1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 1998 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 1-12626 EASTMAN CHEMICAL COMPANY (Exact name of registrant as specified in its charter) DELAWARE 62-1539359 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 100 N. EASTMAN ROAD KINGSPORT, TENNESSEE 37660 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (423) 229-2000 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 X No --- --- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. <TABLE> <CAPTION> Number of Shares Outstanding at Class September 30, 1998 <S> <C> Common Stock, par value $0.01 per share 79,243,594 (including rights to purchase shares of Common Stock or Participating Preferred Stock) </TABLE> - ------------------------------------------------------------------------------- PAGE 1 OF 46 TOTAL SEQUENTIALLY NUMBERED PAGES EXHIBIT INDEX ON PAGE 20
2 TABLE OF CONTENTS <TABLE> <CAPTION> - -------------------------------------------------------------------------------- ITEM PAGE - -------------------------------------------------------------------------------- PART I. FINANCIAL INFORMATION <S> <C> <C> 1. Financial Statements 3 - 8 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 9-16 PART II. OTHER INFORMATION 1. Legal Proceedings 17 2. Changes in Securities 17 6. Exhibits and Reports on Form 8-K 18 SIGNATURES Signatures 19 </TABLE> 2
3 EASTMAN CHEMICAL COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF EARNINGS, COMPREHENSIVE INCOME, AND RETAINED EARNINGS (DOLLARS IN MILLIONS, EXCEPT PER SHARE AMOUNTS) <TABLE> <CAPTION> THIRD QUARTER FIRST NINE MONTHS 1998 1997 1998 1997 <S> <C> <C> <C> <C> EARNINGS Sales $ 1,131 $ 1,145 $ 3,444 $ 3,524 Cost of sales 870 857 2,632 2,693 ------- ------- ------- ------- Gross profit 261 288 812 831 Selling and general administrative expenses 75 85 235 247 Research and development costs 45 55 139 145 ------- ------- ------- ------- Operating earnings 141 148 438 439 Interest expense, net 28 26 70 67 Other income, net 10 26 18 31 ------- ------- ------- ------- Earnings before income taxes 123 148 386 403 Provision for income taxes 43 52 135 145 ------- ------- ------- ------- Net earnings $ 80 $ 96 $ 251 $ 258 ======= ======= ======= ======= Net earnings per share --Basic earnings per share $ 1.01 $ 1.23 $ 3.18 $ 3.31 ======= ======= ======= ======= --Diluted earnings per share $ 1.00 $ 1.22 $ 3.15 $ 3.28 ======= ======= ======= ======= COMPREHENSIVE INCOME Net earnings $ 80 $ 96 $ 251 $ 258 Other comprehensive income (loss) 32 (20) 29 (47) ------- ------- ------- ------- Comprehensive income $ 112 $ 76 $ 280 $ 211 ======= ======= ======= ======= RETAINED EARNINGS Retained earnings at beginning of period $ 2,179 $ 2,022 $ 2,078 $ 1,929 Net earnings 80 96 251 258 Cash dividends declared (35) (34) (105) (103) ------- ------- ------- ------- Retained earnings at end of period $ 2,224 $ 2,084 $ 2,224 $ 2,084 ======= ======= ======= ======= </TABLE> The accompanying notes are an integral part of these financial statements. 3
4 EASTMAN CHEMICAL COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL POSITION (DOLLARS IN MILLIONS) <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, 1998 1997 <S> <C> <C> ASSETS Current assets Cash and cash equivalents $ 86 $ 29 Receivables 840 793 Inventories 568 511 Other current assets 185 157 ------- ------- Total current assets 1,679 1,490 ------- ------- Properties Properties and equipment at cost 8,457 8,104 Less: Accumulated depreciation 4,451 4,223 ------- ------- Net properties 4,006 3,881 ------- ------- Other noncurrent assets 454 407 ------- ------- Total assets $ 6,139 $ 5,778 ======= ======= LIABILITIES AND SHAREOWNERS' EQUITY Current liabilities Payables and other current liabilities $ 982 $ 954 ------- ------- Total current liabilities 982 954 Long-term borrowings 1,821 1,714 Deferred income tax credits 439 397 Postemployment obligations 698 724 Other long-term liabilities 221 236 ------- ------- Total liabilities 4,161 4,025 ------- ------- Shareowners' equity Common stock ($0.01 par - 350,000,000 shares authorized; shares issued - 84,412,160 and 84,144,672) 1 1 Paid-in capital 93 77 Retained earnings 2,224 2,078 Other comprehensive income (loss) (8) (37) ------- ------- 2,310 2,119 Less: Treasury stock at cost (5,353,123 and 5,889,311 shares) 332 366 ------- ------- Total shareowners' equity 1,978 1,753 ------- ------- Total liabilities and shareowners' equity $ 6,139 $ 5,778 ======= ======= </TABLE> The accompanying notes are an integral part of these financial statements. 4
5 EASTMAN CHEMICAL COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOW (DOLLARS IN MILLIONS) <TABLE> <CAPTION> FIRST NINE MONTHS 1998 1997 <S> <C> <C> Cash flows from operating activities Net earnings $ 251 $ 258 ----- ----- Adjustments to reconcile net earnings to net cash provided by operating activities Depreciation 258 242 Provision for deferred income taxes 16 6 Increase in receivables (45) (54) Increase in inventories (55) (76) Increase in incentive pay and employee benefit liabilities 18 49 Increase (decrease) in liabilities excluding borrowings, incentive pay, and employee benefit liabilities (4) 91 Other items, net 20 (7) Total adjustments 208 251 ----- ----- Net cash provided by operating activities 459 509 ----- ----- Cash flows from investing activities Additions to properties and equipment (368) (567) Acquisitions and investments in joint ventures (32) -- Proceeds from sales of assets 1 19 Capital advances to suppliers (21) (22) Other items, net -- (2) ----- ----- Net cash used in investing activities (420) (572) ----- ----- Cash flows from financing activities Net increase (decrease) in commercial paper borrowings 84 (113) Proceeds from long-term borrowings 23 295 Dividends paid to shareowners (105) (104) Treasury stock purchases -- (8) Other items, net 16 5 ----- ----- Net cash provided by financing activities 18 75 ----- ----- Net change in cash and cash equivalents 57 12 Cash and cash equivalents at beginning of period 29 24 ----- ----- Cash and cash equivalents at end of period $ 86 $ 36 ===== ===== </TABLE> The accompanying notes are an integral part of these financial statements. 5
6 EASTMAN CHEMICAL COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The accompanying unaudited interim consolidated financial statements have been prepared by the Company in accordance and consistent with the accounting policies stated in the Company's 1997 Annual Report on Form 10-K and should be read in conjunction with the consolidated financial statements appearing therein. In the opinion of the Company, all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation have been included in the interim consolidated financial statements. The interim consolidated financial statements are based in part on approximations and have not been audited by independent accountants. 2. INVENTORIES <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, (Dollars in millions) 1998 1997 At FIFO or average cost (approximates current cost): <S> <C> <C> Finished goods $ 444 $ 436 Work in process 147 140 Raw materials and supplies 220 211 ----- ----- Total inventories at FIFO or average cost 811 787 Reduction to LIFO value (243) (276) ----- ----- Total inventories at LIFO value $ 568 $ 511 ===== ===== </TABLE> Inventories valued on the LIFO method are approximately 70-75% of total inventories in each of the periods. 3. HOLSTON DEFENSE CORPORATION Holston Defense Corporation ("Holston"), a wholly owned subsidiary of the Company, has, as its sole business, managed the government-owned Holston Army Ammunition Plant in Kingsport, Tennessee (the "Facility") since 1949 under a series of contracts with the Department of Army (the "DOA"). Holston is currently managing the Facility under a contract that terminates on December 31, 1998 (the "Contract"). The DOA has concluded the previously reported bidding process and has awarded a contract to manage the Facility to a third party commencing January 1, 1999. Accordingly, Holston will not continue to manage the Facility after termination of the Contract. The Contract generally provides for payment of a management fee to Holston and reimbursement by the DOA of allowable costs incurred by Holston for the operation of the Facility. Holston's operating results historically have been insignificant to the Company's consolidated sales and earnings. Pension and other postretirement benefits are currently provided to Holston's present and past employees under the terms of Holston's plans. The Company has previously recognized, in accordance with generally accepted accounting principles, pension and other postretirement benefit obligations related to Holston totaling approximately $95 million. The Company expects that the DOA will reimburse these pension and other postretirement benefit obligations and such amounts will be credited to earnings at the time of receipt of reimbursement from the DOA. The reimbursement may or may not occur in a single payment. 6
7 Termination of Holston's management of the Facility will result in termination payments to certain Holston employees and will require additional funding for the acceleration of obligations under the pension and other postretirement benefits plans. The Company has recognized additional liabilities of approximately $35 million for termination and pension curtailment. The recognition of these liabilities had no effect on earnings because the Company recorded a receivable from the DOA for the reimbursement of such amounts. Holston plans to terminate its pension plan in a standard termination as of January 1, 1999. In order to terminate the pension plan in a standard termination, the assets of the plan must be sufficient to provide all benefit liabilities with respect to each participant. Holston is in the process of determining the amount to be funded. The Company will be required to advance funds to pay such pension benefit liabilities, as well as other termination costs, if there are delays in payment or reimbursement by the DOA of all or portions of these costs. The Company is negotiating with the DOA the settlement of certain postretirement benefit obligations. The Company's potential obligation for these postretirement benefit obligations, if any, in excess of the negotiated amount will be recognized as a liability at such time that it is probable and reasonably estimable that projected benefit obligations exceed assets provided by the DOA. The Company expects that the DOA will reimburse the Company for all costs associated with termination of the Contract. Although the DOA's position with respect to similar contracts is that it has no legal liability for unfunded postretirement benefit costs, other than pension obligations, and the DOA may disagree with the specific amount of other postretirement obligations, it is the opinion of the Company, based on the Contract terms, applicable law, and legal and equitable precedents, that substantially all of the other postretirement benefit costs will be paid by the DOA or recovered from the government in related proceedings, and that the amounts, if any, not paid or recovered, or the advancement of funds by the Company pending such reimbursement or recovery, should not have a material adverse effect on the consolidated financial position or results of operations of the Company. 4. ACQUISITIONS AND INVESTMENTS In September 1998 Eastman purchased for cash a European manufacturer of specialty polymers. This transaction is accounted for as a purchase. The Company expects to substantially complete the purchase accounting in the fourth quarter 1998. This acquisition is not expected to have a material effect on financial position or results of operations of the Company. 5. PAYABLES AND OTHER CURRENT LIABILITIES <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, (Dollars in millions) 1998 1997 <S> <C> <C> Trade creditors $296 $281 Accrued payrolls and vacation 89 99 Accrued variable-incentive compensation 73 92 Accrued pension liabilities 168 140 Accrued taxes 127 95 Other 229 247 ---- ---- Total $982 $954 ==== ==== </TABLE> 6. LONG-TERM BORROWINGS During third quarter 1998 the Company issued $23 million tax-exempt bonds at variable interest rates, the proceeds of which are to be used for the construction of certain solid waste disposal facilities in Kingsport, Tennessee. The proceeds from this issuance are included in other noncurrent assets and are held in trust until such time as needed to fund the qualifying projects. <TABLE> <CAPTION> 7. DIVIDENDS THIRD QUARTER FIRST NINE MONTHS 1998 1997 1998 1997 <S> <C> <C> <C> <C> Cash dividends declared per share $ .44 $ .44 $ 1.32 $ 1.32 </TABLE> 7
8 8. EARNINGS PER SHARE <TABLE> <CAPTION> THIRD QUARTER FIRST NINE MONTHS 1998 1997 1998 1997 <S> <C> <C> <C> <C> Shares used for earnings per share calculation (in millions): --Basic 79.1 78.2 78.8 78.0 --Diluted 79.5 78.9 79.5 78.6 </TABLE> Certain shares underlying options outstanding during the third quarters of 1998 and 1997 and at September 30, 1998 and 1997 were excluded from the computation of diluted earnings per share because the options' exercise prices were greater than average market price of the common shares. Excluded from third quarter of 1998 and 1997 calculations were shares underlying options to purchase 1,462,714 common shares at a range of prices from $56.8750 to $74.2500 and 569,887 common shares at a range of prices from $60.4375 to $74.2500, respectively. Excluded from the year to date 1998 and 1997 calculations were shares underlying options to purchase 990,386 common shares at a range of prices from $56.8750 to $74.2500 and 581,368 common shares at a range of prices from $57.6250 to $74.2500, respectively. Additionally, 200,000 shares underlying an option issued to the Chief Executive Officer in third quarter 1997 were excluded from diluted earnings per share calculations because the conditions to exercise had not been met as to any of the shares as of September 30, 1998. 9. ANTITRUST VIOLATION AND SETTLEMENT On September 30, 1998, Eastman entered into a voluntary plea agreement with the Department of Justice and agreed to pay an $11 million fine to resolve a charge brought against the Company for violation of Section One of the Sherman Act. The charge, which is not deductible for federal income tax purposes, was recorded in Cost of Sales in the third quarter and will be paid in installments over a five year period. 10. COMPREHENSIVE INCOME The Company adopted SFAS No. 130, "Reporting Comprehensive Income" in 1998. Components of other comprehensive income (loss) are cumulative translation adjustments and minimum pension liabilities. Amounts of other comprehensive income (loss) are presented net of applicable taxes. Because cumulative translation adjustments are considered a component of permanently invested unremitted earnings of subsidiaries outside the United States, no taxes are provided on such amounts. 11. SUPPLEMENTAL CASH FLOW INFORMATION In March 1998 the Company issued 536,188 treasury shares to its Employee Stock Ownership Plan as partial settlement of the Company's Eastman Performance Plan payout. The shares issued had a market value of $35 million and a carrying value of $33 million. In March 1997 the Company issued 611,962 shares of previously unissued common stock with a market value of $34 million to the Employee Stock Ownership Plan as partial settlement of the Eastman Performance Plan payout. These noncash transactions are not reflected in the Consolidated Statements of Cash Flow. 8
9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company's Consolidated Financial Statements and Management's Discussion and Analysis contained in the 1997 Annual Report on Form 10-K and the unaudited interim consolidated financial statements included elsewhere in this report. All references to earnings per share contained in this report are basic earnings per share unless otherwise noted. RESULTS OF OPERATIONS EARNINGS <TABLE> <CAPTION> (Dollars in millions, except THIRD QUARTER FIRST NINE MONTHS per share amounts) 1998 1997 CHANGE 1998 1997 CHANGE <S> <C> <C> <C> <C> <C> <C> Operating earnings $ 141 $ 148 (5)% $ 438 $ 439 0% Net earnings 80 96 (17)% 251 258 (3)% Net earnings per share --Basic Earnings Per Share 1.01 1.23 (18)% 3.18 3.31 (4)% --Diluted Earnings Per Share 1.00 1.22 (18)% 3.15 3.28 (4)% </TABLE> Higher sales volumes in third quarter for all three segments, including significantly higher volume for the Core Plastics segment, reflected good demand overall for the Company's products. However, competitive markets resulting from global economic conditions and industry overcapacities caused selling prices to decline, negatively impacting revenues and earnings. Costs for most major raw materials, including propane feedstock, paraxylene, purified terephthalic acid ("PTA"), ethylene glycol and natural gas, were below 1997 levels. Preproduction costs for third quarter decreased following the second quarter startup of new manufacturing facilities in Rotterdam, Argentina and Malaysia, although for nine months preproduction costs were higher than in 1997. As a result of good demand and new manufacturing capacity, sales volumes for the quarter and nine months improved significantly for container plastics and EASTAPAK polymers with gains experienced in Latin America, North America and Europe. Although sales volume for fibers products improved for the quarter, particularly in the Asia Pacific region, volume was still below nine months 1997 and selling prices were lower. Productivity gains and cost structure improvements achieved as a result of the Company's Advantaged Cost 2000 initiative and a lower effective tax rate had a positive effect on results for the quarter and nine months. A stronger U.S. dollar produced an unfavorable effect on sales denominated in currencies other than U.S. dollars, although the earnings impact was offset by gains realized on currency hedging transactions. Operating results for the third quarter and nine months were negatively impacted by a charge for violation of the Sherman Act. In 1997, third quarter and nine months net earnings were favorably impacted by a gain from a patent infringement award. 9
10 SUMMARY BY INDUSTRY SEGMENT SPECIALTY AND PERFORMANCE SEGMENT <TABLE> <CAPTION> THIRD QUARTER FIRST NINE MONTHS (Dollars in millions) 1998 1997 CHANGE 1998 1997 CHANGE <S> <C> <C> <C> <C> <C> <C> Sales $635 $645 (2)% $1,898 $1,989 (5)% Operating earnings 111(1) 116 (4)% 311(1) 364 (15)% </TABLE> (1) Includes charge of $11 million for violation of the Sherman Act. Sales volumes were higher during third quarter for most product lines, although selling prices were generally under pressure. Operating earnings for the segment overall were positively impacted by significantly lower costs for raw materials and energy and cost structure improvements, but negatively impacted by recognition of a charge for violation of the Sherman Act. Specialty plastics sales volumes improved reflecting good markets and new applications for EASTAR and SPECTAR. Although acetate tow prices were lower than third quarter 1997, business conditions for acetate tow improved with higher sales volume third quarter. Coatings, inks and resins sales volumes for the quarter were strong, particularly for solvents, but the strong competitive environment and industry overcapacity pressured selling prices. Performance chemicals sales and earnings declined for third quarter and nine months, reflecting the effect of discontinued businesses, industry overcapacity, competitive pricing and recognition of a fine for violation of the Sherman Act. Sales and earnings for fine chemicals improved third quarter, reflecting cost recovery related to custom manufacturing projects. CORE PLASTICS SEGMENT <TABLE> <CAPTION> THIRD QUARTER FIRST NINE MONTHS (Dollars in millions) 1998 1997 CHANGE 1998 1997 CHANGE <S> <C> <C> <C> <C> <C> <C> Sales $335 $325 3% $1,024 $994 3% Operating earnings (loss) 3 (10) - 25 (35) - </TABLE> Container plastics results for third quarter and nine months reflected substantially higher sales volume for EASTAPAK polymers following the second quarter startup of new manufacturing facilities in Rotterdam and Argentina. Preproduction costs for third quarter decreased, although for nine months were higher than in 1997. EASTAPAK polymers selling prices, although significantly higher for nine months, were pressured in third quarter by industry overcapacity. Polyethylene selling prices and margins were negatively impacted by the effect of excess industry capacities for ethylene and polyethylene. However, this was offset partially by increased sales of specialty grade polyethylene performance polymers and lower raw materials cost. Segment earnings were positively impacted by cost structure improvements. CHEMICAL INTERMEDIATES SEGMENT <TABLE> <CAPTION> THIRD QUARTER FIRST NINE MONTHS (Dollars in millions) 1998 1997 CHANGE 1998 1997 CHANGE <S> <C> <C> <C> <C> <C> <C> Sales $161 $175 (8)% $522 $541 (4)% Operating earnings 27 42 (36)% 102 110 (7)% </TABLE> Generally lower selling prices attributable to excess industry capacity and competitive market conditions negatively impacted sales and earnings for the quarter and nine months, but the effect was partially offset by higher volumes, cost structure improvements and favorable raw materials and energy costs. (For supplemental analysis of Specialty and Performance, Core Plastics, and Chemical Intermediates segment results, see Exhibit 99.01 to this Form 10-Q.) 10
11 SUMMARY BY CUSTOMER LOCATION SALES BY REGION <TABLE> <CAPTION> THIRD QUARTER FIRST NINE MONTHS (Dollars in millions) 1998 1997 CHANGE 1998 1997 CHANGE <S> <C> <C> <C> <C> <C> <C> United States and Canada $736 $763 (4)% $2,268 $2,310 (2)% Asia Pacific 106 119 (11) 310 390 (21) Europe, Middle East, and Africa 188 187 1 590 581 2 Latin America 101 76 33 276 243 14 </TABLE> Sales in the United States for third quarter 1998 were $696 million, down 3% from 1997 third quarter sales of $718 million. For nine months, sales in the United States were $2.14 billion compared to $2.18 billion in 1997. For the quarter and nine months, significant sales volume improvements were offset by selling price declines reflecting global economic conditions. Sales outside the United States for third quarter 1998 were $435 million, up 2% from 1997 third quarter sales of $427 million. Sales outside the United States were 38% of total sales in third quarter 1998 compared with 37% for third quarter 1997. For nine months, sales outside the United States were $1.31 billion, a decrease of 3% from 1997 sales of $1.34 billion. Decreased sales in Asia Pacific for nine months are mainly a result of lower sales volumes and prices for acetate tow resulting from excess industry capacity, although for the quarter, acetate tow volumes improved. Some decline in Asia Pacific is also attributable to the region's weakened economies. Sales in Latin America reflect strong demand and new capacity for EASTAPAK polymers following the second quarter startup of a new manufacturing site in Argentina. A strong U.S. dollar against foreign currencies resulted in unfavorable currency exchange effects, primarily in Europe. SUMMARY OF CONSOLIDATED RESULTS <TABLE> <CAPTION> THIRD QUARTER FIRST NINE MONTHS (Dollars in millions) 1998 1997 CHANGE 1998 1997 CHANGE <S> <C> <C> <C> <C> <C> <C> SALES $1,131 $1,145 (1)% $3,444 $3,524 (2)% </TABLE> Sales volumes for most product lines and regions improved for third quarter, with significant improvement in the Core Plastics segment. However, the effect of increased volumes was offset by generally lower selling prices reflecting global economic conditions. For nine months overall volume was moderately ahead of 1997 but the effect of generally lower selling prices and a shift in the mix of products sold resulted in lower sales. For the quarter and nine months, sales were negatively affected by the strength of the U.S. dollar against foreign currencies, primarily in Europe. <TABLE> <CAPTION> THIRD QUARTER FIRST NINE MONTHS (Dollars in millions) 1998 1997 CHANGE 1998 1997 CHANGE <S> <C> <C> <C> <C> <C> <C> GROSS PROFIT $ 261 $ 288 (9)% $ 812 $ 831 (2)% As a percentage of sales 23.1% 25.2% 23.6% 23.6% </TABLE> Although lower raw materials and energy costs and productivity gains had a positive impact on gross profit, declining selling prices and a charge for violation of the Sherman Act caused a decline in gross profit for the quarter and nine months. 11
12 <TABLE> <CAPTION> THIRD QUARTER FIRST NINE MONTHS (Dollars in millions) 1998 1997 CHANGE 1998 1997 CHANGE <S> <C> <C> <C> <C> <C> <C> SELLING AND GENERAL ADMINISTRATIVE EXPENSES $ 75 $ 85 (12)% $235 $247 (5)% As a percentage of sales 6.6% 7.4% 6.8% 7.0% </TABLE> The decrease in selling and general administrative expenses reflects timing of expenditures and a reduction in labor hours. <TABLE> <CAPTION> THIRD QUARTER FIRST NINE MONTHS (Dollars in millions) 1998 1997 CHANGE 1998 1997 CHANGE <S> <C> <C> <C> <C> <C> <C> RESEARCH AND DEVELOPMENT COSTS $ 45 $ 55 (18)% $139 $145 (4)% As a percentage of sales 4.0% 4.8% 4.0% 4.1% </TABLE> Due to timing of expenditures, research and development costs were lower for the quarter, but were relatively unchanged for nine months. <TABLE> <CAPTION> THIRD QUARTER FIRST NINE MONTHS (Dollars in millions) 1998 1997 CHANGE 1998 1997 CHANGE <S> <C> <C> <C> <C> <C> <C> INTEREST COSTS $32 $31 $97 $91 LESS CAPITALIZED INTEREST 4 5 27 24 --- --- --- --- NET INTEREST EXPENSE $28 $26 8% $70 $67 4% === === === === </TABLE> Interest costs were higher for the quarter and nine months as a result of an increase in long-term borrowings consistent with the Company's capital expansion and operating activities. <TABLE> <CAPTION> THIRD QUARTER FIRST NINE MONTHS (Dollars in millions) 1998 1997 CHANGE 1998 1997 CHANGE <S> <C> <C> <C> <C> <C> <C> OTHER INCOME, NET $10 $26 (62)% $18 $31 (42)% </TABLE> Other income and other charges include interest income, royalty income, gains and losses on asset sales, results from equity investments, foreign exchange transactions, and other items. Amounts for third quarter 1997 and nine months 1997 include a gain from a patent infringement award. LIQUIDITY, CAPITAL RESOURCES AND OTHER FINANCIAL DATA <TABLE> <CAPTION> FINANCIAL INDICATORS 1998 1997 <S> <C> <C> For the first nine months Ratio of earnings to fixed charges 4.2x 4.6x At the period ended September 30 and December 31 Current ratio 1.7x 1.6x Percent of long-term borrowings to total capital 48% 49% Percent of floating-rate borrowings to total borrowings 16% 12% </TABLE> <TABLE> <CAPTION> CASH FLOW FIRST NINE MONTHS (Dollars in millions) 1998 1997 <S> <C> <C> Net cash provided by (used in) Operating activities $ 459 $ 509 Investing activities (420) (572) Financing activities 18 75 ----- ----- Net change in cash and cash equivalents $ 57 $ 12 ===== ===== Cash and cash equivalents at end of period $ 86 $ 36 ===== ===== </TABLE> 12
13 Cash provided by operating activities decreased from nine months 1997 due to changes in receivables and inventories and timing of expenditures, including those related to pension funding. Cash used in investing activities declined as a result of reduced capital expansion activity in 1998, slightly offset by the acquisition of a specialty polymers business. Cash provided by financing activities in 1998 reflects an increase in commercial paper borrowings and proceeds received from a $23 million issuance of tax-exempt bonds. Cash provided by financing activities in 1997 reflects treasury stock purchases and proceeds received from a $300 million issuance of 7.60% debentures due February 1, 2027 which were used to repay commercial paper borrowings outstanding at that time. Also reflected in cash flows from financing activities is the payment of dividends in both years. CAPITAL EXPENDITURES AND OTHER COMMITMENTS Eastman anticipates that total capital expenditures in 1998 will be approximately $500-550 million and depreciation expense is expected to be approximately $350 million. For 1999 the Company estimates that capital expenditures will be approximately $450-500 million and depreciation is expected to increase somewhat due to full year depreciation on facilities which began operations in 1998. Long-term commitments related to planned capital expenditures are not material. LIQUIDITY Eastman has access to an $800 million revolving credit facility ("Credit Facility") expiring in December 2000. Although the Company does not have any amounts outstanding under the Credit Facility, any such borrowings would be subject to interest at varying spreads above quoted market rates, principally LIBOR. The Credit Facility also requires a facility fee on the total commitment that varies based on Eastman's credit rating. The annual rate for such fee was .075% as of September 30, 1998. The Credit Facility contains a number of covenants and events of default, including the maintenance of certain financial ratios. Eastman was in compliance with all such covenants for all periods. Eastman utilizes commercial paper, generally with maturities of 90 days or less, to meet its liquidity needs. The Company's commercial paper, supported by the Credit Facility, is classified as long-term borrowings because the Company has the ability and intent to refinance such borrowings long term. As of September 30, 1998 the Company's commercial paper outstanding balance was $296 million at an effective interest rate of 5.72%. At September 30, 1997 the Company's commercial paper outstanding balance was $189 million at an effective interest rate of 5.7%. During the third quarter 1998 the Securities and Exchange Commission declared effective the Company's registration statement to issue up to $1 billion of debt or equity securities. No securities have been sold from this shelf registration. Also during third quarter the Company issued $23 million tax-exempt bonds at variable interest rates, the proceeds of which are to be used for the construction of certain solid waste disposal facilities in Kingsport, Tennessee. The proceeds from this issuance are held in trust as restricted cash and become available to the Company as expenditures are made for construction of the designated solid waste disposal facilities. The Company repurchased a total of 5,935,301 shares of common stock during 1995, 1996 and 1997 at a cost of $369 million, and is currently authorized to purchase up to an additional $231 million of its common stock. Repurchased shares may be used to meet common stock requirements for compensation and benefit plans and other corporate purposes. In March 1998 the Company issued 536,188 treasury shares to the Eastman Employee Stock Ownership Plan in partial settlement of the 1997 Eastman Performance Plan obligation. Existing sources of capital, together with cash flows from operations, are expected to be sufficient to meet the Company's foreseeable cash flow requirements. 13
14 <TABLE> <CAPTION> DIVIDENDS THIRD QUARTER FIRST NINE MONTHS 1998 1997 1998 1997 <S> <C> <C> <C> <C> Cash dividends declared per share $ .44 $ .44 $ 1.32 $ 1.32 </TABLE> YEAR 2000 ISSUE The year 2000 issue is the result of computer programs written using two digits rather than four to define the applicable year. Without corrective action, programs with time-sensitive software could potentially recognize a date ending in "00" as the year 1900 rather than the year 2000, causing many computer applications to fail or create erroneous results. This is a significant issue for most, if not all, companies, with far reaching implications, some of which cannot be anticipated or predicted with any degree of certainty. Year 2000 problems could affect many of the Company's processes, including production, distribution, research and development, financial, administrative and communications operations. The Company's date dependent systems can be summarized into three categories: computerized business systems; computerized distributed control systems for manufacturing; and other devices using embedded chips. Internal identification of all business, manufacturing and embedded chip devices for year 2000 compliance is complete. An outside consultant has evaluated our identification, assessment, and testing process related to manufacturing and embedded equipment and concluded that the results of our internal processes are reliable. Remediation and final acceptance testing of the Company's existing business computer systems is on target for completion by yearend 1998. Very few problems have surfaced in this area, primarily because of the Company's aggressive implementation of enterprise software and standardized desktop/office software earlier in this decade. Parallel assessment and remediation of date dependent manufacturing control systems and devices is proceeding. Manufacturers of these products are being contacted to ascertain year 2000 compliance and product compliancy responses have been received for more than seventy percent of identified products. A minimal number of devices have been determined to be non-compliant, with most requiring software upgrades at minimal cost. A testing plan has been approved by senior management, which will evaluate all control systems for date sensitive issues and test a representative sample of manufacturing control systems. The Company's current goal for manufacturing control systems is to complete assessment, testing and most of the remediation or workaround solutions on critical control systems early in 1999. However, because of plant scheduling and equipment lead times, some upgrade work may occur later in the year. Some low priority embedded devices will not be tested or remediated but will be managed by contingency plans. Although some risk is inherent with this plan, the Company believes the risk is controllable with contingency plans being developed and that this plan does not pose significant problems for the Company's various manufacturing distributed control systems. Testing, remediation or workaround solutions for other devices with embedded chips continues on a schedule with a targeted completion date at end of first quarter 1999. As a result of assessments, modifications, upgrades, or replacements planned, ongoing or already completed, the Company believes the year 2000 issue as it relates to the Company's own date dependent systems will not pose significant problems for the Company's business, processes and operations. The Company believes that the costs of modifications, upgrades, or replacements of software, hardware, or capital equipment which would not be incurred but for year 2000 compatibility requirements have not and will not have a material impact on the Company's financial position or results of operations. Overall costs attributable to the Company's year 2000 efforts, incurred over a period of several years, are expected to be less than $20 million. 14
15 The Company has identified and is communicating with customers, suppliers, and other critical service providers to determine if entities with which the Company transacts business have an effective plan in place to address the year 2000 issue, and to determine the extent of the Company's vulnerability to the failure of third parties to remediate their own year 2000 issue. The Company has received affirmative readiness responses from approximately ninety percent of its materials suppliers and seventy-five percent of other key service providers. The Company is relying on statements of service and goods suppliers and is not auditing suppliers' preparation plans. Risks associated with this approach are being identified and contingency plans will be developed. Based on current plans and efforts to date, the Company does not anticipate that year 2000 problems will have a material effect on results of operations or financial condition. However, the above expectations are subject to uncertainties. For example, if the Company is unsuccessful in identifying or remediating all year 2000 problems in its critical operations, or if it is affected by the inability of suppliers or major customers to continue operations due to such a problem, then the Company's results of operations or financial condition could be materially impacted. HOLSTON DEFENSE CORPORATION Holston Defense Corporation ("Holston"), a wholly owned subsidiary of the Company, has managed the government-owned Holston Army Ammunition Plant in Kingsport, Tennessee (the "Facility") since 1949 under contract with the Department of Army ("DOA"). The current contract will terminate December 31, 1998 (the "Contract"). The DOA has concluded the previously reported bidding process and has awarded a contract to manage the Facility to a third party commencing January 1, 1999. Accordingly, Holston will not continue to manage the Facility after termination of the Contract. The Contract provides for reimbursement of allowable costs incurred by Holston. Reimbursement of certain previously recognized pension and postretirement benefit costs will be credited to earnings at the time of receipt of reimbursement from the DOA. The Company has recognized liabilities associated with Holston's curtailment of pension, other postretirement benefits and other termination costs in accordance with generally accepted accounting principles. The recording of previously unrecognized liabilities second quarter had no effect on earnings because the Company also recorded a receivable from the DOA for reimbursement of such amounts. The Company expects the DOA to reimburse substantially all such costs and payments, but delays in reimbursement may require the Company to advance funds to pay such costs. The Company expects no significant impact on financial position or results of operations related to termination of the Contract. See Note 3 to Consolidated Financial Statements. RECENTLY ISSUED ACCOUNTING STANDARDS In June 1997 the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which requires enterprises to report selected information about operating segments and related disclosures about products and services, geographic areas, and major customers. The Company will adopt this standard effective with yearend 1998 financial reporting and expects no material change in its current segment structure. In February 1998 the FASB issued SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits," which standardizes and improves disclosures related to pensions and other postretirement benefits. The Company will comply with the new disclosure requirements of this standard which become effective for the Company's yearend 1998 financial reporting. In June 1998 the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which standardizes the accounting for derivative instruments, including certain derivative instruments embedded in other contracts, by requiring that an entity recognize those items as assets or liabilities in the statement of financial position and measure them at fair value. The Company is evaluating the effect of this standard on its financial statements and will comply with requirements of the new standard which become effective for the Company's 2000 financial reporting cycle. Given current activities, the Company expects no material effect on net earnings, but the standard will likely have an impact on other comprehensive income. Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use," was issued by the American Institute of Certified Public Accountants in March 1998 and 15
16 requires capitalization of certain internal-use computer software costs which will subsequently be amortized over a three year period. The Company will comply with the requirements of this SOP effective for the Company's 1999 financial reporting. The Company's current practice has been to expense such costs as incurred. Consequently, the standard will result in a favorable effect on earnings in the year of adoption. OUTLOOK Given the current economic environment, the Company anticipates it will be a challenge to achieve an improvement in earnings before non-recurring charges for the fourth quarter 1998. Current global economic conditions and industry overcapacities are expected to continue to negatively impact selling prices for many products. Within the Core Plastics segment, demand and volume for EASTAPAK polymers are expected to continue to grow. Continued SPECTAR copolymer volume growth is also expected due to strong demand. Recently introduced polyethylene performance polymers, MXSTEN and TENITE HIFOR, are expected to continue to gain market acceptance. Within the Chemical Intermediates segment, the completed oxo plant expansion is expected to produce continued volume gains. The Company continues to explore options for diminishing the impact of the container plastics business on its portfolio, although it is unlikely that any action will be announced prior to year end 1998. Interest expense and depreciation are expected to increase and capitalized interest is expected to decline for the remainder of 1998 following the startup earlier this year of three new manufacturing facilities. The Company is making good progress toward its Advantaged Cost 2000 initiative of $500 million in cost structure improvements by the year 2000. Improvements in labor and material costs and productivity gains totaling over $100 million were achieved in 1997. The Company expects to continue its progress through on-going business process improvements and increased volumes from new and existing plants. The above-stated expectations, other forward-looking statements in this report, and other statements of the Company relating to matters such as cost reduction targets; additional available manufacturing capacity; capital spending and depreciation; the year 2000 issue; global economic conditions; and supply and demand, volumes, price, costs, margins, and sales and earnings expectations and strategies for individual products, businesses, and segments, as well as for the whole of the Company, are based upon certain underlying assumptions. These assumptions are in turn based upon internal estimates and analyses of current market conditions and trends, management plans and strategies, economic conditions, and other factors and are subject to risks and uncertainties inherent in projecting future conditions and results. The forward-looking statements in this Management's Discussion and Analysis are based upon the following assumptions and those mentioned in the context of the specific statements: continued good overall demand for the Company's products; no significant impact from further deterioration of global economic conditions; downward pressure on selling prices overall; continued demand growth worldwide for EASTAPAK polymers; continued capacity additions within the PET industry worldwide; capacity additions within the ethylene industry worldwide; declines in preproduction expenses related to new manufacturing facilities; stabilization of acetate tow demand and volume; availability of key purchased raw materials with stabilization of or no significant increase in costs; continuing good market reception of new polyethylene products and continued shift of polyethylene product mix to less commodity products; availability of recent or planned manufacturing capacity increases for container plastics, SPECTAR, coatings, and oxo products; and labor and material productivity gains sufficient to meet targeted cost structure reductions. Actual results could differ materially from current expectations if one or more of these assumptions prove to be inaccurate or are unrealized. - ----------------------------------- EASTAPAK, SPECTAR, EASTAR, MXSTEN, and TENITE HIFOR are trademarks of Eastman Chemical Company. 16
17 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS As previously announced, on September 30, 1998 Eastman entered into a voluntary plea agreement with the Department of Justice and agreed to pay an $11 million fine to resolve a charge brought against the Company for violation of Section One of the Sherman Act. Under the agreement, Eastman entered a plea of guilty to one count of price-fixing for sorbates, a class of food preservatives, from January 1995 through June 1997. The plea agreement was approved by the United States District Court for the Northern District of California in San Francisco on October 21, 1998. The Company recognized the entire fine in third quarter 1998 and will pay the fine in installments over a period of five years. As previously reported, in May 1997 the Company received notice from the Tennessee Department of Environment and Conservation ("TDEC") alleging that the manner in which hazardous waste was fed into certain boilers at the Tennessee Eastman facility in Kingsport, Tennessee violated provisions of the Tennessee Hazardous Waste Management Act. Based upon subsequent communications with the TDEC and the U.S. Environmental Protection Agency, the Company believes that these agencies may be contemplating enforcement proceedings which, if commenced, could result in monetary sanctions in excess of the $100,000 threshold of Regulation S-K, Item 103, Instruction 5.C. under the Securities Exchange Act of 1934 for reporting such contemplated proceedings in this Report. The Company's operations are parties to or targets of lawsuits, claims, investigations, and proceedings, including product liability, personal injury, patent, commercial, contract, environmental, antitrust, health and safety, and employment matters, which are being handled and defended in the ordinary course of business. While the Company is unable to predict the outcome of these matters, it does not believe, based upon currently available facts, that the ultimate resolution of any of such pending matters, including the TDEC allegations described in the preceding paragraph, will have a material adverse effect on the Company's financial position or results of operations. ITEM 2. CHANGES IN SECURITIES (c) On July 1, 1998, the Company granted options to purchase an aggregate of 816 shares of its common stock on or after January 1, 1999 at an exercise price of $61.375 per share. Such options were granted to non-employee directors who elected under the 1996 Non-Employee Director Stock Option Plan to receive options in lieu of all or a portion of their semi-annual cash retainer fee. The Company issued the options in reliance upon the exemption from registration of Section 4(2) of the Securities Act of 1933. 17
18 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits filed as part of this report are listed in the Exhibit Index appearing on page 20. (b) Reports on Form 8-K The Company did not file any reports on Form 8-K during the quarter ended September 30, 1998. 18
19 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Eastman Chemical Company Date: October 28, 1998 By: /s/ Allan R. Rothwell ---------------------------------- Allan R. Rothwell Senior Vice President and Chief Financial Officer (On behalf of the Registrant and as Principal Financial Officer) 19
20 <TABLE> <CAPTION> EXHIBIT INDEX EXHIBIT DESCRIPTION SEQUENTIAL NUMBER PAGE NUMBER <S> <C> <C> 3.01 Amended and Restated Certificate of Incorporation of Eastman Chemical Company (incorporated herein by reference to Exhibit 3.01 to Eastman Chemical Company's Registration Statement on Form S-1, File No. 33-72364, as amended) 3.02 Amended and Restated By-laws of Eastman Chemical Company, as amended October 1, 1994 (incorporated by reference to Exhibit 3.02 to Eastman Chemical Company's Annual Report on Form 10-K for the year ended December 31, 1994) 4.01 Form of Eastman Chemical Company Common Stock certificate (incorporated herein by reference to Exhibit 3.02 to Eastman Chemical Company's Annual Report on Form 10-K for the year ended December 31, 1993) 4.02 Stockholder Protection Rights Agreement dated as of December 13, 1993, between Eastman Chemical Company and First Chicago Trust Company of New York, as Rights Agent (incorporated herein by reference to Exhibit 4.4 to Eastman Chemical Company's Registration Statement on Form S-8 relating to the Eastman Investment Plan, File No. 33-73810) 4.03 Indenture, dated as of January 10, 1994, between Eastman Chemical Company and The Bank of New York, as Trustee (incorporated herein by reference to Exhibit 4(a) to Eastman Chemical Company's current report on Form 8-K dated January 10, 1994 (the "8-K")) 4.04 Form of 6 3/8% Notes due January 15, 2004 (incorporated herein by reference to Exhibit 4(c) to the 8-K) 4.05 Form of 7 1/4% Debentures due January 15, 2024 (incorporated herein by reference to Exhibit 4(d) to the 8-K) 4.06 Officers' Certificate pursuant to Sections 201 and 301 of the Indenture (incorporated herein by reference to Exhibit 4(a) to Eastman Chemical Company's Current Report on Form 8-K dated June 8, 1994 (the "June 8-K")) 4.07 Form of 7 5/8% Debentures due June 15, 2024 (incorporated herein by reference to Exhibit 4(b) to the June 8-K) 4.08 Form of 7.60% Debentures due February 1, 2027 (incorporated herein by reference to Exhibit 4.08 to Eastman Chemical Company's Annual Report on Form 10-K for the year ended December 31, 1996 (the "1996 10-K")) </TABLE> 20
21 <TABLE> <CAPTION> EXHIBIT INDEX EXHIBIT DESCRIPTION SEQUENTIAL NUMBER PAGE NUMBER <S> <C> <C> 4.09 Officer's Certificate pursuant to Sections 201 and 301 of the Indenture related to 7.60% Debentures due February 1, 2027 (incorporated herein by reference to Exhibit 4.09 to the 1996 10-K) 4.10 Credit Agreement, dated as of December 19, 1995 (the "Credit Agreement") among Eastman Chemical Company, the Lenders named therein, and The Chase Manhattan Bank, as Agent (incorporated herein by reference to Exhibit 4.08 to Eastman Chemical Company's Annual Report on Form 10-K for the year ended December 31, 1995) *10.01 Eastman ESOP Excess Plan (as amended) 22 *10.02 Eastman Executive Deferred Compensation Plan (as amended) 32 12.01 Statement re: Computation of Ratios of Earnings to Fixed Charges 45 27.01 Financial Data Schedule (for SEC use only) 99.01 Supplemental Business Segment Information 46 - ----------------------------------------------------------------------------------------------- </TABLE> *Management contract or compensatory plan or arrangement filed pursuant to Item 601(b)(10)(ii) of Regulation S-K. 21