

 

   

The weighted average expected long-term rate of return on pension plan assets;

 

   

The weighted average rate of future salary increases; and

 

   

The anticipated mortality rate tables.

The discount rate reflects the rate at which pensions could be effectively settled. When selecting a discount rate, we take into consideration yields on government bonds and high-grade corporate bonds, as well as annuity pricing information that is furnished by the Pension Benefit Guaranty Corporation (for U.S. plans) and by insurance carriers in each specific country (for foreign plans), for instruments with durations that are consistent with the duration of the related liabilities that are being measured. In addition, for certain plans, a cash flow model that uses the yields of high-grade corporate bonds with maturities consistent with our anticipated cash flow projections is prepared and used.

The expected long-term rate of return on plan assets is determined based on the various plans’ current and projected asset mix. To determine the expected overall long-term rate of return on assets, we take into account the rates on long-term debt investments that are held in the portfolio, as well as expected trends in the equity markets, for plans including equity securities.

The rate of increase in future compensation levels is determined based on salary and wage trends in the chemical and other similar industries, as well as our specific compensation targets.

The mortality tables that are used represent the most commonly used mortality projections for each particular country.

The following table presents the sensitivity of our projected pension benefit obligation (“PBO”), accumulated benefit obligation (“ABO”), shareholders’ deficit (“Deficit”) and 2007 expense to the following changes in key assumptions:

 

    

Increase /
(Decrease) at

December 31, 2006

    Increase / (Decrease)  
     PBO     ABO     Deficit     2007 Expense  

Assumption:

        

Increase in discount rate of 0.5%

   $ (32 )   $ (28 )   $ 32     $ (4 )

Decrease in discount rate of 0.5%

   $ 35     $ 31     $ (35 )   $ 2  

Increase in estimated return on assets of 1.0%

     N/A       N/A       N/A     $ (3 )

Decrease in estimated return on assets of 1.0%

     N/A       N/A       N/A     $ 3  

 

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Impairment of Long-Lived Assets, Goodwill and Other Intangible Assets

As events warrant, we evaluate the recoverability of long-lived assets by assessing whether the carrying value can be recovered over their remaining useful lives through the expected future undiscounted operating cash flows of the underlying business. Any impairment loss that may be required is determined by comparing the carrying value of the assets to their estimated fair value.

We perform an annual goodwill impairment test to assess whether the estimated fair value of each reporting unit is less than the carrying amount of the unit’s net assets. We use a comparable analysis technique commonly used in the investment banking and private equity industries to estimate the values of our reporting units based on the EBITDA multiple technique. Under this technique, estimated values are the result of an EBITDA multiple that is determined from this process and applied to an appropriate historical EBITDA amount. As of December 31, 2006, the fair value of each reporting unit exceeded the carrying amount of assets and liabilities assigned to each unit.

Recently Issued Accounting Standards

In June 2006, the FASB issued Financial 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 interpretation requires the cumulative effect of applying FIN 48 to be reflected as an adjustment to the opening balance of retained earnings. We are currently evaluating the impact of FIN 48 on our 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 to measure 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. We are currently evaluating the impact of FIN 48 on our 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), which we refer to as SFAS 158. This statement requires employers who sponsor one or more single employer defined benefit plans to recognize the overfunded or underfunded status of each plan in the balance sheet as an asset for overfunded plans, or a liability for underfunded and unfunded plans. Under SFAS 158, we now report previously unrecognized actuarial gains and losses, and prior service costs and credits, net of income taxes, in equity as a component of Accumulated other comprehensive income, which we refer to as AOCI.

As we amortize the actuarial gains and losses and prior service amounts into the income statement, this tax-effected amortization will reduce the amounts that are reported in AOCI. In future years, AOCI may also be impacted by additional actuarial gains or losses, or by plan amendments, that affect the benefits of participants, to the extent that these changes are not immediately recognized in the income statement. Additional actuarial gains or losses may result from changes in actuarial assumptions and asset performance that differ from projections that are made when our actuaries perform the annual plan valuations.

The adoption of SFAS 158 had no impact on our income statements for the year ended December 31, 2006 or for any prior period. Also, the adoption of SFAS 158 did not affect any financial covenants contained in the agreements governing our debt and is not expected to affect operating results in future periods. The significant impacts on our balance sheet at December 31, 2006 from adopting SFAS 158 were an increase in Long-term pension obligations of $32, a decrease in Other postemployment liabilities of $74 and an increase in Other comprehensive income of $53. We are not permitted to restate prior periods for the effect of SFAS 158, so our prior year data was not impacted. See Note 12 to the Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for additional information about our benefit plans and the effects of our adopting the new accounting standard.

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 was issued to provide interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. SAB 108 is effective for fiscal years ending on or after November 15, 2006, with earlier adoption encouraged. The adoption of this standard had no impact on our Consolidated Financial Statements.

 

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ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risk, including changes in currency exchange rates, interest rates and certain commodity prices. To manage the volatility related to these exposures we use various financial instruments, including some derivatives, to help us hedge our foreign currency exchange risk and interest rate risk. We also use raw material purchasing contracts and pricing contracts with our customers to help mitigate commodity price risks. These contracts generally do not contain minimum purchase requirements.

The following table summarizes our derivative financial instruments as of December 31, 2006 and 2005. Fair values are determined from quoted market prices at these dates.

 

     2006     2005  
  

Average

Days

To Maturity

  

Average

Contract

Rate

   Notional
Amount
  

Fair Value

Asset (Liability)

   

Average

Days

To Maturity

  

Average

Contract

Rate

   Notional
Amount
  

Fair Value

Asset (Liability)

 

Currency to Sell for Euros

                      

U.S. dollars (1)

   59    1.3228    27    —       27    1.1890    45    —    

U.S. dollars (1)

   639    1.2038    286    (29 )   990    1.2038    289    5  

British pound (1)

   —      —      —      —       90    0.6987    41    (1 )

U.S. dollars (1)

   —      —      —      —       60    1.2122    3    —    

U.S. dollars (2)

   —      —      —      —       122    1.2031    24    —    

Interest Rate Swap

                      

Interest swap

   913    —      1,000    (5 )   —      —      —      —    

Commodity Future Contracts

                      

Natural gas futures

   —      —      5    —       —      —      3    1  

(1) Forward contracts
(2) Deal contingent forward contract (for a pending acquisition)

Foreign Exchange Risk. Our international operations accounted for approximately 55% of our sales in 2006 and 49% in 2005. As a result, we have significant exposure to foreign exchange risk on transactions that can potentially be denominated in many foreign currencies. These transactions include foreign currency denominated imports and exports of raw materials and finished goods (both intercompany and third party) and loan repayments. The functional currency of our operating subsidiaries is the related local currency.

It is our policy to reduce foreign currency cash flow exposure from exchange rate fluctuations by hedging firmly committed foreign currency transactions wherever it is economically feasible. Our use of forward contracts is designed to protect our cash flows against unfavorable movements in exchange rates, to the extent of the amount that is under contract. We do not attempt to hedge foreign currency exposure in a manner that would entirely eliminate the effect of changes in foreign currency exchange rates on net income and cash flow. We do not speculate in foreign currency nor do we hedge the foreign currency translation of our international businesses to the U.S. dollar for purposes of consolidating our financial results, or other foreign currency net asset or liability positions. The counter-parties to our forward contracts are financial institutions with investment grade credit ratings.

Effective October 11, 2005, we entered into a $289 cross-currency and interest rate swap agreement structured for a non-U.S. subsidiary’s $290 U.S. dollar denominated floating rate term loan. The initial notional amount of $289 amortizes quarterly based on the terms of the loan. The swap is a three-year agreement designed to offset balance sheet and interest rate exposures and cash flow variability associated with the exchange rate fluctuations on the term loan. The euro to U.S. dollar exchange rate under the swap agreement is 1.2038. We pay a variable rate equal to Euribor plus 271 basis points. We receive a variable rate equal to the U.S. dollar LIBOR plus 250 basis points. The amount we receive under this agreement is approximately equal to the non-U.S. subsidiary’s interest rate on its $290 term loan. The net impact of this interest rate swap was a decrease in our interest expense of $4 and $1 for the years ended December 31, 2006 and 2005, respectively. We paid a weighted average interest rate of 5.91% and 4.89% and received a weighted average interest rate of 7.35% and 6.61% in 2006 and 2005, respectively.

Our foreign exchange risk is also mitigated because we operate in many foreign countries, which reduces the concentration of risk in any one currency. In addition, our foreign operations have limited imports and exports, which reduces the potential impact of foreign currency exchange rate fluctuations.

        Interest Rate Risk. We are a party to various interest rate swap agreements that are designed to offset the cash flow variability that is associated with interest rate fluctuations on our variable rate debt. We do not enter into speculative financial contracts of any type. The fair values of these swaps are determined by using estimated market values. Under interest rate swaps, we agree with other parties to exchange at specified intervals the difference between the fixed rate and floating rate interest amounts that are calculated from the agreed notional principal amount. The counter-parties to our interest rate swaps are financial institutions with investment grade credit ratings.

 

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On May 10, 2006, we entered into interest rate swap agreements with two counterparties. These swaps are three-year agreements that are designed to offset the cash flow variability that results from interest rate fluctuations on our variable rate debt. The initial aggregate notional amount of the swaps is $1,000, which we amortize on a quarterly basis based on the expected payments on our term loan so that we can maintain a fixed to variable debt ratio of approximately 65% fixed to 35% variable. Under the interest rate swaps, we pay a fixed rate equal to approximately 7.9% per year and receive a variable rate based on the terms of the underlying debt. We account for these swaps as qualifying cash flow hedges in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 138 and SFAS No. 149.

As a result of our debt refinancing in November 2006, we entered into an additional interest rate swap in January 2007, with an initial notional amount of $300 which, combined with the swaps entered into in May 2006, will effectively maintain a fixed interest rate on between 60% and 70% of our total debt. This swap becomes effective in 2008.

Some of our debt, including debt under our floating rate notes and borrowings under our senior secured credit facilities, is at variable interest rates that expose us to interest rate risk. If interest rates increase, our debt service obligations on variable rate debt would increase even though the amount borrowed would not increase. Assuming the amount of our variable debt remains the same, an increase of 1% in the interest rates on our variable rate debt, including variable rate debt that is subject to interest rate swap agreements, would increase our 2007 estimated debt service requirements by approximately $13. See additional discussion about interest rate risk in Item 1A of Part I of this Annual Report on Form 10-K.

Following is a summary of our outstanding debt as of December 31, 2006 and 2005 (See Note 8 to the Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for additional information on our debt). The fair value of our publicly held debt is based on the price at which the bonds are traded or quoted at December 31, 2006 and 2005. All other debt fair values are determined from quoted market interest rates at December 31, 2006 and 2005.

 

     2006    2005

Year

  

Debt

Maturities

  

Weighted
Average

Interest
Rate

    Fair Value   

Debt

Maturities

  

Weighted
Average

Interest

Rate

    Fair Value

2006

           $ 38    9.1 %   $ 38

2007

   $ 66    8.4 %   $ 66      15    9.2 %     15

2008

     37    8.5 %     37      18    9.2 %     18

2009

     55    8.5 %     59      181    9.2 %     189

2010

     24    8.5 %     25      845    9.3 %     870

2011

     43    8.5 %     44      473    8.0 %     473

2012 and beyond

     3,167    8.5 %     3,123      771    8.7 %     703
                               
   $ 3,392      $ 3,354    $ 2,341      $ 2,306
                               

We do not use derivative financial instruments in our investment portfolios. Our cash equivalent investments are made in instruments that meet the credit quality standards that are established in our investment policies, which also limits the exposure to any one issue. At December 31, 2006 and 2005, we had $7 and $29, respectively, invested at average rates of 3% and 7%, respectively, primarily in interest-bearing time deposits and marketable securities. Due to the short maturity of our cash equivalents, the carrying value on these investments approximates fair value and our interest rate risk is not significant. A 10% increase or decrease in interest returns on invested cash would not have had a material effect on our net income and cash flows at December 31, 2006 and 2005.

Commodity Risk. We are exposed to price risks on raw material purchases, most significantly with phenol, methanol, urea, acetone, propylene and chlorine. For our commodity raw materials, we have purchase contracts that have periodic price adjustment provisions. Commitments with certain suppliers, including our phenol and urea suppliers, provide up to 100% of our estimated requirements but also provide us with the flexibility to purchase a certain portion of our needs in the spot market, when it is favorable to us. We rely on long-term agreements with key suppliers for most of our raw materials. The loss of a key source of supply or a delay in shipments could have an adverse effect on business. Should any of our suppliers fail to deliver or should any key long-term supply contracts be cancelled, we would be forced to purchase raw materials in the open market, and no assurances can be given that we would be able to make these purchases or make them at prices that would allow us to remain competitive. One supplier provides over 10% of certain raw material purchases, and we could incur significant time and expense if we had to replace this supplier. In addition, several feedstocks at various facilities are transported through a pipeline from one supplier. If we were unable to receive these feedstocks through these pipeline arrangements, we may not be able to obtain them from other suppliers at competitive prices or in a timely manner. See the discussion about the risk factor on raw materials in Item 1A of Part I of this Annual Report on Form 10-K.

 

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Natural gas is essential in our manufacturing processes, and its cost can vary widely and unpredictably. To help control our natural gas costs, we hedge a portion of our natural gas purchases for North America by entering into futures contracts for natural gas. These contracts are settled for cash each month based on the closing market price on the last day that the contract trades on the New York Mercantile Exchange. We recognize gains and losses on commodity futures contracts each month as gas is used. Our future commitments are marked to market on a quarterly basis.

Our commodity risk is moderated through our selected use of customer contracts with selling price provisions that are indexed to publicly available indices for the relevant commodity raw materials.

 

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ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Index to Consolidated Financial Statements

 

     Page
Number

Consolidated Financial Statements of Hexion Specialty Chemicals, Inc.

  

Consolidated Statements of Operations: For the years ended December 31, 2006, 2005 and 2004

   47

Consolidated Balance Sheets: At December 31, 2006 and 2005

   48

Consolidated Statements of Cash Flows: For the years ended December 31, 2006, 2005 and 2004

   50

Consolidated Statement of Shareholder’s Deficit and Comprehensive Income: For the years ended December 31, 2006, 2005 and 2004

   52

Notes to Consolidated Financial Statements

   53

Reports of Independent Registered Public Accounting Firms

   93

Schedule II – Valuation and Qualifying Accounts

   95

 

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HEXION SPECIALTY CHEMICALS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

 

     Year Ended December 31,  
     2006     2005     2004  
     (In millions, except share and per share data)  

Net sales

   $ 5,205     $ 4,442     $ 2,019  

Cost of sales

     4,485       3,781       1,785  
                        

Gross profit

     720       661       234  

Selling, general & administrative expense

     384       391       163  

Transaction costs (See Note 2)

     20       44       56  

Integration costs (See Note 2)

     57       13       —    

Other operating (income) expense, net (See Note 3)

     (27 )     5       6  
                        

Operating income

     286       208       9  

Interest expense

     242       203       117  

Loss on extinguishment of debt (See Note 8)

     121       17       —    

Other non-operating expense, net

     3       16       5  
                        

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

     (80 )     (28 )     (113 )

Income tax expense (See Note 15)

     14       48       —    
                        

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

     (94 )     (76 )     (113 )

Earnings from unconsolidated entities, net of taxes

     3       2       —    

Minority interest in net (income) loss of consolidated subsidiaries

     (4 )     (3 )     8  
                        

Loss from continuing operations

     (95 )     (77 )     (105 )

Loss from discontinued operations (See Note 4)

     (14 )     (10 )     —    
                        

Net loss

     (109 )     (87 )     (105 )

Accretion of redeemable preferred stock (See Note 11)

     33       30       —    
                        

Net loss available to common shareholders

     (142 )     (117 )     (105 )
                        

Comprehensive loss

   $ (11 )   $ (172 )   $ (36 )
                        

Basic and Diluted Per Share Data

      

Loss from continuing operations

   $ (1.55 )   $ (1.30 )   $ (1.27 )

Loss from discontinued operations

     (0.17 )     (0.11 )     —    
                        

Net loss available to common shareholders

   $ (1.72 )   $ (1.41 )   $ (1.27 )
                        

Common stock dividends declared (See Note 13)

   $ 6.12     $ 6.66     $ —    
                        

Weighted average number of common shares outstanding during the period—basic and diluted

     82,583,068       82,629,906       82,629,906  

See Notes to Consolidated Financial Statements

 

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HEXION SPECIALTY CHEMICALS, INC.

CONSOLIDATED BALANCE SHEETS

 

     December 31,
2006
    December 31,
2005
 
     (In millions)  

ASSETS

    

Current Assets

    

Cash and equivalents (See Note 2)

   $ 64     $ 183  

Accounts receivable (less allowance for doubtful accounts of $21 and $19, respectively)

     763       589  

Inventories:

    

Finished and in-process goods

     362       287  

Raw materials and supplies

     187       146  

Other current assets

     102       131  

Assets of discontinued operations (See Note 4)

     —         39  
                

Total Current Assets

     1,478       1,375  
                

Other Assets

     107       103  
                

Property and Equipment

    

Land

     96       62  

Buildings

     276       205  

Machinery and equipment

     2,009       1,779  
                
     2,381       2,046  

Less accumulated depreciation

     (830 )     (655 )
                
     1,551       1,391  

Goodwill (See Note 6)

     193       164  

Other Intangible Assets, net (See Note 6)

     179       176  
                

Total Assets

   $ 3,508     $ 3,209  
                

See Notes to Consolidated Financial Statements

 

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HEXION SPECIALTY CHEMICALS, INC.

CONSOLIDATED BALANCE SHEETS

 

     December 31,     December 31,  
     2006     2005  
     (In millions, except share and
per share data)
 

LIABILITIES, REDEEMABLE PREFERRED STOCK AND SHAREHOLDER’S DEFICIT

    

Current Liabilities

    

Accounts and drafts payable

   $ 616     $ 493  

Debt payable within one year

     66       38  

Interest payable

     58       45  

Income taxes payable

     108       91  

Other current liabilities

     263       216  

Liabilities of discontinued operations (See Note 4)

     —         25  
                

Total Current Liabilities

     1,111       908  

Long-Term Liabilities

    

Long-term debt (See Note 8)

     3,326       2,303  

Long-term pension obligations (See Note 12)

     197       200  

Non-pension postemployment benefit obligations (See Note 12)

     26       117  

Deferred income taxes (See Note 15)

     142       138  

Other long-term liabilities

     107       92  
                

Total Liabilities

     4,909       3,758  
                

Minority interest in consolidated subsidiaries

     13       11  

Commitments and Contingencies (See Notes 9 and 10)

    

Redeemable Preferred Stock - $0.01 par value; liquidation preference $25 per share; 60,000,000 shares authorized, 14,781,959 issued and outstanding at December 31, 2005 (See Note 11)

     —         364  

Shareholder’s Deficit

    

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

     1       1  

Additional paid-in (deficit) capital

     (17 )     515  

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

     (296 )     (296 )

Accumulated other comprehensive income (loss)

     81       (70 )

Accumulated deficit

     (1,183 )     (1,074 )
                

Total Shareholder’s Deficit

     (1,414 )     (924 )
                

Total Liabilities, Redeemable Preferred Stock and Shareholder’s Deficit

   $ 3,508     $ 3,209  
                

See Notes to Consolidated Financial Statements

 

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HEXION SPECIALTY CHEMICALS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

    

Year ended

December 31,

 
     2006     2005     2004  
     (In millions)  

Cash Flows provided by (used in) Operating Activities

      

Net loss

   $ (109 )   $ (87 )   $ (105 )

Adjustments to reconcile net loss to net cash provided by (used in) operating activities:

      

Depreciation and amortization

     171       147       86  

Loss on sale of discontinued operations

     14       —         —    

Gain on sale of businesses, net of taxes

     (33 )     (2 )     (1 )

Write-off of deferred IPO costs

     15       —         —    

Write-off of deferred financing fees

     27       11       —    

Minority interest in net income of consolidated subsidiaries

     4       3       (8 )

Stock based compensation expense

     6       12       4  

Deferred tax benefit

     (18 )     (3 )     (3 )

Amortization of deferred financing fees

     9       9       5  

Debt redemption interest adjustment

     6       —         —    

Impairments

     12       8       2  

Other non-cash adjustments

     (3 )     19       —    

Net change in operating assets and liabilities (net of acquisitions):

      

Accounts receivable

     (112 )     8       (81 )

Inventories

     (56 )     57       (53 )

Accounts and drafts payable

     86       (23 )     133  

Income taxes payable

     15       58       —    

Other assets, current and non-current

     (3 )     (53 )     (20 )

Other liabilities, current and long-term

     (7 )     12       9  

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

     (3 )     (5 )     —    
                        

Net cash provided by (used in) operating activities

     21       171       (32 )
                        

Cash Flows used in Investing Activities

      

Capital expenditures

     (122 )     (103 )     (57 )

Capitalized interest

     (3 )     —         —    

Casualty loss insurance proceeds

     2       —         —    

Acquisition of businesses, net of cash acquired

     (201 )     (252 )     (152 )

Proceeds from the sale of businesses, net of cash sold

     47       3       —    

Cash combination of Borden Chemical

     —         —         185  

Proceeds from the sale of assets

     —         —         4  

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

     —         (2 )     —    
                        

Net cash used in investing activities

     (277 )     (354 )     (20 )
                        

Cash Flows provided by Financing Activities

      

Net short-term debt borrowings (repayments)

     13       (4 )     (6 )

Borrowings of long-term debt

     4,471       1,193       293  

Repayments of long-term debt

     (3,433 )     (748 )     (195 )

Payment of dividends on common stock

     (485 )     (523 )     —    

Proceeds from issuance of preferred stock, net of issuance costs

     —         334       —    

Redemption of preferred stock

     (397 )     —         —    

Long-term debt and credit facility financing fees

     (38 )     (22 )     —    

IPO related costs

     (4 )     (11 )     —    

Capital contribution related to Resolution Specialty transaction

     —         —         60  

Other

     —         —         (4 )

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

     1       —         —    
                        

Net cash provided by financing activities

     128       219       148  
                        

Effect of exchange rates on cash and equivalents

     9       (5 )     7  

(Decrease) increase in cash and equivalents

     (119 )     31       103  

Cash and equivalents at beginning of year

     183       152       49  
                        

Cash and equivalents at end of year

   $ 64     $ 183     $ 152  
                        

 

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HEXION SPECIALTY CHEMICALS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

    

Year ended

December 31,

     2006    2005    2004
     (In millions)

Supplemental Disclosures of Cash Flow Information

        

Cash paid:

        

Interest, net

   $ 220    $ 192    $ 102

Debt redemption costs

     94      —        —  

Income taxes, net

     16      8      3

Non-cash investing and financing activity:

        

Settlement of note receivable from parent

     —        581      —  

Unpaid common stock dividends declared

     20      27      —  

Redeemable preferred stock accretion

     —        30      —  

Issuance of Note in Resolution Specialty transaction

     —        —        50

See Notes to Consolidated Financial Statements

 

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HEXION SPECIALTY CHEMICALS, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDER’S DEFICIT AND COMPREHENSIVE INCOME

 

     Common
Stock
   Paid-in
Capital
    Treasury
Stock
    Receivable
from
Parent
   

Accumulated

Other
Comprehensive
(Loss) Income (a)

    Accumulated
Deficit
    Total  
     (In millions)  

Balance, December 31, 2003

   $ 1    $ 143     $ —       $ —       $ 82     $ (74 )   $ 152  
                                                       

Net loss

     —        —         —         —         —         (105 )     (105 )

Translation adjustments

     —        —         —         —         67       —         67  

Minimum pension liability adjustment, net of tax

     —        —         —         —         2       —         2  
                     

Comprehensive loss

     —        —         —         —         —         —         (36 )
                     

Acquisition of Resolution Specialty to Consolidated group

     —        57       —         —         —         —         57  

Acquisition of Borden Chemical to Consolidated group

     —        1,252       (296 )     (542 )     (131 )     (817 )     (534 )

Interest accrued on notes from parent of Borden Chemical

     —        19       —         (19 )     —         —         —    

Compensation expense under deferred compensation plan

     —        4       —         —         —         —         4  

Deferred tax adjustments as a result of the Combination

     —        48       —         —         —         —         48  
                                                       

Balance, December 31, 2004

   $ 1    $ 1,523     $ (296 )   $ (561 )   $ 20     $ (996 )   $ (309 )
                                                       

Net loss

     —        —         —         —         —         (87 )     (87 )

Translation adjustments

     —        —         —         —         (69 )     —         (69 )

Minimum pension liability adjustment, net of tax of $8

     —        —         —         —         (16 )     —         (16 )
                     

Comprehensive loss

                  (172 )
                     

Effect of the Hexion Formation

     —        (581 )     —         581       —         —         —    

Purchase accounting related to acquisition of minority interest

     —        121       —         —         (5 )     11       127  

Dividends declared ($6.66 per share)

     —        (550 )     —         —         —         —         (550 )

Stock-based compensation expense

     —        12       —         —         —         —         12  

Redeemable preferred stock accretion

     —        (30 )     —         —         —         —         (30 )

Interest accrued on notes from parent of Borden Chemical

     —        20       —         (20 )     —         —         —    

Other

     —        —         —         —         —         (2 )     (2 )
                                                       

Balance, December 31, 2005

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

Net loss

     —        —         —         —         —         (109 )     (109 )

Translation adjustments, net of tax of $1

     —        —         —         —         80       —         80  

Deferred losses on cash flow hedges

     —        —         —         —         (4 )     —         (4 )

Minimum pension liability adjustment, net of tax of $2

     —        —         —         —         22       —         22  
                     

Comprehensive loss

                  (11 )
                     

Impact of adoption of new accounting standard for pension and postretirement obligations, net of tax of $0 (See Note 12)

     —        —         —         —         53       —         53  

Dividends declared ($6.12 per share)

     —        (505 )     —         —         —         —         (505 )

Stock-based compensation expense

     —        6       —         —         —         —         6  

Redeemable preferred stock accretion

     —        (33 )     —         —         —         —         (33 )
                                                       

Balance, December 31, 2006

   $ 1    $ (17 )   $ (296 )   $ —       $ 81     $ (1,183 )   $ (1,414 )
                                                       

(a) Accumulated other comprehensive income at December 31, 2006 represents $103 of net foreign currency translation gains, net of tax, a $4 unrealized loss on derivative instruments, net of tax, and a $18 loss, net of tax, relating to net actuarial losses and prior service costs for the Company’s defined benefit pension and postretirement benefit plans (See Note 12). Accumulated other comprehensive loss at December 31, 2005 represents $23 of net foreign currency translation gains and a $93 net loss relating to the Company’s minimum pension liability adjustment.

See Notes to Consolidated Financial Statements

 

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HEXION SPECIALTY CHEMICALS, INC.

Notes to Consolidated Financial Statements

(In millions, except share and per share data)

1. Background and Basis of Presentation

Hexion Specialty Chemicals, Inc. (“Hexion” or “the Company”) manufactures and markets thermosetting resins worldwide, including epoxy resins and intermediates, forest products resins, coating products, and phenolic specialty resins. At December 31, 2006, the Company had 104 production and manufacturing facilities, with 39 located in the United States.

Hexion was formed on May 31, 2005 from the combination of three Apollo Management, L.P. (“Apollo”) controlled companies (the “Hexion Formation”); Resolution Performance Products, LLC (“Resolution Performance”), Resolution Specialty Materials, Inc. (“Resolution Specialty”) and Borden Chemical, Inc. (“Borden Chemical”). At the Hexion Formation, Borden Chemical changed its name to Hexion Specialty Chemicals, Inc., and BHI Acquisition Corp. (“BHI Acquisition”), Borden Chemical’s parent, changed its name to Hexion LLC. Prior to the Hexion Formation, on April 29, 2005, a subsidiary of Borden Chemical acquired Bakelite Aktiengesellschaft (“Bakelite” or the “Bakelite Acquisition”).

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. 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.

Basis of Presentation—Prior to the Hexion Formation, Resolution Performance, Resolution Specialty and Borden Chemical were considered entities under the common control of Apollo affiliates as defined in Emerging Issues Task Force (“EITF”) 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 Hexion Formation, the financial statements of these entities are being presented retroactively on a consolidated basis in a manner similar to a pooling of interests, and they include the results of operations of each business only from the date of acquisition by the Apollo affiliates.

The accompanying Hexion Consolidated Financial Statements include the following entities:

 

   

the former Resolution Performance and its majority-owned subsidiaries as of December 31, 2006 and 2005 and for the years ended December 31, 2006, 2005 and 2004;

 

   

the former Resolution Specialty and its majority-owned subsidiaries as of December 31, 2006 and 2005 and for the years ended December 31, 2006 and 2005 and from August 2, 2004, the date of acquisition; and

 

   

the former Borden Chemical and its majority-owned subsidiaries (which includes Bakelite since April 29, 2005, the date of acquisition) as of December 31, 2006 and 2005 and for the years ended December 31, 2006 and 2005 and from August 12, 2004, the date of acquisition.

Resolution Performance, Resolution Specialty and Bakelite have been accounted for by the purchase method. Borden Chemical elected not to apply push-down accounting because it was a public reporting registrant as a result of public debt that was outstanding before and after the acquisition by Apollo.

2. Summary of Significant Accounting Policies

Principles of Consolidation—The Consolidated Financial Statements include the accounts of the Company and its majority-owned subsidiaries, in which minority shareholders hold no substantive participating rights, after eliminating 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 included in income on the equity method of accounting. Investments in the other companies are carried at cost.

The Company has recorded a minority interest for the equity interests in consolidated subsidiaries that are not 100% owned. At December 31, 2004, the minority interest primarily reflected the equity interest in Resolution Performance and Resolution Specialty that was held by management and other third-parties. On May 31, 2005, the Resolution Performance and Resolution Specialty minority interests were purchased at the time of the Hexion Formation and were recorded as a step acquisition. At December 31, 2006 and 2005, the minority interest primarily reflects the minority owner’s interest of 40% and 35% at December 31, 2006 and 2005, respectively, in HA-International, LLC (“HAI”), a joint venture between the Company and Delta-HA, Inc.

 

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The Company has a 50% ownership interest in two joint ventures that manufacture formaldehyde, resins and UV-curable coatings and adhesives in China. These joint ventures are accounted for using the equity method of accounting. As the Company does not have the ability to exercise significant influence over the operating and financial policies of these joint ventures, they have not been consolidated and the Company’s share of net earnings are presented as Earnings from unconsolidated entities on the Consolidated Statements of Operations.

Foreign Currency Translations—Assets and liabilities of foreign affiliates are translated at the exchange rates in effect at the balance sheet date, and income and expenses are translated at average exchange rates during the year. The effect of translation is accounted for as an adjustment to Shareholder’s deficit and is included in Accumulated other comprehensive income (loss). Transaction gains and losses are included as a component of net income.

Use of Estimates—The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. The most significant estimates that are included in the financial statements are environmental remediation, legal liabilities, deferred tax assets and liabilities and related valuation allowances, income tax accruals, pension and postretirement assets and liabilities, valuation allowances for accounts receivable and inventories, general insurance liabilities, asset impairments, and fair values of assets acquired and liabilities assumed in business acquisitions. Actual results could differ from these estimates.

Cash and Equivalents—The Company considers all highly liquid investments that are purchased with an original maturity of three months or less to be cash equivalents. At December 31, 2006 and 2005, the Company had interest-bearing time deposits and other cash equivalent investments of $7 and $29, respectively. They are included on the Consolidated Balance Sheets as a component of Cash and equivalents.

Allowance for Doubtful AccountsThe allowance for doubtful accounts is estimated using factors such as customer credit ratings and past collection history. Receivables are charged against the allowance for doubtful accounts when it is probable that the receivable will not be recovered.

Inventories—Inventories are stated at lower of cost or market using the first-in, first-out method. Costs include direct material, direct labor and applicable manufacturing overheads. Abnormal manufacturing costs are recognized as period costs and fixed manufacturing overheads are allocated based on normal production capacity. An allowance is provided for excess and obsolete inventories based on management’s review of inventories on-hand compared to the estimated future usage and sales. Inventories on the Consolidated Balance Sheets are presented net of an allowance for excess and obsolete of $13 and $15 at December 31, 2006 and 2005, respectively.

Deferred Expenses—Deferred financing costs are presented as a component of Other assets on the Consolidated Balance Sheets and are amortized over the life of the related debt or credit facility using the straight-line method because no installment payments are required. Upon extinguishment of any of the debt, the related debt issuance costs are written off. At December 31, 2006 and 2005, the Company’s unamortized deferred financing costs were $48 and $54, respectively. See Note 8.

Property and Equipment—Land, buildings and machinery and equipment are stated at cost less accumulated depreciation. Depreciation is recorded on the straight-line basis over the estimated useful lives of properties (the average estimated useful lives for buildings is 20 years and for machinery and equipment 15 years). Assets under capital leases are amortized over the lesser of their useful lives or the lease term. Major renewals and betterments are capitalized. Maintenance, repairs and minor renewals are expensed as incurred. When property and equipment is retired or disposed of, the asset and related depreciation are removed from the accounts and any gain or loss is reflected in income. Depreciation expense was $157, $135 and $81 for the years ended December 31, 2006, 2005 and 2004, respectively. The Company capitalizes interest costs that are incurred during the construction of property and equipment.

Goodwill and Intangibles—The excess of purchase price over net tangible and identifiable intangible assets of businesses acquired is carried as Goodwill on the Consolidated Balance Sheets. The Company does not amortize goodwill or indefinite-lived intangible assets. Separately identifiable intangible assets that are used in the operations of the business (e.g., patents and technology, customer lists and contracts) are recorded at cost and reported as Other intangible assets on the Consolidated Balance Sheets. Intangible assets with determinable lives are amortized on a straight-line basis over the shorter of the legal or useful life of the assets, which range from 1 to 30 years. See Note 6.

Impairment—The Company reviews property and equipment and all amortizable intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. Recoverability is based on estimated undiscounted cash flows. Measurement of the impairment loss, if any, is based on the difference between the carrying value and fair value. During the years ended December 31, 2006, 2005 and 2004, impairments of $12, $8 and $2 were included in Other non-operating expense, net on the Consolidated Statements of Operations.

 

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The Company tests goodwill for impairment annually, or when events or changes in circumstances indicate an impairment may exist, by comparing the fair value of each reporting unit to its carrying value to determine if there is an indication that a potential impairment may exist. The Company employs a comparable analysis technique commonly used in the investment banking and private equity industries to estimate the values of its reporting units based on the EBITDA (earnings before interest, income taxes, depreciation and amortization) multiple technique. Under this technique, estimated values are the result of an EBITDA multiple derived from this process applied to an appropriate historical EBITDA amount. Measurement of the impairment loss, if any, is based upon the difference between the carrying value and fair value of the related reporting unit. At December 31, 2006 and 2005, the fair value of each reporting unit exceeded the carrying amount of assets (including goodwill) and liabilities assigned to the units.

General Insurance—The Company is generally insured for losses and liabilities for workers’ compensation, physical damage to property, business interruption and comprehensive general, product and vehicle liability under high-deductible insurance policies.

Legal Claims and Costs—The Company accrues for legal claims and costs in the period in which a claim is made or an event becomes known, if the amounts are probable and reasonably estimable. Each claim is assigned a range of potential liability, and the most likely amount is accrued. The amount accrued includes all costs associated with the claim, including settlements, assessments, judgments, fines and legal fees. See Note 10.

Environmental Matters—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 a quarterly basis and as events and developments warrant. See Note 10.

Asset Retirement Obligations—Asset retirement obligations are initially recorded at their estimated net present values in the period in which the obligation occurs, with a corresponding increase to the related long-lived asset. Over time, the liability is accreted to its settlement value and the capitalized cost is depreciated over the useful life of the related asset. When the liability is settled, a gain or loss is recognized for any difference between the settlement amount and the liability that was recorded.

Revenue Recognition—Revenue for product sales, net of estimated allowances and returns, is recognized as risk and title to the product transfer to the customer, which either occurs at the time shipment is made or upon delivery. In situations where product is delivered by pipeline, risk and title transfers when the product moves across an agreed-upon transfer point, which is typically the customers’ property line. Product sales delivered by pipeline are measured based on daily flow meter readings. The Company’s standard terms of delivery are included in its contracts of sale and on its invoices.

Shipping and Handling—Freight costs that are billed to customers are included in Net sales. Shipping costs are incurred to move the Company’s products from production and storage facilities to the customer. Handling costs are incurred from the point the product is removed from inventory until it is provided to the shipper and generally include costs to store, move and prepare the products for shipment. Shipping and handling costs are recorded in Cost of sales in the Consolidated Statements of Operations.

Research and Development Costs—Funds are committed to research and development activities for technical improvement of products and processes that are expected to contribute to future earnings. All costs associated with research and development are charged to expense as incurred. Research and development and technical service expense was $69, $61 and $30 for the years ended December 31, 2006, 2005 and 2004, respectively and is included in Selling, general & administrative expense in the Consolidated Statements of Operations.

Transaction Costs—The Company incurred Transaction costs totaling $20, $44 and $56 for the years ended December 31, 2006, 2005 and 2004, respectively. For the year ended December 31, 2006, these costs represent the write-off of previously deferred accounting, legal, and printing costs associated with the Company’s proposed IPO, of $15, and costs associated with terminated acquisition activities. For the year ended December 31, 2005, these costs represent accounting, consulting, legal and contract termination fees associated with the Hexion Formation. For the year ended December 31, 2004, these costs represent charges for accounting and legal fees, fees paid to Apollo, payments for cancellation of restricted stock and management bonuses pertaining to the acquisitions of Resolution Specialty and Borden Chemical.

Integration Costs—The Company incurred Integration costs totaling $57 and $13 for the years ended December 31, 2006 and 2005, respectively, primarily for redundancy and plant rationalization costs and incremental administrative costs from integration programs that resulted from the Hexion Formation and recent acquisitions. For the year ended December 31, 2006, $20 of these costs related to the implementation of a single, company-wide, management information and accounting system.

Income Taxes—The Company provides for income taxes in accordance with Statement of Financial Accounting Standard (“SFAS”) No. 109, Accounting for Income Taxes. SFAS No. 109 requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statement carrying amounts and the tax bases of the assets and liabilities.

 

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Deferred tax balances are adjusted to reflect tax rates, based on current tax laws, which will be in effect in the years in which temporary differences are expected to reverse. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. See Note 15.

Derivative Financial Instruments—The Company is a party to forward exchange contracts, interest rate swaps, cross-currency swaps and natural gas futures to reduce its cash flow exposure to changes in foreign exchange rates, interest rates and natural gas prices. The Company does not hold or issue derivative financial instruments for trading purposes. All derivative financial instruments, whether designated in hedging relationships or not, are recorded on the Consolidated Balance Sheets at fair value. If a derivative financial instrument is designated as a fair-value hedge, the changes in the fair value of the derivative financial instrument and the hedged item are recognized in earnings. If the derivative financial instrument is designated as a cash-flow hedge, changes in the fair value of the derivative financial instrument are recorded in Accumulated other comprehensive income (loss) in the Consolidated Balance Sheets, to the extent effective, and are recognized in the income statement when the hedged item impacts earnings. The cash flows from derivative financial instruments accounted for as hedges are classified in the same category as the item being hedged in the Consolidated Statements of Cash Flows. The Company documents effectiveness assessments in order to use hedge accounting at each reporting period. See Note 7.

Earnings Per Share—At the date of the Hexion Formation, the Company had 82,629,906 common shares outstanding (See Note 13). To calculate net loss per share, 82,629,906 was used as the number of weighted average shares outstanding for the years ended December 31, 2005 and 2004 because no new shares were issued from the 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 year ended December 31, 2006, the number of weighted average shares was 82,583,068, which 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.

The Company’s earnings per share is calculated as follows for the years ended December 31:

 

     2006     2005     2004  

Loss from continuing operations

   $ (95 )   $ (77 )   $ (105 )

Deduct: Redeemable preferred stock accretion

     (33 )     (30 )     —    
                        

Loss from continuing operations available to common shareholders

   $ (128 )   $ (107 )   $ (105 )
                        

Per share - Loss from continuing operations available to common shareholders

   $ (1.55 )   $ (1.30 )   $ (1.27 )
                        

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

     82,583,068       82,629,906       82,629,906  

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 accounted for stock-based awards under APB No. 25, Accounting for Stock Issued to Employees, and applied the minimum value method for pro forma disclosures under SFAS No. 123, Accounting for Stock-Based Compensation, the Company was required to apply the prospective transition method. As such, the Company applies this statement to any new awards and to any awards that have been modified, repurchased or cancelled since January 1, 2005. As of December 31, 2006, all outstanding awards are accounted for under SFAS No. 123(R). See Note 14.

 

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Following is the required reconciliation of reported and pro forma net loss and loss per share under SFAS 148 for the year ended December 31, 2004:

 

Net loss, as reported

   $ (105 )
        

Add: Stock-based employee compensation expense included in reported net income, net of related tax effects

     8  

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effect

     (6 )
        

Pro forma net loss

   $ (103 )
        

Average number of common shares outstanding—basic and diluted

     82,629,906  

Per share, as reported (basic and diluted)

   $ (1.27 )

Per share, pro forma (basic and diluted)

   $ (1.25 )

To determine pro forma compensation cost for the plans for the year ended December 31, 2004 in accordance with SFAS No. 123(R), the fair value of each option grant was estimated at the date of the grant using the minimum value method and the Black-Scholes options pricing model with the following assumptions for each of the Company’s respective plans:

 

     Resolution
Performance
    Resolution
Specialty
    Borden
Chemical
 

Risk-free weighted average interest rate

     4.50 %     3.90 %     3.54 %

Dividend rate

     0 %     0 %     0 %

Expected life

     7.0 years       6.3 years       5.0 years  

Estimated fair value of option grants (a)

   $ —       $ 0.77     $ 1.01  

Concentrations of Credit Risk—Financial instruments that potentially subject the Company to concentrations of credit risk are primarily temporary cash investments and accounts receivable. The Company places its temporary cash investments with high quality institutions and, by policy, limits the amount of credit exposure to any one institution. Concentrations of credit risk for accounts receivable are limited due to the large number of customers in the Company’s customer base and their dispersion across many different industries and geographies. The Company generally does not require collateral or other security to support customer receivables.

Concentrations of Supplier Risk—The Company relies on long-term agreements with key suppliers for most of its raw materials. The loss of a key source of supply or a delay in shipments could have an adverse effect on its business. Should any of the suppliers fail to deliver or should any of the key long-term supply contracts be cancelled, the Company would be forced to purchase raw materials at current market prices. One supplier provides over 10% of certain raw material purchases. In addition, several of the feedstocks at various facilities are transported through a pipeline from one supplier.

Reclassifications—Certain prior period balances have been reclassified to conform with current presentations.

Recently Issued Accounting Standards

In June 2006, FASB Interpretation (“FIN”) No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 was issued. 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 will adopt FIN 48 as of January 1, 2007. The interpretation requires the cumulative effect of applying FIN 48 to be reflected as an adjustment to the opening balance of retained earnings. The Company is currently evaluating the impact of FIN 48 on its consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This statement establishes a standard definition of fair value, establishes a framework under generally accepted accounting principles to measure 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). SFAS 158 requires employers to recognize the funded status of each single employer defined benefit pension and postretirement plan and of postemployment benefits as an asset, in the case of overfunded plans, or a liability for unfunded or underfunded plans, in the balance sheet. Upon the adoption of SFAS 158, accumulated previously unrecognized actuarial gains and losses and prior service costs and credits are reported as a component of Accumulated other comprehensive income (loss) in Shareholders’ deficit, net of their related income tax effect.

 

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Amortization of these amounts are included in the income statement, and other incremental changes in these amounts not recognized in the income statement in the year in which they arise, are recognized as changes in Accumulated other comprehensive income (loss) as they occur. The Statement 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. The Company elected to adopt this standard at December 31, 2006. See Note 12 for details of the impact of adoption on the Consolidated Balance Sheets.

In September 2006, the SEC issued Staff Accounting Bulletin (“SAB”) No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB 108 was issued to provide interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. SAB 108 is effective for fiscal years ending on or after November 15, 2006, with earlier adoption encouraged. The adoption of this standard had no impact on the Company.

3. Acquisitions and Divestitures

Acquisitions

The Company accounts for acquisitions using the purchase method of accounting. As required under this method, 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 had 2005 sales of approximately $200 and has eight manufacturing facilities in Europe and Asia Pacific. On June 1, 2006, the Company acquired the ink and adhesive resins business of Akzo Nobel (the “Inks Acquisition”). The business had 2005 sales of approximately $215 and has ten manufacturing facilities in Europe, Asia Pacific, North America and South America. The aggregate purchase price, net of cash acquired, for the acquisitions in 2006, including related direct costs, was $201. The pro forma effects of the acquisitions were not material. On October 20, 2006, an application was filed by certain of Hexion’s 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 the Commission’s decision to permit the acquisition. The Company is currently evaluating the potential impact of this matter.

On February 1, 2007, the Company acquired the adhesives and resins business of Orica Limited in Australia and New Zealand to increase the Company’s formaldehyde-based resins capacity in the Asia-Pacific region. The business had 2006 sales of approximately $85 and has three manufacturing facilities. The purchase price, not including transaction fees and expenses, was approximately $60. The purchase price is subject to certain post-closing adjustments based on the amount of working capital as of the closing date. This acquisition and the related transaction fees and expenses were financed through borrowings by the Company’s Australian subsidiary.

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 had 2005 sales of $38 and 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 HAI. At December 31, 2006, the Company’s remaining ownership in HAI is 60%. The Company recognized gains totaling $39 ($33 on an after tax basis) related to these divestitures that are included in Other operating income, net for the year ended December 31, 2006.

4. Discontinued Operations

On August 1, 2006, the Company sold its Taro Plast S.p.A. business (“Taro Plast”). Taro Plast was acquired in the Bakelite Acquisition and was formerly reported in the Epoxy and Phenolic Resins segment. Accordingly, Taro Plast has been reported as a discontinued operation for all periods presented. The aggregate carrying value of the discontinued business was $14 at December 31, 2005. Taro Plast has been classified separately in the Consolidated Financial Statements at and for the year 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 follow:

 

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
      

 

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Net sales and loss from discontinued operations in the Consolidated Statements of Operations for the years ended December 31 related to the Taro Plast sale follow:

 

     2006     2005  

Net sales

   $ 28     $ 28  

Loss from discontinued operations

     (14 )     (1 )

Loss from discontinued operations for the year ended December 31, 2006 includes an impairment charge of $13 for the amount by which the carrying amount of the net assets of Taro Plast exceeded the selling price. As the Company is party to a participation exemption, there was no tax benefit on the capital loss for the year ended December 31, 2006.

In 1998, pursuant to a merger and recapitalization transaction sponsored by The Blackstone Group (“Blackstone”) and financing arranged by The Chase Manhattan Bank, 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”). The Company received $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 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 for $15. This amount was subsequently paid by the Company in July 2005. As the settlement directly related to a divested business that was accounted for as a discontinued operation in 1997, the Company included the settlement cost in Loss from discontinued operations in its Consolidated Statement of Operations for the year ended December 31, 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 a $6 settlement from a class action suit related to raw material purchases by the divested businesses between July 21, 1991 and June 30, 1995. Because the settlement was related to the previously divested businesses, the Company included the settlement proceeds in Loss from discontinued operations in its Consolidated Statement of Operations for the year ended December 31, 2005.

Losses from discontinued operations are recorded in the Consolidated Statements of Operations net of tax; however, because 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, the corresponding benefit 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 to provide 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. These 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. In addition, upon the closing of the Resolution Specialty and Borden Chemical transactions in the third quarter of 2004, the Company paid $12 for transaction and advisory services, and reimbursed expenses of $1. Prior to the Hexion Formation, on May 31, 2005, Resolution Performance and Resolution Specialty terminated their agreements with Apollo, thereby releasing any and all obligations and

 

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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 in Transaction costs in the Company’s Consolidated Statements of Operations for the year ended December 31, 2005.

At the time of the Hexion Formation, 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 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.

Under the agreements in effect during the years ended December 31, 2006, 2005 and 2004, the Company paid fees of $3, $4 and $2, respectively. The 2003 management fee of less than $1 was paid in 2005. These amounts are included in Other operating expense in the Company’s Consolidated Statements of Operations.

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

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 $9, $25 and $11 for the years ended December 31, 2006, 2005 and 2004, respectively. Accounts receivable from these affiliates were $1 and $2 at December 31, 2006 and 2005, respectively. The Company also purchases raw materials and services from certain Apollo affiliates. These purchases totaled $10, $12 and $12 for the years ended December 31, 2006, 2005 and 2004. The Company had accounts payable to Apollo affiliates of less than $1 at December 31, 2006 and 2005 related to these purchases.

When Borden Chemical was acquired in 2004, Borden Chemical paid transaction-related costs of $9 on behalf of BHI Investment LLC, $22 on behalf of BW Holdings, LLC and shared deal incentive costs of $14. These amounts are included in Transaction costs in the Company’s Consolidated Statement of Operations for the year ended December 31, 2004.

During 2006, the Company assumed the non-qualified pension liabilities of Borden Capital Inc., an affiliate, for a payment of $2, which approximated the book value of the liabilities.

6. Goodwill and Intangible Assets

The changes in the carrying amount of goodwill by segment for the years ended December 31, 2006 and 2005 are as follows:

 

     Epoxy and
Phenolic
Resins
    Formaldehyde
and Forest
Products
   Performance
Products
    Coatings
and Inks
   Total  

Goodwill balance at December 31, 2004

   $ 11     $ 23    $ 17     $ —      $ 51  

Acquisitions

     96       20      —         7      123  

Discontinued operations

     (5 )     —        —         —        (5 )

Foreign currency translation

     (4 )     —        (1 )     —        (5 )
                                      

Goodwill balance at December 31, 2005

   $ 98     $ 43    $ 16     $ 7    $ 164  

Acquisitions

     —         9      —         11      20  

Purchase accounting adjustments

     2       —        —         —        2  

Foreign currency translation

     5       1      1       —        7  
                                      

Goodwill balance at December 31, 2006

   $ 105     $ 53    $ 17     $ 18    $ 193  
                                      

The Company’s intangible assets with identifiable useful lives consist of the following as of December 31:

 

     2006    2005
     Gross
Carrying
Amount
   Accumulated
Amortization
   Net
Book
Value
   Gross
Carrying
Amount
   Accumulated
Amortization
   Net
Book
Value

Intangible assets:

                 

Patents and technology

   $ 118    $ 33    $ 85    $ 114    $ 28    $ 86

Customer lists and contracts

     77      18      59      60      14      46

Other

     21      1      20      32      3      29
                                         
   $ 216    $ 52    $ 164    $ 206    $ 45    $ 161
                                         

 

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The Company has $15 of tradenames at December 31, 2006 and 2005 with indefinite lives. The impact of foreign currency translation is included in accumulated amortization.

Total intangible amortization expense for the years ended December 31, 2006, 2005 and 2004 was $14, $12 and $5, respectively.

Estimated annual intangible amortization expense for 2007 through 2011 is as follows:

 

2007

   $ 15

2008

     14

2009

     12

2010

     12

2011

     12

7. Financial Instruments

The following tables present the carrying or notional amounts and fair values of the Company’s financial instruments at December 31, 2006 and 2005. The fair value of a financial instrument is the estimated amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Fair values of debt are determined from quoted market prices, where available, based on other similar financial instruments, or based upon interest rates that are currently available to the Company for the issuance of debt with similar terms and maturities.

The following table includes the carrying amount and fair value of the Company’s non-derivative financial instruments as of December 31:

 

     2006    2005
     Carrying
Amount
   Fair
Value
   Carrying
Amount
   Fair
Value

Debt

   $ 3,392    $ 3,354    $ 2,341    $ 2,306

The carrying amounts of cash and equivalents, accounts receivable, accounts payable and other accruals are considered reasonable estimates of their fair values because of the short-term maturity of these financial instruments.

The following table summarizes the Company’s derivative financial instruments as of December 31:

 

     2006     2005  
    

Average

Days

To Maturity

  

Average

Contract

Rate

  

Notional

Amount

  

Fair Value

Asset (Liability)

   

Average

Days

to Maturity

  

Average

Contract

Rate

   Notional
Amount
  

Fair Value

Asset (Liability)

 

Currency to Sell for Euros

                      

U.S. dollars (1)

   59    1.3228    27    —       27    1.1890    45    —    

U.S. dollars (1)

   639    1.2038    286    (29 )   990    1.2038    289    5  

British pound (1)

   —      —      —      —       90    0.6987    41    (1 )

U.S. dollars (1)

   —      —      —      —       60    1.2122    3    —    

U.S. dollars (2)

   —      —      —      —       122    1.2031    24    —    

Interest Rate Swap

                      

Interest swap

   913    —      1,000    (5 )   —      —      —      —    

Commodity Future Contracts

                      

Natural gas futures

   —      —      5    —       —      —      3    1  

(1) Forward contracts
(2) Deal contingent forward contract (for a pending acquisition)

 

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At December 31, 2006, the Company had derivative losses of $34 that were classified as Other current liabilities. At December 31, 2005, the Company had derivative losses of $1 that were classified as Other current liabilities and derivative gains of $5 that were classified as Other current assets. Gains and losses are recognized on a quarterly basis in the Consolidated Statements of Operations. The Company does not hold or issue derivative financial instruments for trading purposes.

Foreign Exchange and Interest Rate Swaps

International operations account for a significant portion of the Company’s revenue and operating income. The Company’s policy is to reduce foreign currency cash flow exposure from exchange rate fluctuations by hedging anticipated and firmly committed transactions when it is economically feasible. The Company periodically enters into forward contracts to buy and sell foreign currencies to reduce foreign exchange exposure and protect the U.S. dollar value of certain transactions to the extent of the amount under contract. These contracts are designed to minimize the impact from foreign currency exchange on operating income and on certain balance sheet items. The counter-parties to our forward contracts and interest rate swap agreements are financial institutions with investment grade ratings. The Company does not apply hedge accounting to these derivative instruments.

The Company periodically uses interest rate swaps to alter interest rate exposures between fixed and floating rates on certain long-term debt. Under interest rate swaps, the Company agrees with other parties to exchange, at specified intervals, the difference between fixed rate and floating rate interest amounts calculated using an agreed-upon notional principal amount.

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 is amortized on a quarterly basis based on expected payments on the Company’s term loan to effectively maintain a fixed to variable debt ratio of approximately 65% fixed to 35% variable. As a result of the interest rate swaps, the Company pays a fixed rate equal to approximately 7.9% per year and receives a variable rate based on the terms of the underlying debt. The Company accounts for the swaps as qualifying cash flow hedges in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 138 and SFAS No. 149. Any hedge ineffectiveness is included in Interest expense, net on the Consolidated Statements of Operations.

As a result of the debt refinancing in November 2006, the Company entered into an additional interest rate swap in January 2007, with an initial notional amount of $300 which, combined with the swaps entered into in May 2006, will effectively maintain a fixed interest rate on between 60% and 70% of the Company’s total debt. This swap becomes effective in 2008.

Effective October 11, 2005, the Company entered into a $289 cross-currency and interest rate swap agreement structured for a non-U.S. subsidiary’s $290 U.S. dollar denominated floating rate term loan. The initial notional amount of $289 amortized quarterly based on the terms of the loan. The swap is a three-year agreement designed to offset balance sheet and interest rate exposures and cash flow variability associated with the exchange rate fluctuations on the term loan. The euro to U.S. dollar exchange rate under the swap agreement is 1.2038. The Company pays a variable rate equal to Euribor plus 271 basis points. The Company receives a variable rate equal to the U.S. dollar LIBOR plus 250 basis points. The amount the Company receives under this agreement is approximately equal to the non-U.S. subsidiary’s interest rate on its $290 term loan. The net impact of this interest rate swap was a decrease in the Company’s interest expense of $4 and $1 for the years ended December 31, 2006 and 2005, respectively. The Company paid a weighted average interest rate of 5.91% and 4.89% and received a weighted average interest rate of 7.35% and 6.61% in 2006 and 2005, respectively.

Deal Contingent Forwards

On December 6, 2005, the Company entered into a foreign currency forward position of $24 to purchase euros with U.S. dollars at a rate of 1.2031. The contract was contingent on the close of the Inks Acquisition. As a result of the Inks Acquisition on June 1, 2006, the Company settled the forward contract and recognized a gain of $1. The purpose of the hedge was to mitigate the risk of foreign currency exposure related to the pending transaction. The Company did not apply hedge accounting to this forward contract.

Commodity Future Contracts

The Company is exposed to price fluctuations associated with raw materials purchases, most significantly with methanol, phenol, urea, acetone, propylene and chlorine. For these commodity raw materials, the Company has purchase contracts in place that contain periodic price adjustment provisions. The Company also adds selling price provisions to certain customer contracts that are indexed to publicly available indices for the associated commodity raw materials. The Board of Directors approves all commodity futures and commodity commitments based on delegation of authority documents.

The Company hedges a portion of its natural gas purchases for certain North American plants. The Company used futures contracts to hedge 76% and 66% of its 2006 and 2005 natural gas usage at these plants, respectively. The contracts are settled for cash each month based on the closing market price on the last day the contract trades on the New York Mercantile Exchange. Commitments settled under these contracts totaled $8 and $5 in 2006 and 2005, respectively. The Company does not apply hedge accounting to these future contracts. The Company recorded a net loss of $1 in 2006 and a gain of $2 in 2005 for these

 

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commitments, which are recognized each month as the gas is used. Remaining obligations are marked to market on a quarterly basis. The Company had future commitments under these contracts of $5 and $3 at December 31, 2006 and 2005, respectively, and recorded an unrealized loss of less than $1 at December 31, 2006 related to future commitments.

8. Debt and Lease Obligations

Debt outstanding at December 31 is as follows:

 

     2006    2005
     Long-Term    Due Within
One Year
   Long-Term    Due Within
One Year

Revolving Credit Facilities due 2011 at 9.3% at December 31, 2006

   $ 23    $ —      $ —      $ —  

Senior Secured Notes:

           

Floating rate second-priority senior secured notes due 2014 at 9.9% at December 31, 2006

     200      —        —        —  

9.75% Second-priority senior secured notes due 2014

     625      —        —        —  

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      —  

Floating rate second-priority senior secured notes due 2010 at 9.8% at December 31, 2005 (includes $2 of unamortized debt discount at December 31, 2005)

     —        —        298      —  

Credit Agreements:

           

Floating rate term loans due 2012 at 6.2% at December 31, 2005

     —        —        493      5

Floating rate term loans due 2013 at 7.9% at December 31, 2006

     1,975      20      —        —  

Debentures:

           

9.2% debentures due 2021

     115      —        115      —  

7.875% debentures 2023

     247      —        247      —  

8.375% sinking fund debentures due 2016

     78      —        78      —  

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

     —        —        336      —  

Other Borrowings:

           

Industrial Revenue Bonds due 2009 at 10%

     34      —        34      —  

Capital Leases

     11      —        11      1

Other at 6.2% and 5.6% at December 31, 2006 and 2005, respectively

     18      46      23      32
                           

Total debt

   $ 3,326    $ 66    $ 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.

Senior Secured Credit Facilities and Senior Secured Notes

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 (collectively, the “May 2006 Senior Secured Credit Facilities”), are each subject to an earlier maturity date, on any date that more than $200 in the aggregate principal amount of certain of the Company’s debt will mature within 91 days of that date. Repayment of 1% total per year of the term loan and LOCs must be made (in the case of the term loan facility, quarterly, and in the case of the LOC, annually) with the balance payable at the final maturity date. Further, the Company may be required to make additional repayments on the term loan, upon specific events, or, beginning in 2008, if excess cash flow is generated.

In November 2006, the Company amended and restated the May 2006 Senior Secured Credit Facilities. The amended and restated credit facilities provide for a seven-year $2,000 term loan facility and a seven-year $50 synthetic letter of credit facility, with the term of these facilities beginning May 2006, and continued access to the five-year $225 revolving credit facility (collectively, the “New Senior Senior Secured Credit Facilities”).

The interest rates for term loans to the Company under the New Senior Secured Credit Facilities are based on, at the Company’s option, (a) adjusted LIBOR plus 2.50% 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 1.00%. Term loans to the Company’s Netherlands subsidiary are at the Company’s option, (a) EURO LIBOR plus 2.50% or (b) the rate quoted by JPMCB as its base rate for those loans plus 1.00%. The weighted average interest rate on the term loans in effect at December 31, 2006 was approximately 7.9%.

 

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The New Senior Secured Credit Facilities have commitment fees (other than with respect to the LOC) equal to 0.50% per year 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 year. Available borrowings under the New Senior Secured Credit Facilities was $189 at December 31, 2006.

Certain Company subsidiaries guarantee obligations under the New Senior Secured Credit Facilities. The New Senior Secured Credit Facilities are secured by 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 certain financial ratios. 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.

At December 31, 2006 and 2005, the Company was in compliance with all of the financial covenants and restrictions that were contained in the indentures that govern its notes and credit facilities.

When the Company entered into the May 2006 Senior Secured Credit Facilities, it repaid all of the amounts that were outstanding under its May 2005 term loan and synthetic letter of credit facilities. In addition, the Company repurchased or redeemed all of its outstanding 8% Senior secured notes, 9.5% Senior Second secured notes, 13.5% Senior subordinated notes and Redeemable Preferred Stock (See Note 11).

In addition to entering into the New Senior Secured Credit Facilities, in November 2006, through the Company’s wholly owned finance subsidiaries, Hexion U.S. Finance Corp. and Hexion Nova Scotia Finance, ULC, the Company sold $200 of Floating rate second-priority senior secured notes due 2014 and $625 of 9.75% Second-priority senior secured notes due 2014 (the “New Senior Secured Notes”). The net proceeds from the New Senior Secured Credit Facilities and the New Senior Secured Notes were used to repurchase or redeem all of the outstanding Floating rate second-priority notes dues 2010 and 9% Second-priority senior secured notes. In addition, the Company used $480 of the proceeds to fund a common stock dividend to its parent (See Note 13).

For the year ended December 31, 2006, the Company recognized a loss on the extinguishment of debt related to its 2006 refinancing activities of $121, consisting of redemption costs net of debt premiums and the write-off of deferred financing costs. In addition, the Company incurred financing costs of $38, which are included within Other assets on the Consolidated Balance Sheets and will be amortized over the life of the related debt.

Debentures

 

    

Origination

Date

  

Interest

Payable

  

Early