UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
For the fiscal year ended December 31, 2005
or
For the transition period from to
Commission file number 001-12019
QUAKER CHEMICAL CORPORATION
(Exact name of Registrant as specified in its charter)
Registrant’s telephone number, including area code: (610) 832-4000
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Name of each Exchange on which registered
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 Act. Yes ¨ No x
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
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. ¨
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. (Check one):
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x
State aggregate market value of common stock held by non-affiliates of the Registrant. (The aggregate market value is computed by reference to the last reported sale on the New York Stock Exchange on June 30, 2005): $169,466,548.
Indicate the number of shares outstanding of each of the Registrant’s classes of common stock as of the latest practicable date: 9,752,466 shares of Common Stock, $1.00 Par Value, as of February 28, 2006.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant’s definitive Proxy Statement relating to the Annual Meeting of Shareholders to be held on May 10, 2006 are incorporated by reference into Part III.
PART I
As used in this Report, the terms “Quaker,” the “Company,” “we” and “our” refer to Quaker Chemical Corporation, its subsidiaries, and associated companies, unless the context otherwise requires.
General Description
Quaker develops, produces, and markets a broad range of formulated chemical specialty products for various heavy industrial and manufacturing applications and, in addition, offers and markets chemical management services (“CMS”). Quaker’s principal products and services include: (i) rolling lubricants (used by manufacturers of steel in the hot and cold rolling of steel and by manufacturers of aluminum in the hot rolling of aluminum); (ii) corrosion preventives (used by steel and metalworking customers to protect metal during manufacture, storage, and shipment); (iii) metal finishing compounds (used to prepare metal surfaces for special treatments such as galvanizing and tin plating and to prepare metal for further processing); (iv) machining and grinding compounds (used by metalworking customers in cutting, shaping, and grinding metal parts which require special treatment to enable them to tolerate the manufacturing process, achieve closer tolerance and improve tool life); (v) forming compounds (used to facilitate the drawing and extrusion of metal products); (vi) hydraulic fluids (used by steel, metalworking, and other customers to operate hydraulically activated equipment); (vii) technology for the removal of hydrogen sulfide in various industrial applications; (viii) chemical milling maskants for the aerospace industry and temporary and permanent coatings for metal and concrete products; (ix) construction products such as flexible sealants and protective coatings for various applications; and (x) programs to provide chemical management services. Individual product lines representing more than 10% of consolidated revenues for any of the past three years are as follows:
Rolling lubricants
Machining and grinding compounds
Chemical management services
Hydraulic fluids
Corrosion preventives
A substantial portion of Quaker’s sales worldwide are made directly through its own employees and its CMS programs with the balance being handled through value added resellers and agents. Quaker employees visit the plants of customers regularly and, through training and experience, identify production needs which can be resolved or alleviated either by adapting Quaker’s existing products or by applying new formulations developed in Quaker’s laboratories. Quaker makes little use of advertising but relies heavily upon its reputation in the markets which it serves. Generally, separate manufacturing facilities of a single customer are served by different personnel. As part of the Company’s chemical management services, certain third party product sales to customers are managed by the Company. Where the Company acts as a principal, revenues are recognized on a gross reporting basis at the selling price negotiated with the customers. Where the Company acts as an agent, such revenue is recorded using net reporting as service revenues, at the amount of the administrative fee earned by the Company for ordering the goods. Third party products transferred under arrangements resulting in net reporting totaled $38.8 million, $35.2 million, and $26.6 million for 2005, 2004, and 2003, respectively. The Company recognizes revenue in accordance with the terms of the underlying agreements, when title and risk of loss have been transferred, collectibility is reasonably assured, and pricing is fixed or determinable. This generally occurs for product sales when products are shipped to customers or, for consignment arrangements upon usage by the customer and when services are performed. License fees and royalties are recognized in accordance with agreed upon terms, when performance obligations are satisfied, the amount is fixed or determinable, and collectibility is reasonably assured and are included in other income.
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Competition
The chemical specialty industry comprises a number of companies of similar size as well as companies larger and smaller than Quaker. Quaker cannot readily determine its precise position in every industry it serves. Based on information available to Quaker, however, it is estimated that Quaker holds a leading and significant global position (among a group in excess of 25 other suppliers) in the market for process fluids to produce sheet steel. It is also believed that Quaker holds significant global positions in the markets for process fluids in portions of the automotive and industrial markets. Many competitors are in fewer and more specialized product classifications or provide different levels of technical services in terms of specific formulations for individual customers. Competition in the industry is based primarily on the ability to provide products that meet the needs of the customer and render technical services and laboratory assistance to customers and, to a lesser extent, on price.
Major Customers and Markets
During 2005, Quaker’s five largest customers (each composed of multiple subsidiaries or divisions with semi-autonomous purchasing authority) accounted for approximately 25% of its consolidated net sales with the largest customer (General Motors) accounting for approximately 9% of consolidated net sales. A significant portion of Quaker’s revenues are realized from the sale of process fluids and services to manufacturers of steel, automobiles, appliances, and durable goods, and, therefore, Quaker is subject to the same business cycles as those experienced by these manufacturers and their customers. Furthermore, steel customers typically have limited manufacturing locations as compared to metalworking customers and generally use higher volumes of products at a single location. Accordingly, the loss or closure of a steel mill of a significant customer can have a material adverse effect on Quaker’s business.
Raw Materials
Quaker uses over 1,000 raw materials, including mineral oils and derivatives, animal fats and derivatives, vegetable oils and derivatives, ethylene derivatives, solvents, surface active agents, chlorinated paraffinic compounds, and a wide variety of other organic and inorganic compounds. In 2005, only three raw material groups (mineral oil and derivatives, animal fats and derivatives, and vegetable oils and derivatives) each accounted for as much as 10% of the total cost of Quaker’s raw material purchases. The price of mineral oil can be affected by the price of crude oil and refining capacity. Accordingly, significant fluctuations in the price of crude oil can have a material effect upon the Company’s business. Many of the raw materials used by Quaker are “commodity” chemicals, and, therefore, Quaker’s earnings can be affected by market changes in raw material prices. Quaker has multiple sources of supply for most materials, and management believes that the failure of any single supplier would not have a material adverse effect upon its business. Reference is made to the disclosure contained in Item 7A of this Report.
Patents and Trademarks
Quaker has a limited number of patents and patent applications, including patents issued, applied for, or acquired in the United States and in various foreign countries, some of which may prove to be material to its business. Principal reliance is placed upon Quaker’s proprietary formulae and the application of its skills and experience to meet customer needs. Quaker’s products are identified by trademarks that are registered throughout its marketing area.
Research and Development—Laboratories
Quaker’s research and development laboratories are directed primarily toward applied research and development since the nature of Quaker’s business requires continual modification and improvement of formulations to provide chemical specialties to satisfy customer requirements. Research and development costs are expensed as incurred. Research and development expenses during 2005, 2004, and 2003 were $14.2 million, $13.8 million, and $10.1 million, respectively.
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Quaker maintains quality control laboratory facilities in each of its manufacturing locations. In addition, Quaker maintains in Conshohocken, Pennsylvania, and Uithoorn, The Netherlands, laboratory facilities that are devoted primarily to applied research and development.
Most of Quaker’s subsidiaries and associated companies also have laboratory facilities. Although not as complete as the Conshohocken or Uithoorn laboratories, these facilities are generally sufficient for the requirements of the customers being served. If problems are encountered which cannot be resolved by local laboratories, such problems may be referred to the laboratory staff in Conshohocken or Uithoorn.
Regulatory Matters
In order to facilitate compliance with applicable Federal, state, and local statutes and regulations relating to occupational health and safety and protection of the environment, the Company has an ongoing program of site assessment for the purpose of identifying capital expenditures or other actions that may be necessary to comply with such requirements. The program includes periodic inspections of each facility by Quaker and/or independent environmental experts, as well as ongoing inspections and training by on-site personnel. Such inspections are addressed to operational matters, record keeping, reporting requirements, and capital improvements. In 2005, capital expenditures directed solely or primarily to regulatory compliance amounted to approximately $0.7 million compared to $1.1 million and $0.5 million in 2004 and 2003, respectively. In 2006, the Company expects to incur approximately $0.8 million for capital expenditures directed primarily to regulatory compliance. Incorporated by reference is the information regarding AC Products, Inc. contained in Note 18 of Notes to Consolidated Financial Statements included in Item 8 of this Report.
Number of Employees
On December 31, 2005, Quaker’s consolidated companies had 1,226 full-time employees of whom 517 were employed by the parent company and its U.S. subsidiaries and 709 were employed by its non-U.S. subsidiaries. Associated companies of Quaker (in which it owns 50% or less) employed 155 people on December 31, 2005.
Product Classification
The Company’s reportable segments are as follows:
(1) Metalworking process chemicals—industrial process fluids for various heavy industrial and manufacturing applications.
(2) Coatings—temporary and permanent coatings for metal and concrete products and chemical milling maskants.
(3) Other chemical products—other various chemical products.
Incorporated by reference is the segment information contained in Note 13 of Notes to Consolidated Financial Statements included in Item 8 of this Report.
Non-U.S. Activities
Since significant revenues and earnings are generated by non-U.S. operations, Quaker’s financial results are affected by currency fluctuations, particularly between the U.S. dollar, the E.U. euro, and the Brazilian real, and the impact of those currency fluctuations on the underlying economies. Incorporated by reference is the foreign exchange risk information contained in Item 7A of this Report and the geographic information in Note 13 of Notes to Consolidated Financial Statements included in Item 8 of this Report.
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Quaker on the Internet
Financial results, news and other information about Quaker can be accessed from the Company’s Web site at http://www.quakerchem.com. This site includes important information on products and services, financial reports, news releases, and career opportunities. The Company’s periodic and current reports, including exhibits and supplemental schedules filed therewith, and amendments to those reports, filed with the Securities and Exchange Commission (“SEC”) are available on the Company’s Web site, free of charge, as soon as reasonably practicable after they are electronically filed with or furnished to the SEC. Information that can be accessed through the Company’s Web site is not incorporated by reference in this Report and accordingly you should not consider this information part of this Report.
Factors that May Affect Our Future Results
(Cautionary Statements under the Private Securities Litigation Reform Act of 1995)
Certain information included in this Report and other materials filed or to be filed by Quaker with the SEC (as well as information included in oral statements or other written statements made or to be made by us) contain or may contain 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. These statements can be identified by the fact that they do not relate strictly to historical or current facts. We have based these forward-looking statements on our current expectations about future events. These forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, anticipations, intentions, financial condition, results of operations, future performance and business, including:
Such statements include information relating to current and future business activities, operational matters, capital spending, and financing sources. From time to time, oral or written forward-looking statements are also included in Quaker’s periodic reports on Forms 10-Q and 8-K, press releases and other materials released to the public.
Any or all of the forward-looking statements in this Report, in Quaker’s Annual Report to Shareholders for 2005, and in any other public statements we make may turn out to be wrong. This can occur as a result of inaccurate assumptions or as a consequence of known or unknown risks and uncertainties. Many factors discussed in this Report will be important in determining our future performance. Consequently, actual results may differ materially from those that might be anticipated from our forward-looking statements.
We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. However, any further disclosures made on related subjects in Quaker’s subsequent reports on Forms 10-K, 10-Q and 8-K should be consulted. These forward-looking statements are subject to risks, uncertainties and assumptions about us and our operations that are subject to change based on various important factors, some of which are beyond our control. A major risk is that the Company’s demand is largely derived from the demand for its customers’ products, which subjects the Company to uncertainties related to downturns in a customer’s business and unanticipated customer production shutdowns. Other major risks and uncertainties include, but are not limited to, significant increases in raw material costs, worldwide economic and political conditions, foreign currency fluctuations, and terrorist attacks such as those that occurred on September 11, 2001, each of which is discussed in greater detail in Item 1A of this Report. Furthermore, the Company is subject to the same business cycles as those experienced by steel, automobile, aircraft, appliance, and durable goods manufacturers. These risks, uncertainties, and possible inaccurate assumptions relevant to our business could cause our actual results to differ materially from expected and historical results. Other factors
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beyond those discussed in this Report could also adversely affect us. Therefore, we caution you not to place undue reliance on our forward-looking statements. This discussion is provided as permitted by the Private Securities Litigation Reform Act of 1995.
Changes to the industries and markets that Quaker serves could have a material adverse effect on the Company’s liquidity, financial position and results of operations.
The chemical specialty industry comprises a number of companies of similar size as well as companies larger and smaller than Quaker. It is estimated that Quaker holds a leading global position in the markets for process fluids to produce sheet steel and in portions of the automotive and industrial markets. The industry remains highly competitive, and a number of companies with significant financial resources and/or customer relationships compete with us to provide similar products and services. Our competitors may be positioned to offer more favorable pricing and service terms, resulting in reduced profitability and loss of market share for us. Historically, competition in the industry has been based primarily on the ability to provide products that meet the needs of the customer and render technical services and laboratory assistance to the customer and, to a lesser extent, on price. Success factors critical to the Company’s business include successfully differentiating the Company’s offering from its competition, operating efficiently and profitably as a globally integrated whole, and increasing market share and customer penetration through internally developed business programs and strategic acquisitions.
The business environment in which the Company operates remains challenging. The Company is subject to the same business cycles as those experienced by steel, automobile, aircraft, appliance, and durable goods manufacturers. A major risk is that the Company’s demand is largely derived from the demand for its customers’ products, which subjects the Company to uncertainties related to downturns in our customers’ business and unanticipated customer production shutdowns or curtailments. Customer production within the steel and automotive industries has been recently slowing especially in the U.S. and European markets. The Company has limited ability to adjust its cost level contemporaneously with changes in sales and gross margins. Thus, a significant downturn in sales or gross margins due to weak end-user markets, loss of a significant customer, and/or rising raw material costs could have material adverse effect on the Company’s liquidity, financial position and results of operations.
Our business depends on attracting and retaining qualified management personnel.
The unanticipated departure of any key member of our management team could have an adverse effect on our business. Given the relative size of the Company and the breadth of its global operations, there are a limited number of qualified management personnel to assume the responsibilities of management level employees should there be management turnover. In addition, because of the specialized and technical nature of our business, our future performance is dependent on the continued service of, and our ability to attract and retain qualified management, commercial and technical personnel. Competition for such personnel is intense, and we may be unable to continue to attract or retain such personnel.
Inability to obtain sufficient price increases or contract concessions to offset increases in the costs of raw material could have a material adverse effect on the Company’s liquidity, financial position and results of operations. Price increases implemented could result in the loss of customers.
Quaker uses over 1,000 raw materials, including mineral oils and derivatives, animal fats and derivatives, vegetable oils and derivatives, ethylene derivatives, solvents, surface active agents, chlorinated paraffinic compounds, and a wide variety of other organic and inorganic compounds. In 2005, only three raw material groups (mineral oil and derivatives, animal fats and derivatives, and vegetable oils and derivatives) each accounted for as much as 10% of the total cost of Quaker’s raw material purchases. The price of mineral oil can be affected by the price of crude oil and refining capacity. In addition, many of the raw materials used by Quaker are “commodity” chemicals. Accordingly, Quaker’s earnings can be affected by market changes in raw material prices.
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Over the past three years, Quaker has experienced significant increases in its raw material costs, particularly crude-oil derivatives. For example, the price of crude-oil averaged $57 per barrel in 2005 versus $42 in 2004. In addition, refining capacity has also been constrained by hurricanes and other factors, which separately and further contributed to higher raw material costs and negatively impacted margins. In response, the Company has aggressively pursued price increases to offset the increased raw material costs. Although the Company has been successful in recovering a substantial amount of the raw material cost increases, it has experienced competitive as well as contractual constraints limiting pricing actions. The contractual limitations include certain of the Company’s CMS contracts for which there are fixed fees that do not allow for adjustments, notwithstanding the increases in third party product purchase costs. In addition, as a result of the Company’s pricing actions, customers may become more likely to consider competitor’s products, some of which may be available at a lower cost. Significant loss of customers could result in a material adverse effect on the Company’s results of operations.
Bankruptcy of a significant customer could have a material adverse effect on our liquidity, financial position and results of operations.
During 2005, our five largest customers (each composed of multiple subsidiaries or divisions with semi-autonomous purchasing authority) together accounted for approximately 25% of our consolidated net sales with the largest customer (General Motors) accounting for approximately 9% of consolidated net sales.
A significant portion of Quaker’s revenues is derived from sales to customers in the U.S. steel industry, where a number of bankruptcies occurred during recent years. In addition, certain large industrial customers have also experienced financial difficulty. As part of the bankruptcy process, the Company’s pre-petition receivables may not be realized, customer manufacturing sites may be closed or contracts voided. The bankruptcy of a major customer could have a material adverse effect on the Company’s liquidity, financial position and results of operations. Steel customers typically have limited manufacturing locations as compared to metalworking customers and generally use higher volumes of products at a single location. The loss or closure of a steel mill or other major customer site of a significant customer could have a material adverse effect on Quaker’s business.
Failure to comply with any material provisions of our credit facility could have a material adverse effect on our liquidity, financial position and results of operations.
The Company maintains a $100.0 million unsecured credit facility (the “Credit Facility”) with a group of lenders, which can be increased to $125.0 million at the Company’s option if lenders agree to increase their commitments and the Company satisfies certain conditions. The Credit Facility, which matures on September 30, 2010, provides the availability of revolving credit borrowings. In general, the borrowings under the Credit Facility bear interest at either a base rate or LIBOR rate plus a margin based on the Company’s consolidated leverage ratio.
The Credit Facility contains limitations on capital expenditures, investments, acquisitions and liens, as well as default provisions customary for facilities of its type. While these covenants and restrictions are not currently considered to be overly restrictive, they could become more difficult to comply with as our business or financial conditions change. In addition, deterioration in the Company’s results of operations or financial position could significantly increase borrowing costs.
Quaker is exposed to market rate risk for changes in interest rates, due to the variable interest rate applied to the Company’s borrowings under its credit facilities. Accordingly, if interest rates rise significantly, the cost of debt to Quaker will increase, perhaps significantly, depending on the extent of Quaker’s borrowings under the Credit Facility. At December 31, 2005, the Company had $63.8 million outstanding under its credit facilities. In the fourth quarter of 2005, the Company entered into interest rate swaps in order to fix a portion of its variable rate debt and mitigate the risks associated with higher interest rates. The combined notional value of the swaps was $15.0 million at December 31, 2005.
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Failure to generate taxable income could have a material adverse effect on our financial position and results of operations.
At the end of 2005, the Company had net U.S. deferred tax assets totaling $15.3 million, excluding deferred tax assets relating to additional minimum pension liabilities. In addition, the Company has $3.5 million in operating loss carryforwards related to certain of its foreign operations. The Company records valuation allowances when necessary to reduce its deferred tax assets to the amount that is more likely than not to be realized. The Company considers future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. However, in the event the Company were to determine that it would not be able to realize all or part of its net deferred tax assets in the future, an adjustment to the deferred tax asset would be a non-cash charge to income in the period such determination was made, which could have a material adverse effect on the Company’s financial statements.
The continued upward pressure in the Company’s crude oil based raw materials has outpaced the Company’s selling price increases, negatively impacting profitability. The Company continues to closely monitor this situation as it relates to its net deferred tax assets and the assessment of valuation allowances. The Company is implementing actions that could positively impact taxable income.
Environmental laws and regulations and pending legal proceedings may materially and adversely affect the Company’s liquidity, financial position and results of operations.
The Company is a party to proceedings, cases, and requests for information from, and negotiations with, various claimants and Federal and state agencies relating to various matters including environmental matters. Incorporated herein by reference is the information concerning pending asbestos-related litigation against an inactive subsidiary and amounts accrued associated with certain environmental investigatory and non-capital remediation costs in Note 18 of Notes to Consolidated Financial Statements which appears in Item 8 of this Report.
The scope of our international operations subject the Company to risks, including risks from changes in trade regulations, currency fluctuations, and political and economic instability.
Since significant revenues and earnings are generated by non-U.S. operations, Quaker’s financial results are affected by currency fluctuations, particularly between the U.S. dollar, the E.U. euro, and the Brazilian real, and the impact of those currency fluctuations on the underlying economies. During the past three years, sales by non-U.S. subsidiaries accounted for approximately 53% to 55% of the annual consolidated net sales. All these operations use the local currency as their functional currency. The Company generally does not use financial instruments that expose it to significant risk involving foreign currency transactions; however, the size of non-U.S. activities has a significant impact on reported operating results and attendant net assets. Therefore, as exchange rates vary, Quaker’s results can be materially affected. Incorporated by reference is the foreign exchange risk information contained in Item 7A of this Report and the geographic information in Note 13 of Notes to Consolidated Financial Statements included in Item 8 of this Report.
Additional risks associated with the Company’s international operations include but are not limited to the following:
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Terrorist attacks, or other acts of violence or war may affect the markets in which we operate and our profitability.
Terrorist attacks may negatively affect our operations. There can be no assurance that there will not be further terrorist attacks against the United States or United States businesses. Terrorist attacks or armed conflicts may directly impact our physical facilities or those of our suppliers or customers. Additional terrorist attacks may disrupt the global insurance and reinsurance industries with the result that we may not be able to obtain insurance at historical terms and levels for all of our facilities. Furthermore, additional attacks may make travel and the transportation of our supplies and products more difficult and more expensive and ultimately affect the sales of our products. The consequences of terrorist attacks or armed conflicts are unpredictable, and we may not be able to foresee events that could have an adverse effect on our business.
None.
Quaker’s corporate headquarters and a laboratory facility are located in Conshohocken, Pennsylvania. Quaker’s other principal facilities are located in Detroit, Michigan; Middletown, Ohio; Placentia, California; Santa Fe Springs, California; Uithoorn, The Netherlands; Santa Perpetua de Mogoda, Spain; Rio de Janeiro, Brazil; Tradate, Italy; and Wuxi, China. All the properties except Placentia, California and Santa Fe Springs, California are used by the metalworking segment. The Placentia, California and Santa Fe Springs, California properties are used by the coatings segment. With the exception of the Conshohocken, Placentia, Santa Fe Springs and Tradate sites, which are leased, all of these principal facilities are owned by Quaker and as of December 31, 2005 were mortgage free. Quaker also leases sales, laboratory, manufacturing, and warehouse facilities in other locations.
In January 2001, the Company contributed its Conshohocken, Pennsylvania property and buildings (the “Site”) into a real estate joint venture (the “Venture”) in exchange for a 50% interest in the Venture. The Venture did not assume any debt or other obligations of the Company and the Company did not guarantee nor was it obligated to pay any principal, interest or penalties on any of the Venture’s indebtedness. The Venture renovated certain of the existing buildings at the Site, as well as built new office space. In December 2000, the Company entered into an agreement with the Venture to lease approximately 38% of the Site’s available office space for a 15-year period commencing February 2002, with multiple renewal options. The Company believes the terms of this lease were no less favorable than the terms it would have obtained from an unaffiliated third party. In February 2005, the Venture sold its real estate assets to an unrelated third party, which resulted in $4.2 million of proceeds to the Company after payment of the Venture’s obligations.
In 2005, the Company completed the sale of its Villeneuve, France site. Quaker had ceased manufacturing operations at this facility in March 2002. Production was consolidated into its facilities in Uithoorn, The Netherlands and Santa Perpetua de Mogoda, Spain.
Quaker’s aforementioned principal facilities (excluding Conshohocken) consist of various manufacturing, administrative, warehouse, and laboratory buildings. Substantially all of the buildings (including Conshohocken) are of fire-resistant construction and are equipped with sprinkler systems. All facilities are primarily of masonry and/or steel construction and are adequate and suitable for Quaker’s present operations. The Company has a program to identify needed capital improvements that are implemented as management considers necessary or
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desirable. Most locations have various numbers of raw material storage tanks ranging from 7 to 66 at each location with a capacity ranging from 1,000 to 82,000 gallons and processing or manufacturing vessels ranging in capacity from 15 to 16,000 gallons.
Each of Quaker’s 50% or less owned non-U.S. associated companies owns or leases a plant and/or sales facilities in various locations.
The Company is a party to proceedings, cases, and requests for information from, and negotiations with, various claimants and Federal and state agencies relating to various matters including environmental matters. Incorporated herein by reference is the information concerning pending asbestos-related litigation against an inactive subsidiary and amounts accrued associated with certain environmental investigatory and non-capital remediation costs in Note 18 of Notes to Consolidated Financial Statements which appears in Item 8 of this Report. The Company is a party to other litigation which management currently believes will not have a material adverse effect on the Company’s results of operations, cash flow, or financial condition.
No matters were submitted to a vote of security holders during the last quarter of the period covered by this Report.
Set forth below are the executive officers of the Company. Each of the executive officers is elected annually to a one-year term.
Name, Age, and Present
Position with the Company
Business Experience During Past Five
Years and Period Served as an Officer
Ronald J. Naples, 60
Chairman of the Board and
Chief Executive Officer, and Director
Michael F. Barry, 47
Senior Vice President and Managing
Director—North America
D. Jeffry Benoliel, 47
Vice President, Secretary
and General Counsel
José Luiz Bregolato, 60
Vice President and Managing
Director—South America
Mark A. Featherstone, 44
Vice President and Global Controller
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Mark Harris, 51
Senior Vice President—Global Strategy and Marketing
Neal E. Murphy, 48
Vice President, Chief Financial Officer
and Treasurer
Jan F. Nieman, 45
Director—Asia/Pacific
Wilbert Platzer, 44
Director—Europe
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PART II
The Company’s common stock is listed on the New York Stock Exchange (“NYSE”) under the trading symbol KWR. The following table sets forth, for the calendar quarters during the past two years, the range of high and low sales prices for the common stock as reported on the NYSE composite tape (amounts rounded to the nearest penny), and the quarterly dividends declared and paid:
First quarter
Second quarter
Third quarter
Fourth quarter
As of January 17, 2006, there were 1,013 shareholders of record of the Company’s common stock, its only outstanding class of equity securities.
Every holder of Quaker common stock is entitled to one vote or ten votes for each share held of record on any record date depending on how long each share has been held. As of January 17, 2006, 9,726,425 shares of Quaker common stock were issued and outstanding. Based on the information available to the Company, on January 17, 2006, the holders of 997,148 shares of Quaker common stock would have been entitled to cast ten votes for each share, or approximately 53% of the total votes that would have been entitled to be cast as of that record date and the holders of 8,729,277 shares of Quaker common stock would have been entitled to cast one vote for each share, or approximately 47% of the total votes that would have been entitled to be cast as of that date. The number of shares that are indicated as entitled to one vote includes those shares presumed to be entitled to only one vote. Because the holders of these shares may rebut this presumption, the total number of votes entitled to be cast as of January 17, 2006 could be more than 18,700,757.
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The following table sets forth selected financial information for the Company and its consolidated subsidiaries:
Summary of Operations:
Net sales
Income before taxes, equity income and minority interest
Net income
Per share:
Net income-basic
Net income-diluted
Dividends declared
Dividends paid
Financial Position:
Working capital
Total assets
Long-term debt
Shareholders’ equity
Following amounts in thousands
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Executive Summary
Quaker Chemical Corporation is a worldwide developer, producer, and marketer of chemical specialty products and a provider of chemical management services for various heavy industrial and manufacturing applications around the globe, with significant sales to the steel and automotive industries. The business environment in which the Company operates remains challenging as significantly higher raw material and third-party finished product costs continue to negatively impact the Company’s gross margins and the Company continues to experience sluggish demand in its U.S. and European markets.
The principal factors impacting 2005 earnings included higher raw material costs, a $10.3 million pre-tax charge for restructuring and related activities, and a $1.0 million tax charge attributable to the repatriation of accumulated earnings of its foreign subsidiaries. These costs were offset in part by $4.2 million of pre-tax income from the sale of property by the Company’s real estate joint venture and lower minority interest primarily as a result of the Company’s first quarter 2005 acquisition of the remaining 40% interest in its Brazilian affiliate.
In 2005, Quaker took action to significantly reduce its base operating costs in the U.S. and Europe, which represent more mature markets for the Company. This restructuring included involuntary terminations, a freeze of the Company’s U.S. pension plan, and a voluntary early retirement offering to eligible U.S. employees, resulting in a net $10.3 million pre-tax charge. The Company believes this restructuring program will allow funding for continued operating expense investments and key growth initiatives. In addition, assuming a stable raw material cost situation in 2006, this action should allow gross margin improvement from the Company’s pricing actions to flow to operating income. The Company will maintain its commitment to its globally integrated approach to our business and strategic initiatives.
Much of the revenue growth in 2005 was a reflection of the pricing actions taken by the Company to mitigate higher raw material costs incurred throughout 2004 and 2005. However, the pace and size of raw material cost increases continue to outpace the Company’s selling price increases. Limited refining capacity to produce crude oil derivatives continues to impact margins. Also contributing to the gross margin decline was significantly higher third-party product purchase costs with respect to the Company’s CMS contracts.
In the fourth quarter of 2005, the Company enhanced its capital structure by entering into a $100 million credit facility. This facility enabled the consolidation of short-term debt into a longer-term facility and ensured liquidity to support future growth. Additional capital structure measures were taken in the form of substantial repatriation of accumulated foreign earnings. This action improved the balance between foreign and domestic debt levels, enabled better cash management, improved our global tax position, and lowered our consolidated borrowing costs. These foreign earnings repatriation actions resulted in a $1.0 million largely non-cash tax charge in the fourth quarter.
In summary, the full year results reflect the challenging business environment in which the Company operates and our response to that environment. Continued softness in key markets especially in steel, continued high raw material costs, as well as competitive and contractual constraints limiting pricing actions continue to impact the Company’s margins. Notwithstanding these limitations, the Company was able to recover a substantial portion of the raw material cost increases through selling price increases and renegotiate several of its CMS contracts to improve profitability. In addition, the Company also was awarded several new CMS contracts which provide for increased price protection. The Company remains focused on pursuing revenue opportunities, managing its raw material and other costs and aggressively pursuing price and cost savings initiatives.
Critical Accounting Policies and Estimates
Quaker’s discussion and analysis of its financial condition and results of operations are based upon Quaker’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires Quaker to make estimates
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and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, Quaker evaluates its estimates, including those related to customer sales incentives, product returns, bad debts, inventories, property, plant, and equipment, investments, intangible assets, income taxes, financing operations, restructuring, incentive compensation plans, pensions and other postretirement benefits, and contingencies and litigation. Quaker bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Quaker believes the following critical accounting policies describe the more significant judgments and estimates used in the preparation of its consolidated financial statements:
1. Accounts receivable and inventory reserves and exposures—Quaker establishes allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of Quaker’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. As part of its terms of trade, Quaker may custom manufacture products for certain large customers and/or may ship product on a consignment basis. Further, a significant portion of Quaker’s revenues is derived from sales to customers in the U.S. steel industry, where a number of bankruptcies have occurred during recent years. When a bankruptcy occurs, Quaker must judge the amount of proceeds, if any, that may ultimately be received through the bankruptcy or liquidation process. These matters may increase the Company’s exposure should a bankruptcy occur, and may require writedown or disposal of certain inventory due to its estimated obsolescence or limited marketability. Reserves for customers filing for bankruptcy protection are generally established at 75-100% of the amount outstanding at the filing date, dependent on the Company’s evaluation of likely proceeds from the bankruptcy process. Large and/or financially distressed customers are generally reserved for on a specific review basis while a general reserve is established for other customers based on historical experience. The Company’s consolidated allowance for doubtful accounts was $4.1 million and $6.8 million at December 31, 2005 and 2004, respectively. Further, the Company recorded provisions for doubtful accounts of $1.2 million, $0.5 million and $1.0 million in 2005, 2004 and 2003 respectively. An increase of 10% to the recorded provisions would have decreased the Company’s pre-tax earnings by $0.12 million, $0.05 million and $0.1 million in 2005, 2004 and 2003, respectively.
2. Environmental and litigation reserves—Accruals for environmental and litigation matters are recorded when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. Accrued liabilities are exclusive of claims against third parties and are not discounted. Environmental costs and remediation costs are capitalized if the costs extend the life, increase the capacity or improve the safety or efficiency of the property from the date acquired or constructed, and/or mitigate or prevent contamination in the future. Estimates for accruals for environmental matters are based on a variety of potential technical solutions, governmental regulations and other factors, and are subject to a large range of potential costs for remediation and other actions. A considerable amount of judgment is required in determining the most likely estimate within the range, and the factors determining this judgment may vary over time. Similarly, reserves for litigation and similar matters are based on a range of potential outcomes and require considerable judgment in determining the most probable outcome. If no amount within the range is considered more probable than any other amount, the Company accrues the lowest amount in the range in accordance with generally accepted accounting principles. An inactive subsidiary of the Company is involved in asbestos litigation. If the Company ever concludes that it is probable it will be liable for any of the obligations of such subsidiary, then it will record the associated liabilities if they can be reasonably estimated. The Company will reassess this situation periodically in accordance with SFAS No. 5, “Accounting for Contingencies.” See Note 18 of Notes to Consolidated Financial Statements which appears in Item 8 of this Report.
3. Realizability of equity investments—Quaker holds equity investments in various foreign companies, whereby it has the ability to influence, but not control, the operations of the entity and its future results.
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Quaker records an investment impairment charge when it believes an investment has experienced a decline in value that is other than temporary. Future adverse changes in market conditions, poor operating results of underlying investments, or devaluation of foreign currencies could result in losses or an inability to recover the carrying value of the investments that may not be reflected in an investment’s current carrying value. These factors may result in an impairment charge in the future. The carrying amount of the Company’s equity investments at December 31, 2005 was $6.6 million and was comprised of three investments totaling $3.6, $2.2 and $0.8 million, respectively.
4. Tax exposures and valuation allowances—Quaker records expenses and liabilities for taxes based on estimates of amounts that will be ultimately determined to be deductible in tax returns filed in various jurisdictions. The filed tax returns are subject to audit, often several years subsequent to the date of the financial statements. Disputes or disagreements may arise during audits over the timing or validity of certain items or deductions, which may not be resolved for extended periods of time. Quaker establishes reserves for potential tax audit and other exposures as transactions occur and reviews these reserves on a regular basis; however, actual exposures and audit adjustments may vary from these estimates. Quaker also records valuation allowances when necessary to reduce its deferred tax assets to the amount that is more likely than not to be realized. While Quaker has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event Quaker were to determine that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should Quaker determine that it would not be able to realize all or part of its net deferred tax assets in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made which could have a material adverse impact on the Company’s financial statements. U.S. income taxes have not been provided on the undistributed earnings of non-U.S. subsidiaries since it is the Company’s intention to continue to reinvest these earnings in those subsidiaries for working capital needs and growth initiatives. U.S. and foreign income taxes that would be payable if such earnings were distributed may be lower than the amount computed at the U.S. statutory rate due to the availability of tax credits.
5. Restructuring liabilities—Restructuring charges may consist of charges for employee severance, rationalization of manufacturing facilities and other items. In 2001, Quaker recorded restructuring and other exit costs, including involuntary termination of certain employees, in accordance with the Financial Accounting Standards Board’s (“FASB”) Emerging Issues Task Force (“EITF”) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” Certain of these items, particularly those involving impairment charges for assets to be sold or closed, require significant estimates and assumptions in terms of estimated sale proceeds, date of sale, transaction costs and other matters, and these estimates can change based on market conditions and other factors. In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which nullified EITF Issue No. 94-3. The Company adopted the provisions of SFAS No. 146 effective for exit or disposal activities initiated after December 31, 2002. The principal difference between SFAS No. 146 and EITF 94-3 relates to its requirements for recognition of a liability for a cost associated with an exit or disposal activity. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF 94-3, a liability for exit costs is recognized at the date of an entity’s commitment to an exit plan.
6. Goodwill and other intangible assets— Goodwill and other intangible assets are evaluated in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” Intangible assets, which do not have indefinite lives, are recorded at fair value and amortized over a straight-line basis based on third party valuations of the assets. Goodwill and intangible assets, which have indefinite lives, are no longer amortized and are required to be assessed at least annually for impairment. The Company compares the assets’ fair value to their carrying value primarily based on future discounted cash flows in order to determine if an impairment charge is warranted. The estimates of future cash flows involve considerable management judgment and are based upon assumptions about expected future operating performance. Assumptions used in these forecasts are consistent with internal planning. The actual cash flows could differ from
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management’s estimates due to changes in business conditions, operating performance, and economic conditions. The Company completed its annual impairment assessment as of the end of the third quarter 2005, and no impairment charge was warranted. The Company’s consolidated goodwill and indefinite-lived intangible assets at December 31, 2005 and 2004 were $36.0 million and $35.5 million, respectively. The Company’s assumption of weighted average cost of capital and estimated future net operating profit after tax (NOPAT) are particularly important in determining whether an impairment charge has been incurred. The Company currently uses a weighted average cost of capital of 12% and, at September 30, 2005, this assumption would have had to increase by more than 4 percentage points before any of the Company’s reporting units would fail step one of the SFAS No. 142 impairment analysis. Further, at September 30, 2005, the Company’s estimate of future NOPAT would have had to decrease by more than 26% before any of the Company’s reporting units would be considered potentially impaired.
7. Postretirement benefits—The Company provides certain pension and other postretirement benefits to employees and retirees. Independent actuaries, in accordance with accounting principles generally accepted in the United States, perform the required valuations to determine benefit expense and, if necessary, non-cash charges to equity for additional minimum pension liabilities. Critical assumptions used in the actuarial valuation include the weighted average discount rate, rates of increase in compensation levels and expected long-term rates of return on assets. If different assumptions were used, additional pension expense or charges to equity might be required. For 2005, the Company incurred such a non-cash charge to equity of $3.5 million. The Company’s pension plan year-end is November 30, which serves as the measurement date. The following table highlights the potential impact on the Company’s pre-tax earnings due to changes in assumptions with respect to the Company’s pension plans, based on assets and liabilities at December 31, 2005:
Discount rate
Expected rate of return on plan assets
Recently Issued Accounting Standards
In June 2005, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 154, “Accounting Changes and Error Corrections: (“SFAS 154”). SFAS 154 requires retrospective application to prior periods’ financial statements of changes in accounting principles unless it is impracticable to determine either period-specific effects or the cumulative effect of the change or, in the unusual instance, that a newly issued accounting pronouncement does not include explicit transition provisions. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company will apply the requirements of the standard as needed.
In December 2004, the FASB issued its final standard on accounting for share-based payments, SFAS 123R (Revised 2004), Share-Based Payment (“SFAS 123R”). SFAS 123R requires companies to expense the fair value of employee stock options and other similar awards. The fair value of the awards are to be measured based on the grant-date fair value of the awards and the cost to be recognized over the period during which an employee is required to provide service in exchange for the award. SFAS 123R eliminates the alternative use of Accounting Principles Board No. 25’s intrinsic value method of accounting for awards, which is the Company’s current accounting policy for stock options. See Note 1 for the pro forma impact of compensation expense from stock options on net earnings and earnings per share. SFAS 123R is effective for the Company beginning January 1, 2006. The Company adopted the provisions of SFAS 123R on a prospective basis. The financial statement impact will be dependent on future stock-based awards and any unvested stock options outstanding. At the time of adoption, the Company will have approximately $0.1 million of pre-tax expense to record related to unvested stock options.
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In December 2004, the FASB issued its final standard on accounting for exchanges on nonmonetary assets, SFAS 153, “Exchange of Nonmonetary Assets an amendment of APB Opinion No. 29” (“SFAS 153”). SFAS 153 requires that exchanges of nonmonetary assets be measured based on the fair value of assets exchanged for annual periods beginning after June 15, 2005. The adoption of SFAS 153 did not have a material impact on the Company’s financial position, results of operations, or cash flows.
In November 2004, the FASB issued Statement of Financial Accounting Standards No. 151, Inventory Costs an amendment of ARB 43, Chapter 4 (“SFAS 151”). SFAS 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) in the determination of inventory carrying costs. The statement requires that such costs be recognized as a current period expense. SFAS 151 also requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. This statement is effective for fiscal years beginning after July 15, 2005. The adoption of SFAS 151 did not have a material impact on the company’s financial position, results of operations, or cash flows.
Liquidity and Capital Resources
Quaker’s cash and cash equivalents decreased to $16.1 million at December 31, 2005 from $29.1 million at December 31, 2004. The decrease was primarily from $11.3 million cash provided by operating activities, offset by $8.5 million cash used in investing activities and $14.8 million cash used in financing activities.
Net cash flow provided by operating activities was $11.3 million in 2005 versus $3.4 million in 2004. The Company’s lower 2005 net income was more than offset by significant improvements in the Company’s working capital accounts as compared to 2004. The improvements in working capital accounts were driven by a significant increase in accounts payable and accrued liabilities. The largest gains in accounts payable occurred due to the timing of payments in North America and Europe. The change in estimated taxes on income was due to a $3.0 million overpaid tax position at the end of 2004 relating to our European operations, which was realized in 2005.
Net cash used in investing activities was $8.5 million in 2005 compared to $6.6 million in 2004. The increased use of cash was primarily due to payments related to an acquisition, offset in part by proceeds from the disposition of partnership assets and lower capital expenditures. In March 2005, the Company acquired the remaining 40% interest in its Brazilian joint venture for $6.7 million. The Company recorded a gain of $3.0 million in the first quarter of 2005 in connection with the sale of real estate assets by the Company’s real estate joint venture. The decrease in capital expenditures was due to lower spending on the Company’s U.S. lab renovation and global ERP implementation. The Company also received $1.9 million of cash proceeds in 2005 from the sale of its Villeneuve, France site. In 2004, the Company received $1.9 million of cash proceeds primarily from the sale of real estate by the company’s majority-owned Australian subsidiary.
In January 2001, the Company contributed its Conshohocken, Pennsylvania property and buildings (the “Site”) into a real estate joint venture (the “Venture”) in exchange for a 50% interest in the Venture. The Venture did not assume any debt or other obligations of the Company and the Company did not guarantee nor was it obligated to pay any principal, interest or penalties on any of the Venture’s indebtedness. The Venture renovated certain of the existing buildings at the Site, as well as built new office space. In December 2000, the Company entered into an agreement with the Venture to lease approximately 38% of the Site’s available office space for a 15-year period commencing February 2002, with multiple renewal options. The Company believes the terms of this lease were no less favorable than the terms it would have obtained from an unaffiliated third party. In February 2005, the Venture sold its real estate assets to an unrelated third party, which resulted in $4.2 million of proceeds to the Company after payment of the Venture’s obligations. The proceeds include a gain of $3.0 million related to the sale by the Venture of its real estate holdings as well as $1.2 million of preferred distributions.
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Net cash flows used in financing activities was $14.8 million in 2005 versus $7.4 million of cash provided by financing activities in 2004. Net repayments of debt of $2.7 million in 2005 versus $16.6 million of net borrowings of debt in 2004 primarily drove the change in cash flows from financing activities. The net borrowings in 2004 were primarily used to fund the Company’s working capital needs as compared to 2005. In addition, higher distributions paid to minority shareholders of certain of the Company’s affiliates contributed to the current year use of cash. The increase in distributions to minority shareholders was driven in large part by a distribution made prior to the Company’s acquisition of the remaining 40% interest in its Brazilian joint venture described above.
Throughout 2004, the Company maintained various short-term credit facilities with multiple banks. At December 31, 2004, the Company’s short-term credit facilities totaled $95.0 million of which $40.0 million was committed and $55.0 million was uncommitted. In September 2005, the Company prepaid its senior unsecured notes due in 2007. The total amount of principal prepaid was $8.6 million. In October 2005, the Company entered into a new syndicated multi-currency credit agreement that provides for financing in the United States and the Netherlands. This facility enabled the Company to consolidate the majority of its short-term debt into a longer-term facility. The new facility terminates on September 30, 2010. The new facility allows for revolving credit borrowings in a principal amount of up to $100.0 million, which can be increased to $125.0 million at the Company’s option if lenders agree to increase their commitments and the Company satisfies certain conditions. In general, borrowings under the credit facility bear interest at either a base rate or LIBOR rate plus a margin based on the Company’s consolidated leverage ratio. The provisions of the agreements require that the Company maintain certain financial ratios and covenants, all of which the Company was in compliance with as of December 31, 2005 and 2004. Under its most restrictive covenants, the Company could have borrowed an additional $32.9 million at December 31, 2005. At December 31, 2005 and 2004, the Company had approximately $63.8 million and $57.1 million outstanding on these credit lines at a weighted average borrowing rate of 4.42% and 2.9%, respectively.
The Company believes that, in 2006, it is capable of supporting its operating requirements including pension plan contributions, payments of dividends to shareholders, possible acquisition opportunities, and possible resolution of contingencies, through internally generated funds supplemented with debt as needed.
In December 2005, an inactive subsidiary of the Company reached a settlement agreement and release with one of its insurance carriers for $15.0 million. The proceeds of the settlement are restricted and can only be used to pay claims and costs of defense associated with this subsidiary’s asbestos litigation. The subsidiary received $7.5 million in December 2005, which was deposited into an interest bearing account, and will receive an additional $7.5 million in December 2006 unless Federal asbestos legislation is adopted. Both the subsidiary and the insurance company acknowledge that as of the effective date of the settlement agreement and release it appears unlikely that Federal asbestos legislation will be enacted into law prior to the scheduled December 2006 payment. However, if the President of the United States signs into law the Federal asbestos legislation, the insurance carrier’s obligation to make the second payment will be cancelled. The restrictions regarding the use of proceeds lapse after a period of 15 years. Due to the restricted nature of the proceeds, a corresponding deferred credit was established in Other non-current liabilities for an equal and offsetting amount, and will remain until the restrictions lapse or the funds are exhausted via payments of claims and costs of defense. See also Notes 16, 17 and 18 of Notes to Consolidated Financial Statements.
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The following table summarizes the Company’s contractual obligations at December 31, 2005, and the effect such obligations are expected to have on its liquidity and cash flow in future periods. Pension and other postretirement plan contributions beyond 2006 are not determinable since the amount of any contribution is heavily dependent on the future economic environment and investment returns on pension trust assets. The timing of payments related to other long-term liabilities, which consist primarily of deferred compensation agreements, cannot be readily determined due to their uncertainty. Interest obligations on the Company’s short and long-term debt are excluded as the majority of the Company’s debt is subject to variable interest rates. (Amounts in millions)
Contractual Obligations
Short-term debt
Capital lease obligations
Non-cancelable operating leases
Purchase obligations
Pension and other postretirement plan contributions
Other long-term liabilities (primarily deferred compensation agreements)
Total contractual cash obligations
Operations
CMS Discussion
During 2003, the Company began a new approach to its chemical management services (CMS) business consistent with the Company’s strategic imperative to sell customer solutions—value—not just fluids. Under the Company’s traditional CMS approach, the Company effectively acts as an agent whereby it purchases chemicals from other companies and resells the product to the customer at little or no margin and earns a set management fee for providing this service. Therefore, the profit earned on the management fee is relatively secure as the entire cost of the products is passed on to the customer. The new approach to CMS is dramatically different. The Company receives a set management fee and the costs that relate to those management fees are largely connected to how well the Company controls product costs and achieves product conversions from other third party suppliers to its own products. With this new approach come new risks and opportunities, as the profit earned from the management fee is subject to movements in product costs as well as the Company’s own performance. The Company believes this new approach is a way for Quaker to become an integral part of our customers’ operational efforts to improve manufacturing costs and to demonstrate value that the Company would not be able to demonstrate as purely a product provider.
With this new approach, the Company was awarded a series of multi-year CMS contracts primarily at General Motors Powertrain and DaimlerChrysler manufacturing sites in 2003, 2004 and 2005. This business was an important step in building the Company’s share and leadership position in the automotive process fluids market and should position the Company well for penetration of CMS opportunities in other metalworking manufacturing sites. This new approach has also had a dramatic impact on the Company’s revenue and margins. Under the traditional CMS approach, where the Company effectively acts as an agent, the revenue and costs from these sales are reported on a net sales or “pass-through” basis. As discussed above, the structure of the new CMS approach is different in that the Company’s revenue received from the customer is a fee for products and services provided to the customer, which are indirectly related to the actual costs incurred. As a result, the Company recognizes in reported revenues the gross revenue received from the CMS site customer, and in cost of goods sold, the third party product purchases, which substantially offset each other until the Company achieves significant product conversions. There are two critical success factors for this new approach. First, is to create
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savings for a customer based on our ability to help apply the product better and improve the customer’s own processes. Second, is to convert more of the product being used to Quaker product rather than a competitor’s product. While the Company’s U.S. CMS program contributed to profitability in 2005, overall performance was tempered by higher third-party product costs.
Comparison of 2005 with 2004
Net sales for 2005 increased to $424.0 million, up 6% from $400.7 million for 2004. Approximately 4% of the sales increase was attributable to higher sales prices, while foreign exchange rate translation favorably impacted net sales by approximately 2%. Volume increases in Asia/Pacific were offset by softer demand in North America and Europe.
Gross profit (net sales less cost of goods sold) as a percentage of sales declined from 32.7% in 2004 to 30.6% in 2005. Higher prices for the Company’s raw materials, particularly crude oil derivatives, and higher third-party product purchase costs with respect to the Company’s CMS contracts, exceeded the pace at which price increases could be implemented through the year. Unfavorable product and regional mix also contributed to the decline in gross profit percentage.
Selling, general and administrative (“SG&A”) expenses for 2005 increased $2.8 million or approximately 3% from 2004. Foreign exchange rate translation accounted for approximately half of the increase with the remainder attributable to inflation, investments in growth initiatives and higher pension costs offset by other cost reduction efforts. SG&A as a percentage of sales decreased from 28.3% to 27.4%.
In the first quarter of 2005, the Company incurred a net pre-tax charge of $1.2 million related to a reduction in its workforce. During the fourth quarter of 2005, the Company furthered this restructuring effort with the goal of significantly reducing operating costs in the U.S. and Europe. The fourth quarter program included involuntary terminations, a freeze of the Company’s U.S. pension plan, and a voluntary early retirement offering to eligible U.S. employees. These actions resulted in a net pre-tax charge of $9.1 million. The Company estimates 2006 savings resulting from these programs to be of a similar magnitude as the charges. These savings will substantially mitigate the increased cost of continued operating expense investments and key growth initiatives.
The increase in other income for 2005 was largely due to the $4.2 million of proceeds received from the sale by the Company’s real estate joint venture of its holdings as previously announced on February 17, 2005. The proceeds included a $3.0 million gain relating to the sale by the venture of its real estate holdings, as well as $1.2 million of preferred return distributions. Preferred distributions in 2004 totaled $0.9 million. Foreign exchange gains in 2005 also contributed to the increase in other income. The increase in net interest expense in 2005 was due to higher average borrowings and higher interest rates on the Company’s debt.
The effective tax rate was 50.4% versus 31.5% in 2004. The increase was primarily due to the Company’s election, in the fourth quarter of 2005, to repatriate substantial accumulated foreign earnings which, primarily to improve its global capital structure, resulted in a $1.0 million charge in tax expense.
At the end of 2005, the Company had net U.S. deferred tax assets totaling $15.3 million, excluding deferred tax assets relating to additional minimum pension liabilities. The Company records valuation allowances when necessary to reduce its deferred tax assets to the amount that is more likely than not to be realized. The Company considers future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. However, in the event the Company were to determine that it would not be able to realize all or part of its U.S. net deferred tax assets in the future, an adjustment to the deferred tax asset would be a non-cash charge to income in the period such determination were made, which could have a material adverse impact on the Company’s financial statements. The continued upward pressure in the Company’s crude oil based raw materials has outpaced the Company’s selling price increases, negatively impacting U.S. profitability. The Company continues to closely monitor this situation as it relates to its net deferred tax assets and the assessment of valuation allowances. The Company is continuing to evaluate alternatives that could positively impact U.S. taxable income.
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The $1.7 million decrease in minority interest in 2005 was primarily due to the Company’s first quarter 2005 acquisition of the remaining 40% interest in its Brazilian affiliate.
Segment Reviews—Comparison of 2005 with 2004
Metalworking Process Chemicals:
Metalworking Process Chemicals consists of industrial process fluids for various heavy industrial and manufacturing applications and represented approximately 93% of the Company’s net sales in 2005. Net sales were up $23.0 million, or 6%, compared with 2004. Favorable currency translation represented approximately 2 percentage points of the growth in this segment, driven by the Brazilian real to U.S. dollar exchange rate. The average Brazilian real to U.S. dollar rate was 0.41 in 2005 compared to 0.34 in 2004. The remaining net sales increase of 4% was due to 35% growth in Asia/Pacific, 7.2% growth in South America, 1% growth in North America, partially offset by decreases in our European net sales, which were down 3%, all on a constant currency basis. The growth in net sales is primarily attributable to the pricing actions taken by the Company throughout 2004 and 2005 to help in offsetting the continued escalation in raw material costs. Volume increases in Asia/Pacific were offset by volume declines in the Company’s North American and European regions. The $6.4 million decrease in this segment’s operating income compared to 2004 is largely reflective of the pace at which raw material costs have escalated beyond the Company’s pricing actions. This segment’s operating income was also impacted by higher selling costs compared to the prior year.
Coatings:
The Company’s Coatings segment, which represented approximately 6% of Company’s net sales for 2005, contains products that provide temporary and permanent coatings for metal and concrete products and chemical milling maskants. Net sales for this segment were up $2.0 million, or 8% in 2005, compared with the prior year, primarily due to higher chemical milling maskant sales to the aerospace industry. Operating income decreased by $0.1 million in 2005 compared to 2004 due to higher raw material and selling costs.
Other Chemical Products:
Other Chemical Products, which represented approximately 1% of net sales in 2005, consists of sulfur removal products for industrial gas streams sold by the Company’s Q2 Technologies joint venture. Net sales for 2005 decreased $1.7 million or 31% due to a variety of market conditions, including special one-time sales to this segment’s largest customer in 2004 affecting the yearly net sales comparison. This segment’s operating income decreased by $0.4 million, consistent with the noted volume decreases and higher raw material costs.
Comparison of 2004 with 2003
Consolidated net sales increased by 18% to $400.7 million in 2004 from $340.2 million in 2003. The impact from foreign exchange rate translation increased sales by approximately $14.7 million, or 4%. The timing of the Company’s 2003 acquisitions increased net sales by $16.2 million, or 5%, and the Company’s new chemical management services (“CMS”) contracts, increased net sales by $17.2 million, or 5%. The remaining 4% increase in net sales was attributable to growth in the Asia/Pacific and North and South American regions partially offset by lower sales in Europe. The decline in business in Europe was substantially caused by softness in sheet steel demand. Although the Company’s market share in this region remained stable during 2004, the increased competitive pressures experienced in late 2003 also affected the yearly comparisons.
Gross profit (net sales less cost of goods sold) as a percentage of sales declined from 35.7% in 2003 to 32.7% in 2004. The new CMS contracts resulted in an increase in the Company’s reported revenue of approximately $17.2 million and a corresponding decrease in gross profit as a percentage of sales of approximately 1.3 percentage points. The remaining decline in gross profit as a percentage of sales was primarily due to increased raw material costs, as well as unfavorable product and geographic mix. Even though the Company experienced a four-year high in the pricing of its key raw material markets at the end of 2003, the
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pricing of these key raw materials continued to escalate in 2004. While the Company benefited from the implementation of price increases announced during the third and fourth quarters of 2004, these gains were more than offset by the continued increase in raw material prices, particularly crude oil-based derivatives.
SG&A as reported for 2004 totaled $113.5 million compared to $97.2 million in 2003. Approximately 40% of the $16.3 million increase was due to foreign exchange rate translation and the Company’s 2003 acquisition activity, which impacted SG&A by approximately $3.9 million and $2.4 million, respectively. The majority of the remaining increase was due to costs associated with strategic initiatives, as well as a range of administrative costs such as Sarbanes-Oxley compliance, pension, incentive compensation, and higher sales commissions. The Company’s strategic initiatives include expanding our presence in the Asia/Pacific region, further supporting our CMS business, the continued rollout of our global ERP system, and continuing development of new, complementary businesses.
During the fourth quarter of 2004, the Company began efforts to realign its organization and reduce costs by announcing the consolidation of its administrative facilities in Hong Kong with its Shanghai headquarters, resulting in a $0.5 million pre-tax charge for restructuring and related activities.
The increase in other income in 2004 reflected a gain on the sale of real estate by the Company’s majority-owned Australian subsidiary, as well as higher priority return distributions from the Company’s real estate joint venture in Conshohocken. The increase in interest expense in 2004 was primarily due to higher debt balances outstanding during 2004 as well as higher short-term interest rates on the Company’s credit facilities.
The Company’s effective tax rate was 31.5% in 2004 and 31% in 2003. The effective tax rate is dependent on many internal and external factors and is assessed by the Company on a regular basis.
The $0.8 million increase in minority interest expense in 2004 was primarily due to the gain on the sale of real estate relating to the Company’s Australian operations mentioned above as well as a stronger performance from the Company’s Brazilian joint venture.
Segment Reviews—Comparison of 2004 with 2003
Metalworking Process Chemicals, which consists of industrial process fluids for various heavy industrial and manufacturing applications, represented approximately 93% of the Company’s sales in 2004. Reported revenues in this segment were up approximately 18% compared with 2003. The Company’s new CMS contracts accounted for approximately 6 percentage points of the revenue growth in this segment. The timing of the Company’s 2003 acquisitions of Vulcan, Eural, and KS Chemie accounted for approximately 5 percentage points of the revenue growth in this segment. Currency translation increased sales by 5 percentage points, primarily due to the higher average Euro to U.S. dollar exchange rate of 1.24 in 2004 compared to 1.13 in 2003. The remaining net sales increase of 2% was primarily due to 17% growth in South America, 13% growth in Asia/Pacific, and 5% increase in the U.S. base business, offset by decreases in our European sales, which was down 3%, all on a constant currency basis. The operating income in this segment increased by $1.8 million or 3%. The disparity between the increase in sales and operating income is largely reflective of the Company’s new approach to its CMS business, discussed above. Further, this segment’s operating income was negatively impacted by significantly higher raw material costs, unfavorable product and regional sales mix as well as higher selling costs.
The Company’s Coatings segment represented approximately 6% of the Company’s sales in 2004 and contained products that provide temporary and permanent coatings for metal and concrete products and chemical milling maskants. Revenues for this segment were up approximately $1.8 million or 8% for 2004 compared with the prior year primarily due to higher chemical milling maskant sales to the aerospace industry, as well as new customer penetration in roofing sealants. Operating income increased $0.6 million over 2003, consistent with the noted volume increases.
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Other Chemical Products represents approximately 1% of total sales in 2004 and consists of sulfur removal products for industrial gas streams sold by the Company’s Q2 Technologies joint venture. Sales for 2004 increased $1.3 million primarily due to special one-time sales to this segment’s largest customer. Operating income increased by $0.2 million over the prior year, due to the noted volume increases offset by higher raw material costs.
Restructuring and Related Activities
In 2001, Quaker’s management approved restructuring plans to realign the organization primarily in Europe and reduce operating costs (2001 program). Quaker’s restructuring plans included the closing and sale of its manufacturing facilities in the U.K. and France. In addition, Quaker consolidated certain functions within its global business units and reduced administrative functions, as well as expensed costs related to abandoned acquisitions. Included in the restructuring charges were provisions for severance of 53 employees. Restructuring and related charges of $5.854 million were recognized in 2001. The charge comprised $2.807 million related to employee separations, $2.450 million related to facility rationalization charges, and $0.597 million related to abandoned acquisitions. Employee separation benefits varied depending on local regulations within certain foreign countries and included severance and other benefits. In January of 2005, the last severance payment under the 2001 program was made and the Company reversed $0.117 million of unused restructuring accruals related to this program. In February 2005, the Company completed the sale of a portion of its Villeneuve, France site for $0.647 million. In July 2005, the Company completed the sale of the remaining portion of its Villeneuve, France site for $1.260 million, which completed all actions contemplated by this program. The Company reversed $0.159 million of unused restructuring accruals related to this program in the fourth quarter of 2005.
In 2003, Quaker’s management approved a restructuring plan (2003 program). Included in the 2003 restructuring charge were provisions for severance for 9 employees totaling $0.273 million. As of March 31, 2005, all severance payments were completed and the Company reversed $0.059 million of unused restructuring accruals related to this program, which completed all actions contemplated by this program.
In 2004, Quaker’s management approved a restructuring plan by announcing the consolidation of its administrative facilities in Hong Kong with its Shanghai headquarters (2004 program). Included in the 2004 restructuring charge were severance provisions for 5 employees totaling $0.119 million and an asset impairment related to the Company’s previous plans to implement its global ERP system at this location totaling $0.331 million. As of March 31, 2005, all severance payments were completed, which completed all actions contemplated by this program.
In the first quarter of 2005, Quaker’s management approved a restructuring plan (2005 1st Quarter Program). Included in the first quarter 2005 restructuring charge were provisions for severance for 16 employees totaling $1.408 million. At December 31, 2005, all severance payments were completed. The Company reversed $0.096 million of unused restructuring charges related to this program, which completed all actions contemplated by this program.
In the fourth quarter of 2005, Quaker’s management approved a restructuring plan (2005 4th Quarter Program) with the goal of significantly reducing operating costs in the U.S. and Europe. The restructuring plan included involuntary terminations, a freeze of the Company’s U.S. pension plan, and a voluntary early retirement window to certain U.S. employees, with enhanced pension and other postretirement benefits. Included in the restructuring charges were provisions for severance (voluntary and involuntary) of 55 employees. Restructuring and related charges of $9.344 million were recognized in the fourth quarter of 2005. The charge comprised $4.024 million related to severance for involuntary terminations, $1.017 million related to one-time payments for voluntary early retirement, $2.668 million related to the U.S. pension plan freeze and $1.635 million for the enhanced pension and other postretirement benefits related to voluntary early retirement participants. The Company expects to complete the initiatives contemplated under this program during 2006. The charges related to the U.S. pension plan freeze and the enhanced pension and other postretirement benefits are not included in the following table, and are included as part of the accrued pension and other postretirement balances. See also Note 9 of Notes to Consolidated Financial Statements.
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Accrued restructuring balances, included in other current liabilities and assigned to the Metalworking segment, are as follows (amounts in millions):
2001 Program:
Restructuring charges
Asset impairment
Payments
Currency translation and other
December 31, 2001 ending balance
December 31, 2002 ending balance
Restructuring reversals
December 31, 2003 ending balance
December 31, 2004 ending balance
December 31, 2005 ending balance
2003 Program:
2004 Program:
2005 1stQuarter Program:
2005 4thQuarter Program:
Total restructuring December 31, 2005 ending balance
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Environmental Clean-up Activities
The Company is involved in environmental clean-up activities in connection with an existing plant location and former waste disposal sites. In April of 1992, the Company identified certain soil and groundwater contamination at AC Products, Inc. (“ACP”), a wholly owned subsidiary. Voluntarily in coordination with the Santa Ana California Regional Water Quality Board, ACP is remediating the contamination. The Company believes that the remaining potential-known liabilities associated with these matters range from approximately $1.2 million to $1.5 million, for which the Company has sufficient reserves. Notwithstanding the foregoing, the Company cannot be certain that liabilities in the form of remediation expenses, fines, penalties, and damages will not be incurred in excess of the amount reserved. See Note 18 of Notes to Consolidated Financial Statements which appears in Item 8 of this Report.
General
The Company generally does not use financial instruments that expose it to significant risk involving foreign currency transactions; however, the size of non-U.S. activities has a significant impact on reported operating results and the attendant net assets. During the past three years, sales by non-U.S. subsidiaries accounted for approximately 53% to 55% of the consolidated net annual sales. See Note 13 of Notes to Consolidated Financial Statements which appears in Item 8 of this Report.
(Cautionary Statements Under the Private Securities Litigation Reform Act of 1995)
Any or all of the forward-looking statements in this report, in Quaker’s Annual Report to Shareholders for 2005 and in any other public statements we make may turn out to be wrong. This can occur as a result of inaccurate assumptions or as a consequence of known or unknown risks and uncertainties. Many factors discussed in this Report will be important in determining our future performance. Consequently, actual results may differ materially from those that might be anticipated from our forward-looking statements.
We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. However, any further disclosures made on related subjects in Quaker’s subsequent reports on Forms 10-K, 10-Q and 8-K should be consulted. These forward-looking statements are
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subject to risks, uncertainties and assumptions about us and our operations that are subject to change based on various important factors, some of which are beyond our control. A major risk is that the Company’s demand is largely derived from the demand for its customers’ products, which subjects the Company to uncertainties related to downturns in a customer’s business and unanticipated customer production shutdowns. Other major risks and uncertainties include, but are not limited to, significant increases in raw material costs, worldwide economic and political conditions, foreign currency fluctuations, and terrorist attacks such as those that occurred on September 11, 2001, each of which is discussed in greater detail in Item 1A of this Report. Furthermore, the Company is subject to the same business cycles as those experienced by steel, automobile, aircraft, appliance, and durable goods manufacturers. These risks, uncertainties, and possible inaccurate assumptions relevant to our business could cause our actual results to differ materially from expected and historical results. Other factors beyond those discussed in this Report could also adversely affect us. Therefore, we caution you not to place undue reliance on our forward-looking statements. This discussion is provided as permitted by the Private Securities Litigation Reform Act of 1995.
Quaker is exposed to the impact of interest rates, foreign currency fluctuations, changes in commodity prices, and credit risk.
Interest Rate Risk. Quaker’s exposure to market rate risk for changes in interest rates relates primarily to its short and long-term debt. Most of Quaker’s debt is negotiated at market rates. Accordingly, if interest rates rise significantly, the cost of debt to Quaker will increase. This can have an adverse effect on Quaker, depending on the extent of Quaker’s borrowings. As of December 31, 2005, Quaker had approximately $63.8 million in borrowings under its credit facilities at a weighted average borrowing rate of approximately 4.42%. In the fourth quarter of 2005, the Company entered into three interest rate swaps in order to fix a portion of its variable rate debt. The combined notional value of the swaps was $15.0 million and had a fair value of $(0.1) million at December 31, 2005. See information included in the caption “Derivatives” of Note 1 of Notes to Consolidated Financial Statements which appears in Item 8 of this Report and is incorporated herein by reference.
Foreign Exchange Risk. A significant portion of Quaker’s revenues and earnings is generated by its foreign operations. These foreign operations also hold a significant portion of Quaker’s assets and liabilities. All such operations use the local currency as their functional currency. Accordingly, Quaker’s financial results are affected by risks typical of global business such as currency fluctuations, particularly between the U.S. dollar, the Brazilian real, and the E.U. euro. As exchange rates vary, Quaker’s results can be materially affected.
The Company generally does not use financial instruments that expose it to significant risk involving foreign currency transactions; however, the size of non-U.S. activities has a significant impact on reported operating results and the attendant net assets. During the past three years, sales by non-U.S. subsidiaries accounted for approximately 53% to 55% of consolidated net annual sales.
In addition, the Company often sources inventory among its worldwide operations. This practice can give rise to foreign exchange risk resulting from the varying cost of inventory to the receiving location as well as from the revaluation of intercompany balances. The Company mitigates this risk through local sourcing efforts.
Commodity Price Risk. Many of the raw materials used by Quaker are commodity chemicals, and, therefore, Quaker’s earnings can be materially affected by market changes in raw material prices. In certain cases, Quaker has entered into fixed-price purchase contracts having a term of up to one year. These contracts provide for protection to Quaker if the price for the contracted raw materials rises, however, in certain limited circumstances, Quaker will not realize the benefit if such prices decline.
Credit Risk. Quaker establishes allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of Quaker’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.
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Downturns in the overall economic climate may also exacerbate specific customer financial issues. A significant portion of Quaker’s revenues is derived from sales to customers in the U.S. steel industry, where a number of bankruptcies occurred during recent years. Through 2003, Quaker recorded additional provisions for doubtful accounts primarily related to bankruptcies in the U.S. steel industry. In addition, in the third quarter of 2005, the Company recorded additional provisions for doubtful accounts in connection with a customer bankruptcy. When a bankruptcy occurs, Quaker must judge the amount of proceeds, if any, that may ultimately be received through the bankruptcy or liquidation process. In addition, as part of its terms of trade, Quaker may custom-manufacture products for certain large customers and/or may ship product on a consignment basis. These practices may increase the Company’s exposure should a bankruptcy occur, and may require writedown or disposal of certain inventory due to its estimated obsolescence or limited marketability. Customer returns of products or disputes may also result in similar issues related to the realizability of recorded accounts receivable or returned inventory.
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INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Financial Statements:
Report of Independent Registered Public Accounting Firm
Consolidated Statement of Income
Consolidated Balance Sheet
Consolidated Statement of Cash Flows
Consolidated Statement of Shareholders’ Equity
Notes to Consolidated Financial Statements
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To the Shareholders and Board of Directors
of Quaker Chemical Corporation:
We have completed integrated audits of Quaker Chemical Corporation’s 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005, and an audit of its 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Consolidated financial statements
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Quaker Chemical Corporation and its subsidiaries at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Internal control over financial reporting
Also, in our opinion, management’s assessment, included in “Management’s Report on Internal Control over Financial Reporting,” appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance
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with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ PricewaterhouseCoopers LLP
PricewaterhouseCoopers LLP
Philadelphia, PA
March 10, 2006
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CONSOLIDATED STATEMENT OF INCOME
Costs and expenses:
Cost of goods sold
Selling, general, and administrative expenses
Restructuring and related activities, net
Operating income
Other income, net
Interest expense
Interest income
Taxes on income
Equity in net income of associated companies
Minority interest in net income of subsidiaries
Per share data:
Net income—basic
Net income—diluted
Weighted average shares outstanding:
Basic
Diluted
See notes to consolidated financial statements.
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CONSOLIDATED BALANCE SHEET
ASSETS
Current assets
Cash and cash equivalents
Accounts receivable, net
Inventories
Deferred income taxes
Prepaid expenses and other current assets
Total current assets
Property, plant and equipment, net
Goodwill
Other intangible assets, net
Investments in associated companies
Other assets
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities
Short-term borrowings and current portion of long-term debt
Accounts payable
Dividends payable
Accrued compensation
Other current liabilities
Total current liabilities
Accrued pension and postretirement benefits
Other non-current liabilities
Total liabilities
Minority interest in equity of subsidiaries
Commitments and contingencies
Common stock, $1 par value; authorized 30,000,000 shares;issued: 2005-9,726,385, 2004-9,668,751 shares
Capital in excess of par value
Retained earnings
Unearned compensation
Accumulated other comprehensive loss
Total shareholders’ equity
Total liabilities and shareholders’ equity
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CONSOLIDATED STATEMENT OF CASH FLOWS
Cash flows from operating activities
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation
Amortization
Minority interest in earnings of subsidiaries
Deferred compensation and other, net
Restructuring and related activities
Gain on sale of partnership assets
Gain on sale of property, plant, and equipment
Pension and other postretirement benefits
Increase (decrease) in cash from changes in current assets and current liabilities, net of acquisitions:
Accounts receivable
Accounts payable and accrued liabilities
Restructuring liabilities
Estimated taxes on income
Net cash provided by operating activities
Cash flows from investing activities
Capital expenditures
Dividends and distributions from associated companies
Payments related to acquisitions
Proceeds from partnership disposition of assets
Proceeds from disposition of assets
Insurance settlement received
Investment in restricted cash
Other, net
Net cash (used in) investing activities
Cash flows from financing activities
Net (decrease) increase in short-term borrowings
Proceeds from long-term debt
Repayment of long-term debt
Stock options exercised, other
Distributions to minority shareholders
Net cash (used in) provided by financing activities
Effect of exchange rate changes on cash
Net (decrease) increase in cash and cash equivalents
Cash and cash equivalents at beginning of year
Cash and cash equivalents at end of year
Supplemental cash flow disclosures
Cash paid during the year for:
Income taxes
Interest
Non-cash activities:
Restricted insurance receivable (See also Note 16 of Notes to Consolidated Financial Statements)
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CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
Balance at December 31, 2002
Currency translation adjustments
Minimum pension liability
Unrealized gain on available-for-sale securities
Comprehensive income
Dividends ($0.84 per share)
Shares issued upon exercise of options
Shares issued for employee stock purchase plan
Shares issued for long-term incentive awards
Amortization of unearned compensation
Balance at December 31, 2003
Dividends ($0.86 per share)
Balance at December 31, 2004
Current period changes in fair value of derivatives
Compensation plan (non-vested stock)
Balance at December 31, 2005
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands except per share amounts)
Note 1—Significant Accounting Policies
Principles of consolidation: All majority-owned subsidiaries are included in the Company’s consolidated financial statements, with appropriate elimination of intercompany balances and transactions. Investments in associated (less than majority-owned) companies are accounted for under the equity method. The Company’s share of net income or losses of investments is included in the consolidated statement of income. The Company periodically reviews these investments for impairments and, if necessary, would adjust these investments to their fair value when a decline in market value is deemed to be other than temporary.
In January 2003, the Financial Accounting Standards Board (“FASB”), issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Certain Variable Interest Entities, (“VIEs”), which is an interpretation of Accounting Research Bulletin (“ARB”) No. 51, “Consolidated Financial Statements.” FIN 46, as revised by FIN 46 (revised December 2003), addresses the application of ARB No. 51 to VIEs, and generally would require that assets, liabilities and results of the activities of a VIE be consolidated into the financial statements of the enterprise that is considered the primary beneficiary. The consolidated financial statements include the accounts of the Company and all of its subsidiaries in which a controlling interest is maintained and would include any VIEs if the Company was the primary beneficiary pursuant to the provisions of FIN 46 (revised December 2003). The Company determined that its real estate joint venture, which was always accounted for under the equity method, was a VIE but that the Company was not the primary beneficiary. In February 2005, the Venture sold its real estate assets, which resulted in $4,187 of proceeds to the Company after payment of the partnership obligations. The proceeds include a gain of $2,989 related to the sale by the Venture of its real estate holdings as well as $1,198 of preferred distributions. These proceeds are included in other income. See also Note 3 of Notes to Consolidated Financial Statements.
Translation of foreign currency: Assets and liabilities of non-U.S. subsidiaries and associated companies are translated into U.S. dollars at the respective rates of exchange prevailing at the end of the year. Income and expense accounts are translated at average exchange rates prevailing during the year. Translation adjustments resulting from this process are recorded directly in shareholders’ equity and will be included in income only upon sale or liquidation of the underlying investment. All non-U.S. subsidiaries use its local currency as its functional currency.
Cash and cash equivalents: The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents.
Inventories: Inventories are valued at the lower of cost or market value. Inventories are valued using the first-in, first-out (“FIFO”) method. See also Note 5 of Notes to Consolidated Financial Statements.
Long-lived assets: Property, plant, and equipment are stated at cost. Depreciation is computed using the straight-line method on an individual asset basis over the following estimated useful lives: buildings and improvements, 10 to 45 years; and machinery and equipment, 3 to 15 years. The carrying value of long-lived assets is periodically evaluated whenever changes in circumstances or current events indicate the carrying amount of such assets may not be recoverable. An estimate of undiscounted cash flows produced by the asset, or the appropriate group of assets, is compared with the carrying value to determine whether an impairment exists. If necessary, the Company recognizes an impairment loss for the difference between the carrying amount of the assets and their estimated fair value. Fair value is based on current and anticipated future undiscounted cash flows. Upon sale or other dispositions of long-lived assets, the applicable amounts of asset cost and accumulated depreciation are removed from the accounts and the net amount, less proceeds from disposals is recorded to income. Expenditures for renewals and betterments, which increase the estimated useful life or capacity of the assets, are capitalized; expenditures for repairs and maintenance are expensed when incurred.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Capitalized software: The Company applies the Accounting Standards Executive Committee Statement of Position (SOP) 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” This SOP requires the capitalization of certain costs incurred in connection with developing or obtaining software for internal use. In connection with the implementation of the Company’s global transaction system, approximately $6,406 and $9,288 of net costs were capitalized at December 31, 2005 and 2004, respectively. These costs are amortized over a period of five years once the assets are placed into service.
Goodwill and other intangible assets: On January 1, 2002, the Company adopted SFAS No. 142, “Goodwill and Other Intangible Assets.” The new standard requires that goodwill and indefinite-lived intangible assets no longer be amortized. In addition, goodwill and indefinite-lived intangible assets are tested for impairment at least annually. These tests will be performed more frequently if there are triggering events. Definite-lived intangible assets are amortized over their estimated useful lives, generally for periods ranging from 5 to 20 years. The Company continually evaluates the reasonableness of the useful lives of these assets. See also Note 15 of Notes to Consolidated Financial Statements.
Revenue recognition: The Company recognizes revenue in accordance with the terms of the underlying agreements, when title and risk of loss have been transferred, collectibility is reasonably assured, and pricing is fixed or determinable. This generally occurs for product sales when products are shipped to customers or, for consignment arrangements upon usage by the customer and when services are performed. License fees and royalties are recognized in accordance with agreed upon terms, when performance obligations are satisfied, the amount is fixed or determinable, and collectibility is reasonably assured and are included in other income. As part of the Company’s chemical management services, certain third-party product sales to customers are managed by the Company. Where the Company acts as a principal, revenues are recognized on a gross reporting basis at the selling price negotiated with customers. Where the Company acts as an agent, such revenue is recorded using net reporting as service revenues, at the amount of the administrative fee earned by the Company for ordering the goods. Third-party products transferred under arrangements resulting in net reporting totaled $38,840, $35,215, and $26,617 for 2005, 2004, and 2003, respectively.
Research and development costs: Research and development costs are expensed as incurred. Research and development expenses are included in selling, general and administrative expenses, and during 2005, 2004, and 2003 were $14,148, $13,808, and $10,050, respectively.
Concentration of credit risk: Financial instruments, which potentially subject the Company to a concentration of credit risk, principally consist of cash equivalents, short-term investments, and trade receivables. The Company invests temporary and excess funds in money market securities and financial instruments having maturities typically within 90 days. The Company has not experienced losses from the aforementioned investments. See also Note 4 of Notes to Consolidated Financial Statements.
Environmental liabilities and expenditures: Accruals for environmental matters are recorded when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. If no amount in the range is considered more probable than any other amount, the Company records the lowest amount in the range in accordance with generally accepted accounting principles. Accrued liabilities are exclusive of claims against third parties and are not discounted. Environmental costs and remediation costs are capitalized if the costs extend the life, increase the capacity or improve safety or efficiency of the property from the date acquired or constructed, and/or mitigate or prevent contamination in the future.
Comprehensive income (loss): The Company presents comprehensive income (loss) in its Statement of Shareholders’ Equity. The components of accumulated other comprehensive loss at December 31, 2005 include:
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accumulated foreign currency translation adjustments of $(5,548), minimum pension liability of $(13,257), unrealized holding gains on available-for-sale securities of $166, and the fair value of derivative instruments of $(71). The components of accumulated other comprehensive loss at December 31, 2004 include: accumulated foreign currency translation adjustments of $2,349 and minimum pension liability of $(9,808) and unrealized holding losses on available-for-sale securities of $119.
Income taxes: The provision for income taxes is determined using the asset and liability approach of accounting for income taxes. Under this approach, deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid. The provision for income taxes represents income taxes paid or payable for the current year plus the change in deferred taxes during the year. Deferred taxes result from differences between the financial and tax bases of the Company’s assets and liabilities and are adjusted for changes in tax rates and tax laws when changes are enacted. Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized.
Stock-based compensation: In December 2002, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure.” This standard amends the transition and disclosure requirements of SFAS No. 123, “Accounting for Stock-Based Compensation.” As permitted by SFAS No. 148, the Company continues to account for stock option grants in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” Accordingly, no compensation expense has been recognized for stock options since all options granted had an exercise price equal to the market value of the underlying stock on the grant date.
The following tables illustrate the effect on net earnings and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123. See also Note 11 of Notes to Consolidated Financial Statements.
Net income—as reported
Add: Stock-based employee compensation expense included in net income, net of related tax effects
Deduct: Total stock-based employee compensation expense determined under the fair value based method for all awards, net of tax
Pro forma net income
Earnings per share:
Basic—as reported
Basic—pro forma
Diluted—as reported
Diluted—pro forma
Derivatives: The Company uses derivative financial instruments primarily for purposes of hedging exposures to fluctuations in interest rates. The Company does not enter into derivative contracts for trading or speculative purposes. In accordance with SFAS 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended and interpreted, all derivatives are recognized on the balance sheet at fair value. For derivative instruments designated as cash flow hedges, the effective portion of any hedge is reported in
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Accumulated Other Comprehensive Income (Loss) until it is cleared to earnings during the same period in which the hedged item affects earnings. The Company uses no derivative instruments designated as fair value hedges.
In the fourth quarter of 2005, the Company entered into three interest rate swaps which convert a portion of its variable rate debt into fixed rate debt. The swaps have a notional amount of $15,000 and at December 31, 2005 had a fair value of $(71). The counterparties to the swaps are major financial institutions. The Company believes the swaps to be highly effective as defined in SFAS 133 and has designated them as cash flow hedges. Accordingly, the fair value of the swaps have been recorded in Accumulated Other Comprehensive Income (Loss).
Recently issued accounting standards:
In December 2004, the FASB issued its final standard on accounting for share-based payments, SFAS 123R (Revised 2004), Share-Based Payment (“SFAS 123R”). SFAS 123R requires companies to expense the fair value of employee stock options and other similar awards. The fair value of the awards are to be measured based on the grant-date fair value of the awards and the cost to be recognized over the period during which an employee is required to provide service in exchange for the award. SFAS 123R eliminates the alternative use of Accounting Principles Board No. 25’s intrinsic value method of accounting for awards, which is the Company’s current accounting policy for stock options. SFAS 123R is effective for the Company beginning January 1, 2006. The Company adopted the provisions of SFAS 123R on a prospective basis. The financial statement impact will be dependent on future stock-based awards and any unvested stock options outstanding. At the time of adoption, the Company will have approximately $90 of pre-tax expense to record related to unvested stock options.
In November 2004, the FASB issued Statement of Financial Accounting Standards No. 151, Inventory Costs an amendment of ARB 43 Chapter 4 (“SFAS 151”). SFAS 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) in the determination of inventory carrying costs. The statement requires that such costs be recognized as a current period expense. SFAS 151 also requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. This statement is effective for fiscal years beginning after July 15, 2005. The adoption of SFAS 151 did not have a material impact on the Company’s financial position, results of operations, or cash flows.
Accounting estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts
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of assets, liabilities, and disclosure of contingencies at the date of the financial statements and the reported amounts of net sales and expenses during the reporting period. Actual results could differ from such estimates.
Reclassifications: Certain reclassifications of prior years’ data have been made to improve comparability.
Note 2—Restructuring and Related Activities
In 2001, Quaker’s management approved restructuring plans to realign the organization primarily in Europe and reduce operating costs (2001 program). Quaker’s restructuring plans included the closing and sale of its manufacturing facilities in the U.K. and France. In addition, Quaker consolidated certain functions within its global business units and reduced administrative functions, as well as expensed costs related to abandoned acquisitions. Included in the restructuring charges were provisions for severance of 53 employees. Restructuring and related charges of $5,854 were recognized in 2001. The charge comprised $2,807 related to employee separations, $2,450 related to facility rationalization charges, and $597 related to abandoned acquisitions. Employee separation benefits varied depending on local regulations within certain foreign countries and included severance and other benefits. In January of 2005, the last severance payment under the 2001 program was made and the Company reversed $117 of unused restructuring accruals related to this program. In February 2005, the Company completed the sale of a portion of its Villeneuve, France site for $647. In July 2005, the Company completed the sale of the remaining portion of its Villeneuve, France site for $1,260, which completed all actions contemplated by this program. The Company reversed $159 of unused restructuring accruals related to this program in the fourth quarter of 2005.
In 2003, Quaker’s management approved a restructuring plan (2003 program). Included in the 2003 restructuring charge were provisions for severance for 9 employees totaling $273. As of March 31, 2005, all severance payments were completed and the Company reversed $59 of unused restructuring accruals related to this program, which completed all actions contemplated by this program.
In 2004, Quaker’s management approved a restructuring plan by announcing the consolidation of its administrative facilities in Hong Kong with its Shanghai headquarters (2004 program). Included in the 2004 restructuring charge were severance provisions for 5 employees totaling $119 and an asset impairment related to the Company’s previous plans to implement its global ERP system at this location totaling $331. As of March 31, 2005, all severance payments were completed, which completed all actions contemplated by this program.
In the first quarter of 2005, Quaker’s management approved a restructuring plan (2005 1st Quarter Program). Included in the first quarter 2005 restructuring charge were provisions for severance for 16 employees totaling $1,408. At December 31, 2005, all severance payments were completed. The Company reversed $96 of unused restructuring charges related to this program, which completed all actions contemplated by this program.
In the fourth quarter of 2005, Quaker’s management approved a restructuring plan (2005 4th Quarter Program) with the goal of significantly reducing operating costs in the U.S. and Europe. The restructuring plan included involuntary terminations, a freeze of the Company’s U.S. pension plan, a voluntary early retirement window to certain U.S. employees, with enhanced pension and other postretirement benefits. Included in the restructuring charges were provisions for severance (voluntary and involuntary) of 55 employees. Restructuring and related charges of $9,344 were recognized in the fourth quarter of 2005. The charge comprised $4,024 related to severance for involuntary terminations, $1,017 related to one-time payments for voluntary early retirement, and $2,668 related to the U.S. pension plan freeze and $1,635 for the enhanced pension and other postretirement benefits related to voluntary early retirement participants. The Company expects to complete the initiatives contemplated under this program during 2006. The charges related to the U.S. pension plan freeze and the enhanced pension and other postretirement benefits are not included in the following table, and are included as part of the accrued pension and other postretirement balances. See also Note 9 of Notes to Consolidated Financial Statements.
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Accrued restructuring balances, included in other current liabilities and assigned to the Metalworking segment, are as follows:
Restructuring Reversals
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Facility
Rationalization
Note 3—Investments in Associated Companies
Investments in associated (less than majority-owned) companies are accounted for under the equity method. Summarized financial information of the associated companies, in the aggregate, is as follows:
Noncurrent assets
Noncurrent liabilities
Gross margin
In January 2001, the Company contributed its Conshohocken, Pennsylvania property and buildings (the “Site”) into a real estate joint venture (the “Venture”) in exchange for a 50% interest in the Venture. The Venture did not assume any debt or other obligations of the Company and the Company did not guarantee nor was it obligated to pay any principal, interest or penalties on any of the Venture’s indebtedness. The Venture renovated certain of the existing buildings at the Site, as well as built new office space. In December 2000, the Company entered into an agreement with the Venture to lease approximately 38% of the Site’s available office space for a 15-year period commencing February 2002, with multiple renewal options. The Company believes the terms of this lease were no less favorable than the terms it would have obtained from an unaffiliated third party. In
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February 2005, the Venture sold its real estate assets to an unrelated third party, which resulted in $4,187 of proceeds to the Company after payment of the Venture’s obligations. The proceeds include a gain of $2,989 related to the sale by the Venture of its real estate holdings as well as $1,198 of preferred distributions. These proceeds are included in other income.
Note 4—Accounts Receivable and Allowance for Doubtful Accounts
Trade accounts receivable are recorded at the invoiced amount and generally do not bear interest. The allowance for doubtful accounts is our best estimate of the amount of probable credit losses in our existing accounts receivable. We determine the allowance based on historical write-off experience by industry and regional economic data. Reserves for customers filing for bankruptcy protection are generally established at 75-100% of the amount owed at the filing date, dependent on the Company’s evaluation of likely proceeds from the bankruptcy process. Large and/or financially distressed customers are generally reserved for on a specific review basis while a general reserve is established for other customers based on historical experience. We perform a formal review of our allowance for doubtful accounts quarterly. Account balances are charged off against the allowance when we feel it is probable the receivable will not be recovered. We do not have any off-balance-sheet credit exposure related to our customers. During 2005, the Company’s five largest customers accounted for approximately 25% of its consolidated net sales with the largest customer (General Motors) accounting for approximately 9% of consolidated net sales.
At December 31, 2005 and 2004, the Company had gross trade accounts receivable totaling $98,009 and $95,022 with trade accounts receivable greater than 90 days past due of $11,725 and $10,938, respectively. Following are the changes in the allowance for doubtful accounts during the years ended December 31, 2005, 2004, and 2003.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
Year ended December 31, 2005
Year ended December 31, 2004
Year ended December 31, 2003
Note 5—Inventories
Total inventories comprise:
Raw materials and supplies
Work in process and finished goods
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Note 6—Property, Plant and Equipment
Property, plant and equipment comprise:
Land
Building and improvements
Machinery and equipment
Construction in progress
Less accumulated depreciation
The Company leases certain equipment under capital leases in Europe and the U.S., including its manufacturing facility in Tradate, Italy. Gross property, plant, and equipment includes $2,659 and $3,130 of capital leases with $345 and $262 of accumulated depreciation at December 31, 2005 and 2004, respectively. The following is a schedule by years of future minimum lease payments:
For the year ended December 31,
2006
2007
2008
2009
2010
2011 and beyond
Total net minimum lease payments
Less amount representing interest
Present value of net minimum lease payments
Note 7—Asset Retirement Obligations
In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations.” SFAS No. 143 addresses accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated retirement costs. The Company adopted the standard as of January 1, 2003 and there was no material impact to the financial statements. In March 2005, the FASB issued its FASB Interpretation No. 47 (“FIN 47”), “Accounting for Conditional Asset Retirement Obligations,” an interpretation of FASB Statement No. 143. The interpretation clarifies that the term conditional asset retirement obligation (“CARO”) as used in SFAS 143, refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. A liability is recorded when there is enough information regarding the timing of the CARO to perform a probability weighted discounted cash flow analysis.
During 2005, the Company reviewed its CARO’s, which consist primarily of asbestos contained in certain manufacturing facilities and decommissioning costs related to its above-ground storage tanks. In the fourth quarter of 2005, due to a change in facts and circumstances at one of its manufacturing facilities, the Company determined enough information regarding the timing of cash flows was available to record a liability for $250.
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Note 8—Taxes on Income
Taxes on income consist of the following:
Current:
Federal
State
Foreign
Deferred:
Total
The components of earnings before income taxes were as follows:
Domestic
Domestic earnings before income taxes do not include foreign earnings that are included in U.S. taxable income. During the fourth quarter of 2005, the Company elected to repatriate substantial accumulated foreign earnings and implemented other tax planning strategies, which enabled the Company to utilize all domestic operating loss carryforwards, and improved its global capital structure. This repatriation was the primary reason for the increase in the Company’s effective tax rate and resulted in a net $1,000 charge to tax expense. After repatriation of foreign earnings, the Company has substantial domestic taxable income for the year ended 2005 and for the cumulative three years ended 2005.
Total deferred tax assets and liabilities are composed of the following at December 31:
Retirement benefits
Allowance for doubtful accounts
Insurance and litigation reserves
Postretirement benefits
Supplemental retirement benefits
Performance incentives
Alternative minimum tax carryforward
Vacation pay
Insurance settlement
Operating loss carryforward
Foreign tax credit
Deferred compensation
Other
Valuation allowance
Total deferred income tax assets, net
Europe pension and other
Total deferred income tax liabilities
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The following is a reconciliation of income taxes at the Federal statutory rate with income taxes recorded by the Company for the years ended December 31:
Income tax provision at the Federal statutory tax rate
State income tax provisions, net
Non-deductible entertainment and business meal expense
Differences in tax rates on foreign earnings and remittances
Excess FTC utilization
Settlement of tax contingencies
Miscellaneous items, net
At December 31, 2005, the Company domestically had a net deferred tax asset of $15,322 inclusive of alternative minimum tax (AMT) credits of $2,092. Additionally the Company has foreign tax credit carryovers of $1,404 which have the following expiration dates: $106 in 2012, $763 in 2013 and $535 in 2014. A full valuation allowance has been taken against these foreign tax credits. Finally, the Company has foreign tax loss carryforwards of $10,429 which have no expiration dates. A partial valuation allowance, based on estimates of future taxable income in each jurisdiction in which the Company operates, has been established with respect to the tax benefit of these losses for $597.
U.S. income taxes have not been provided on the undistributed earnings of non-U.S. subsidiaries because it is the Company’s intention to continue to reinvest these earnings in those subsidiaries to support growth initiatives. U.S. and foreign income taxes that would be payable if such earnings were distributed may be lower than the amount computed at the U.S. statutory rate due to the availability of tax credits. The amount of such undistributed earnings at December 31, 2005 was approximately $27,000. Any income tax liability which might result from ultimate remittance of these earnings is expected to be substantially offset by foreign tax credits.
Note 9—Pension and Other Postretirement Benefits
The Company maintains various noncontributory retirement plans, the largest of which is in the U.S., covering substantially all of its employees in the U.S. and certain other countries. The plans of the Company’s subsidiaries in The Netherlands and in the United Kingdom are subject to the provisions of SFAS No. 87, “Employers’ Accounting for Pensions.” The plans of the remaining non-U.S. subsidiaries are, for the most part, either fully insured or integrated with the local governments’ plans and are not subject to the provisions of SFAS No. 87. The Company’s U.S. pension plan year ends on November 30, which serves as the measurement date. The measurement date for the Company’s postretirement benefits is December 31.
In 2003, the Company adopted SFAS No. 132 (revised 2003), “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” This statement retains the disclosure requirement contained in the original standard and requires additional disclosures about the assets, obligations, cash flows and net periodic cost of defined benefit postretirement plans.
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As part of the Company’s 2005 fourth quarter restructuring program, the Company implemented a freeze of its U.S. pension plan for non-union employees and offered a voluntary early retirement window with enhanced pension and other postretirement benefits. The freeze of the Company’s U.S. pension plan resulted in a plan curtailment charge of $2,668. The pension and other postretirement benefits enhancements resulted in special termination benefits charges of $1,205 and $430, respectively. See also Note 2 of Notes to Consolidated Financial Statements.
The following table shows the Company plans’ funded status reconciled with amounts reported in the consolidated balance sheet as of December 31:
Change in benefit obligation
Benefit obligation at beginning of year
Service cost
Interest cost
Curtailment (gain)/loss
Special termination benefits
Amendments
Translation difference
Actuarial (gain)/loss
Benefits paid
Benefit obligation at end of year
Change in plan assets
Fair value of plan assets at beginning of year
Actual return on plan assets
Employer contribution
Plan participants’ contributions
Fair value of plan assets at end of year
Funded status
Unrecognized transition asset
Unrecognized (gain)/loss
Unrecognized prior service cost
Adjustments for contributions in December
Net amount recognized
Amounts recognized in the balance sheet consist of:
Prepaid benefit cost
Accrued benefit obligation
Intangible asset
Accumulated other comprehensive income
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At December, 31, 2005 and 2004, the accumulated benefit obligation for all defined benefit pension plans was $103,247 ($66,040 Domestic, $37,207 Foreign) and $95,634 ($58,063 Domestic, $37,571 Foreign).
Information for pension plans with accumulated benefit obligation in excess of plan assets:
Projected benefit obligation
Accumulated benefit obligation
Fair value of plan assets
Components of Net Periodic Benefit Cost—Pension Plans
Expected return on plan assets
Pension plan curtailment
Other, amortization, net
Net periodic benefit cost
Components of Net Periodic Benefit Cost—Other Postretirement Plan
Service Cost
Interest cost and other
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Additional Information
Increase (decrease) in minimum liability included in other comprehensive income
Weighted-average assumptions used to determine benefit obligations at December 31:
U.S. Plans:
Rate of compensation increase
Foreign Plans:
Weighted-average assumptions used to determine net periodic benefit costs for years ended December 31:
Expected long-term return on plan assets
The long-term rates of return on assets were selected from within the reasonable range of rates determined by (a) historical real returns for the asset classes covered by the investment policy and (b) projections of inflation over the long-term period during which benefits are payable to plan participants.
Assumed health care cost trend rates at December 31:
Health care cost trend rate for next year
Rate to which the cost trend rate is assumed to decline (the ultimate trend rate)
Year that the rate reaches the ultimate trend rate
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Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
1% point
Increase
Decrease
Effect on total service and interest cost
Effect on postretirement benefit obligations
Plan Assets
The Company’s pension plan strategic target asset allocation and the weighted-average asset allocations at December 31, 2005 and 2004, by asset category were as follows:
Asset Category
U.S. Plans
Equity securities
Debt securities
Foreign Plans
The general principles guiding investment of U.S. pension assets are those embodied in the Employee Retirement Income Security Act of 1974 (ERISA). These principles include discharging the Company’s investment responsibilities for the exclusive benefit of plan participants and in accordance with the “prudent expert” standard and other ERISA rules and regulations. The Company establishes strategic asset allocation percentage targets and appropriate benchmarks for significant asset classes with the aim of achieving a prudent balance between return and risk. The interaction between plan assets and benefit obligations is periodically studied to assist in establishing such strategic asset allocation targets. The Company’s pension investment professionals have discretion to manage the assets within established asset allocation ranges approved by senior management of the Company.
The total value of plan assets for the Company’s pension plans is $72,387 and $69,208 as of December 31, 2005 and 2004, respectively. U.S. pension assets include Company common stock in the amounts of $179 (1% of total U.S. plan assets), and $242 (1% of total U.S. plan assets) at December 31, 2005 and 2004, respectively. “Other” consists principally of hedge funds and cash and cash equivalents.
Cash Flows
Contributions
The Company expects to make minimum cash contributions of $8,024 to its pension plans ($5,539 Domestic, $2,485 Foreign) and $1,124 to its other postretirement benefit plan in 2006.
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Estimated Future Benefit Payments
The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid:
Postretirement
Benefits
The Company maintains a plan under which supplemental retirement benefits are provided to certain officers. Benefits payable under the plan are based on a combination of years of service and existing postretirement benefits. Included in total pension costs are charges of $725, $827, and $626 in 2005, 2004, and 2003, respectively, representing the annual accrued benefits under this plan.
401(k) plan
The Company has a 401(k) plan with an employer match covering substantially all domestic employees. The Company’s 401(k) matching contributions were $625, $575, and $546 for 2005, 2004, and 2003, respectively.
Note 10—Debt
Debt consisted of the following:
6.98% senior unsecured notes
Industrial development authority monthly floating rate (3.15% at December 31, 2005) demand bonds maturing 2014
Credit facilities (4.42% weighted average borrowing rate at December 31, 2005)
Other debt obligations (including capital leases)
Current portion of long-term debt
The long-term financing agreements require the maintenance of certain financial covenants with which the Company is in compliance. During the next five years, payments on the Company’s debt, including capital lease maturities, are due as follows: $5,094 in 2006, $893 in 2007, $935 in 2008, $448 in 2009, and $59,788 in 2010.
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Throughout 2004, the Company maintained various short-term credit facilities with multiple banks. At December 31, 2004, the Company’s short-term credit facilities totaled $95,000, of which $40,000 was committed and $55,000 was uncommitted.
In September 2005, the Company repaid its senior unsecured notes due in 2007. The total amount of principal repaid was $8,572. In October 2005, the Company entered into a new syndicated multi-currency credit agreement that provides for financing in the United States and the Netherlands. This facility enabled the Company to consolidate the majority of its short-term debt into a longer-term facility. The new facility terminates on September 30, 2010. The new facility allows for revolving credit borrowings in a principal amount of up to $100,000, which can be increased to $125,000 at the Company’s option if lenders agree to increase their commitments and the Company satisfies certain conditions. In general, borrowings under the credit facility bear interest at either a base rate or LIBOR rate plus a margin based on the Company’s consolidated leverage ratio.
The provisions of the agreements require that the Company maintain certain financial ratios and covenants, all of which the Company was in compliance with as of December 31, 2005 and 2004. Under its most restrictive covenants, the Company could have borrowed an additional $32,874 at December 31, 2005. At December 31, 2005 and 2004, the Company had approximately $63,766 and $57,124 outstanding on these credit lines at a weighted average borrowing rate of 4.42% and 2.9%, respectively. As of December 31, 2005, the Company maintained a $5,135 stand-by letter of credit which guarantees payment of the industrial development authority bonds. This letter of credit is renewed annually.
At December 31, 2005, the amounts at which the Company’s debt are recorded are not materially different from their fair market value. The estimated fair value of the Company’s senior unsecured notes, based on quoted market prices for similar issues of the same remaining maturities, was approximately $8,972 at December 31, 2004.
Note 11—Shareholders’ Equity
The Company has 30,000,000 shares of common stock authorized, with a par value of $1, and 9,726,385 shares issued.
Holders of record of the Company’s common stock for a period of less than 36 consecutive calendar months or less are entitled to 1 vote per share of common stock. Holders of record of the Company’s common stock for a period greater than 36 consecutive calendar months are entitled to 10 votes per share of common stock.
The Company is authorized to issue 10,000,000 shares of preferred stock, $1.00 par value, subject to approval by the Board of Directors. The Board of Directors may designate one or more series of preferred stock and the number of shares, rights, preferences, and limitations of each series. No preferred stock has been issued.
Under provisions of a stock purchase plan, which permits employees to purchase shares of stock at 85% of the market value, 17,440 shares, 13,084 shares, and 13,358 shares were issued in 2005, 2004, and 2003, respectively. The number of shares that may be purchased by an employee in any year is limited by factors dependent upon the market value of the stock and the employee’s base salary. At December 31, 2005, 432,431 shares are available for purchase.
The Company has a long-term incentive program for key employees which provides for the granting of options to purchase stock at prices not less than market value on the date of the grant. Most options are
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exercisable between one and three years after the date of the grant for a period of time determined by the Company not to exceed seven years from the date of grant for options issued in 1999 or later and ten years for options issued in prior years. The program also provides for cash awards and commencing in 1999, common stock awards, the value of which is determined based on operating results over a three-year period for awards issued starting in 1999, and over a four-year period in prior years. The effect on operations of the change in the estimated value of incentive units during the year was $(44), $82, and $(45) in 2005, 2004, and 2003, respectively.
The table below summarizes stock option transactions in the plan during 2005, 2004, and 2003:
Options outstanding at January 1,
Options granted
Options exercised
Options expired
Options outstanding at December 31,
Options exercisable at December 31,
The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:
Dividend yield
Expected volatility
Risk-free interest rate
Expected life (years)
The following table summarizes information about stock options outstanding at December 31, 2005:
Options Outstanding
Range of
Exercise Prices
$13.30—$15.96
15.97— 18.62
18.63— 21.28
21.29— 23.94
23.95— 26.60
Options were exercised for cash, resulting in the net issuance of 27,640 shares in 2005 and 46,050 shares in 2004. Options to purchase 163,590 shares were available at December 31, 2005 for future grants.
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Shareholders of record on February 20, 1990 received two stock purchase rights for each three shares of common stock outstanding. These rights expired on February 20, 2000. On March 6, 2000, the Company’s Board of Directors approved a new Rights Plan and declared a dividend of one new right (the “Rights”) for each outstanding share of common stock to shareholders of record on March 20, 2000.
The Rights become exercisable if a person or group acquires or announces a tender offer which would result in such person’s acquisition of 20% or more of the Company’s common stock.
Each Right, when exercisable, entitles the registered holder to purchase one one-hundredth of a share of a newly authorized Series B preferred stock at an exercise price of sixty-five dollars per share subject to certain anti-dilution adjustments. In addition, if a person or group acquires 20% or more of the outstanding shares of the Company’s common stock, without first obtaining Board of Directors’ approval, as required by the terms of the Rights Agreement, each Right will then entitle its holder (other than such person or members of any such group) to purchase, at the Right’s then current exercise price, a number of one one-hundredth shares of Series B preferred stock having a total market value of twice the Right’s exercise price.
In addition, at any time after a person acquires 20% of the outstanding shares of common stock and prior to the acquisition by such person of 50% or more of the outstanding shares of common stock, the Company may exchange the Rights (other than the Rights which have become null and void), in whole or in part, at an exchange ratio of one share of common stock or equivalent share of preferred stock, per Right.
The Board of Directors can redeem the Rights for $.01 per Right at any time prior to the acquisition by a person or group of beneficial ownership of 20% or more of the Company’s common stock. Until a Right is exercised, the holder thereof will have no rights as a shareholder of the Company, including without limitation, the right to vote or to receive dividends. Unless earlier redeemed or exchanged, the Rights will expire on March 20, 2010.
Restricted stock bonus: As part of the Company’s 2001 Global Annual Incentive Plan (“Annual Plan”), approved by shareholders on May 9, 2001, a restricted stock bonus of 100,000 shares of the Company’s stock was granted to an executive of the Company. The shares were issued in April 2001, in accordance with the terms of the Annual Plan, and registered in the executive’s name. The shares vested over a five-year period, with the first installment vesting at the end of 2001 on achieving certain performance targets and the four remaining installments vesting annually in January thereafter, subject to the executive’s continued employment by the Company. In 2005, 2004 and 2003, 20,000, 15,000 and 35,000 shares were earned and $355, $266 and $624 was charged to selling, general, and administrative expenses, respectively.
Note 12—Earnings Per Share
The following table summarizes earnings per share (“EPS”) calculations for the years ended December 31, 2005, 2004, and 2003:
Numerator for basic EPS and diluted EPS—net income
Denominator for basic EPS—weighted average shares
Effect of dilutive securities, primarily employee stock options
Denominator for diluted EPS—weighted average shares and assumed conversions
Basic EPS
Diluted EPS
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The following number of stock options are not included in dilutive earnings per share since in each case the exercise price is greater than the market price: 770, 177, and 0, in 2005, 2004, and 2003, respectively.
Note 13—Business Segments
Segment data includes direct segment costs as well as general operating costs, including depreciation, allocated to each segment based on net sales. Inter-segment transactions are immaterial.
The table below presents information about the reported segments for the years ended December 31:
2005
Segment assets
2004
2003
Segment Assets
Operating income comprises revenue less related costs and expenses. Nonoperating expenses primarily consist of general corporate expenses identified as not being a cost of operation, interest expense, interest income, and license fees from nonconsolidated associates.
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A reconciliation of total segment operating income to total consolidated income before taxes for the years ended December 31, 2005, 2004, and 2003 is as follows:
Total operating income for reportable segments
Restructuring and related charges, net
Non-operating charges
Depreciation of corporate assets and amortization
Consolidated income before taxes
The following sales and long-lived asset information is by geographic area as of and for the years ended December 31:
United States
Europe
Asia/Pacific
South America
South Africa
Consolidated
Long-lived assets
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Note 14—Business Acquisitions and Divestitures
In March 2005, the Company acquired the remaining 40% interest in its Brazilian joint venture for $6,700. In addition, annual $1,000 payments for four years will be paid subject to the former minority partners’ compliance with the terms of the purchase agreement. In connection with the acquisition, the Company allocated $1,475 to intangible assets, comprising customer lists of $600 to be amortized over 20 years and non-compete agreements of $875 to be amortized over five years. The Company also recorded $610 of goodwill, which was assigned to the metalworking process chemicals segment. The following table shows the allocation of purchase price of assets and liabilities recorded for this acquisition. The pro forma results of operations have not been provided because the effects were not material:
Fixed assets
Intangibles
Other non-current assets
Total Assets
Liabilities
Cash paid
Note 15—Goodwill and Other Intangible Assets
The Company completed its annual impairment assessment as of the end of the third quarter of 2005 and no impairment charge was warranted. The changes in carrying amount of goodwill for the twelve months ended December 31, 2005 and 2004 are as follows:
Balance as of December 31, 2003
Goodwill additions
Balance as of December 31, 2004
Balance as of December 31, 2005
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Gross carrying amounts and accumulated amortization for definite-lived intangible assets as of December 31 are as follows:
Gross Carrying
Amount
Accumulated
Amortized intangible assets
Customer lists and rights to sell
Trademarks and patents
Formulations and product technology
The Company recorded $1,368, $1,157 and $960 of amortization expense in 2005, 2004 and 2003 respectively. Estimated annual aggregate amortization expense for the subsequent five years is as follows:
For the year ended December 31, 2006
For the year ended December 31, 2007
For the year ended December 31, 2008
For the year ended December 31, 2009
For the year ended December 31, 2010
The Company has one indefinite-lived intangible asset of $600 for trademarks.
Note 16—Other Assets
Other assets comprise:
Restricted insurance settlement
Pension assets
Deferred compensation assets
Supplemental retirement income program
In December 2005, an inactive subsidiary of the Company reached a settlement agreement and release with one of its insurance carriers for $15,000. The proceeds of the settlement are restricted and can only be used to pay claims and costs of defense associated with this subsidiary’s asbestos litigation. The subsidiary received $7,500 in December 2005, which was deposited into an interest bearing account, and will receive an additional $7,500 in December 2006 unless Federal asbestos legislation is adopted. Both the subsidiary and the insurance company acknowledge that as of the effective date of the settlement agreement and release it appears unlikely that Federal asbestos legislation will be enacted into law prior to the scheduled December 2006 payment. However, if the President of the United States signs into law the Federal asbestos legislation, the insurance
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carrier’s obligation to make the second payment will be cancelled. The first payment of $7,500 earned $8 of interest from the time of receipt until the end of 2005. The restrictions regarding the use of proceeds lapse after a period of 15 years. Due to the restricted nature of the proceeds, a corresponding deferred credit was established in Other non-current liabilities for an equal and offsetting amount, and will remain until the restrictions lapse or the funds are exhausted via payments of claims and costs of defense. See Notes 17 and 18 of Notes to Consolidated Financial Statements.
Note 17—Other Non-Current Liabilities
Other (primarily deferred compensation agreements)
See also Notes 16 and 18 of Notes to Consolidated Financial Statements.
Note 18—Commitments and Contingencies
The Company is involved in environmental clean-up activities and litigation in connection with an existing plant location and former waste disposal sites operated by unaffiliated third parties. In April of 1992, the Company identified certain soil and groundwater contamination at AC Products, Inc. (“ACP”), a wholly owned subsidiary. Voluntarily in coordination with the Santa Ana California Regional Water Quality Board, ACP is remediating the contamination. The Company believes that the remaining potential-known liabilities associated with these matters range from approximately $1,200 to $1,500, for which the Company has sufficient reserves. Notwithstanding the foregoing, the Company cannot be certain that liabilities in the form of remediation expenses and damages will not be incurred in excess of the amount reserved.
On or about December 18, 2004, the Orange County Water District (“OCWD”) filed a civil complaint in Orange County Superior Court, California against ACP and other parties potentially responsible for groundwater contamination containing tetrachloroethylene and other compounds, including perchloroethylene (“PCE”). OCWD is seeking to recover compensatory and other damages related to the investigation and remediation of the contamination in the groundwater. AC Products seeks to defend this case vigorously on a number of bases including, most significantly, that it voluntarily investigated and remediated some or all of the PCE that appears to have originated at its facility. In cases such as these, parties often are allocated a percentage of responsibility for the damages awarded or agreed upon. At this point in the case, it is not possible to provide an estimate of the percentage of liability, if any, that AC Products ultimately may bear. Accordingly, it is not possible at this time to estimate the amount, if any, that ACP ultimately may be required to pay in settlement or to satisfy any adverse judgement as a result of the filing of this action or to assess whether the payment of such amount would be material to the Company.
Additionally, although there can be no assurance regarding the outcome of other environmental matters, the Company believes that it has made adequate accruals for costs associated with other environmental problems of which it is aware. Approximately $134 and $168 was accrued at December 31, 2005 and December 31, 2004, respectively, to provide for such anticipated future environmental assessments and remediation costs.
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An inactive subsidiary of the Company that was acquired in 1978 sold certain products containing asbestos, primarily on an installed basis, and is among the defendants in numerous lawsuits alleging injury due to exposure to asbestos. The subsidiary discontinued operations in 1991 and has no remaining assets other than its existing insurance policies and proceeds from an insurance settlement received in late 2005. To date, the overwhelming majority of these claims have been disposed of without payment and there have been no adverse judgements against the subsidiary. Based on a continued analysis of the existing and anticipated future claims against this subsidiary, it is currently projected that the subsidiary’s total liability over the next 50 years for these claims is approximately $10,100 (excluding costs of defense). Although the Company has also been named as a defendant in certain of these cases, no claims have been actively pursued against the Company and the Company has not contributed to the defense or settlement of any of these cases pursued against the subsidiary. These cases have been handled to date by the subsidiary’s primary and excess insurers who agreed to pay all defense costs and be responsible for all damages assessed against the subsidiary arising out of existing and future asbestos claims up to the aggregate limits of the policies. A significant portion of this primary insurance coverage was provided by an insurer that is now insolvent, and the other primary insurers have asserted that the aggregate limits of their policies have been exhausted. The subsidiary is challenging the applicability of these limits to the claims being brought against the subsidiary. In response to this challenge, one of these carriers entered into a settlement and release agreement with the subsidiary for $15,000. The proceeds of the settlement are restricted and can only be used to pay claims and costs of defense associated with the subsidiary’s asbestos litigation. The subsidiary has additional coverage under its excess policies. The Company believes, however, that if the coverage issues under the primary policies with the other carriers are resolved adversely to the subsidiary, the subsidiary’s insurance coverage will likely be exhausted. As a result, liabilities in respect of claims may exceed coverage available to the subsidiary. See also Notes 16 and 17 of Notes to Consolidated Financial Statements.
If the subsidiary’s assets and insurance coverage were to be exhausted, claimants of the subsidiary may actively pursue claims against the Company because of the parent-subsidiary relationship. Although asbestos litigation is particularly difficult to predict, especially with respect to claims that are currently not being actively pursued against the Company, the Company does not believe that such claims would have merit or that the Company would be held to have liability for any unsatisfied obligations of the subsidiary as a result of such claims. After evaluating the nature of the claims filed against the subsidiary and the small number of such claims that have resulted in any payment, the potential availability of additional insurance coverage at the subsidiary level, the additional availability of the Company’s own insurance and the Company’s strong defenses to claims that it should be held responsible for the subsidiary’s obligations because of the parent-subsidiary relationship, the Company believes it is not probable that the Company will incur any material losses.
The Company is party to other litigation which management currently believes will not have a material adverse effect on the Company’s results of operations, cash flows or financial condition.
The Company leases certain manufacturing and office facilities and equipment under non-cancelable operating leases with various terms from one to 25 years expiring in 2020. Rent expense for 2005, 2004, and 2003 was $5,165, $5,037, and $4,771, respectively. The Company’s minimum rental commitments under non-cancelable operating leases at December 31, 2005, were approximately $4,358 in 2006, $3,909 in 2007, $3,203 in 2008, $1,693 in 2009, $1,357 in 2010, and $7,153 thereafter.
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Note 19—Quarterly Results (unaudited)
Gross profit
Net income per share—basic
Net income per share—diluted
Conclusion regarding the Effectiveness of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “1934 Act”). Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this annual report.
Management’s Report on Internal Control over Financial Reporting
The management of Quaker is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) promulgated under the 1934 Act. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.
Our management, with the participation of our principal executive officer and principal financial officer, assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework. Based on its assessment, Quaker’s management has concluded that as of December 31, 2005, the Company’s internal control over financial reporting is effective based on those criteria.
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PricewaterhouseCoopers LLP, the independent registered public accounting firm that audited the financial statements included in Item 8 of this Report, has included in its Report of Independent Registered Public Accounting Firm, included in Item 8, its attestation report on management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, which is incorporated herein by this reference.
Changes in Internal Controls Over Financial Reporting
The Company is in the process of implementing a global ERP system. At the end of 2005, subsidiaries representing more than 60% of consolidated revenue were operational on the global ERP system. Additional subsidiaries and CMS sites are planned to be implemented during 2006. The Company is taking the necessary steps to monitor and maintain the appropriate internal controls during this period of change.
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PART III
Incorporated by reference is (i) the information beginning immediately following the caption “Proposal 1—Election of Directors and Nominee Biographies” in the Registrant’s definitive Proxy Statement relating to the Annual Meeting of Shareholders to be held May 10, 2006 to be filed with the SEC no later than 120 days after the close of its fiscal year ended December 31, 2005 (the “2006 Proxy Statement”) to, but not including, the caption “Compensation of Directors,” (ii) the information in the 2006 Proxy Statement beginning immediately following the caption “Board Committees and Meeting Attendance” to, but not including, the caption “Proposal 2-Approval of the 2001 Global Annual Incentive Plan,” (iii) the information in the 2006 Proxy Statement beginning with and including the caption, “Section 16(a) Beneficial Ownership Reporting Compliance” to, but not including the caption “General,” and (iv) the information appearing in Item 4(a) of this Report.
In addition to the information incorporated by reference from the 2006 Proxy Statement, Mr. Robert P. Hauptfuhrer (Age 74), who has been a director of the Registrant since 1977, has reached the mandatory retirement age and therefore is not eligible for reelection as a director. Mr. Hauptfuhrer is the former Chairman of the Board and Chief Executive Officer of Oryx Energy Company.
The Company has a compliance program, the governing documents of which include a Code of Conduct (which is applicable to all of the Company’s directors, executive officers and employees) and a Financial Code of Ethics for Senior Financial Officers (which is applicable to the Chief Executive Officer, Chief Financial Officer, Global Controller, Controllers of each of the Company’s majority-owned affiliates, Assistant Global Controller, and other individuals performing similar functions designated by the Company’s Board of Directors). The Audit Committee oversees the administration of the program and is directly responsible for the disposition of all reported violations of the Financial Code of Ethics for Senior Financial Officers and complaints received regarding accounting, internal accounting controls, or audit matters. In addition, the Audit Committee approves any waivers to the Code of Conduct for directors and executive officers. The Code of Conduct, Financial Code of Ethics for Senior Financial Officers, Corporate Governance Guidelines and Audit, Compensation/Management Development and Governance Committee Charters have been posted on and are available free of charge by accessing the Investors—Corporate Governance section of our Web site at http://www.quakerchem.com or by written request addressed to Quaker Chemical Corporation, One Quaker Park, 901 Hector Street, Conshohocken, PA 19428 to the attention of Irene Kisleiko, Assistant Secretary of the Company.
The Board has affirmatively determined that three of the four members of the Audit Committee, including its current Chairman, William R. Cook, meet the criteria for an “audit committee financial expert” as defined in Item 401 of SEC Regulation S-K. Each member of the Audit Committee, including Mr. Cook, is “independent” as defined in the listing standards of the New York Stock Exchange.
Incorporated by reference is the information in the 2006 Proxy Statement (i) beginning immediately following the caption “Compensation of Directors” to, but not including, the caption “Board Committees and Meeting Attendance,” (ii) beginning immediately following the caption “Executive Compensation” to, but not including, the caption “Report of the Compensation/Management Development Committee on Executive Compensation” and (iii) immediately following the caption “Compensation Committee Interlocks and Insider Participation” to, but not including, the caption “Report of the Audit Committee.”
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Incorporated by reference is the information in the 2006 Proxy Statement beginning immediately following the caption “Stock Ownership of Certain Beneficial Owners and Management” to, but not including, the subcaption “Section 16(a) Beneficial Ownership Reporting Compliance.”
The following table sets forth certain information relating to the Company’s equity compensation plans as of December 31, 2005. Each number of securities reflected in the table is a reference to shares of Quaker common stock.
Equity Compensation Plans
Equity Compensation Plan Information
Plan Category
Equity compensation plans approved by security holders
Equity compensation plans not approved by security holders
No information is required to be provided in response to this Item 13.
Incorporated by reference is the information in the 2006 Proxy Statement beginning with the subcaption “Audit Fees” to, but not including the statement recommending a vote for ratification of the Company’s independent auditors.
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PART IV
(a) Exhibits and Financial Statement Schedules
All schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.
Financial statements of 50% or less owned companies have been omitted because none of the companies meets the criteria requiring inclusion of such statements.
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(b) Exhibits required by Regulation 601 S-K
See (a) 3 of this Item 15
(c) Financial Statement Schedules
See (a) 2 of this Item 15
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Registrant
By:
Date: March 13, 2006
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signatures
Capacity
Date
/s/ RONALD J. NAPLES
Ronald J. Naples
Chairman of the Board and Chief Executive Officer
Principal Executive Officer and Director
/s/ NEAL E. MURPHY
Neal E. Murphy Vice President, Chief Financial Officer and Treasurer
Principal Financial Officer
/s/ MARK A. FEATHERSTONE
Mark A. Featherstone
Principal Accounting Officer
/s/ JOSEPH B. ANDERSON, JR.
Joseph B. Anderson, Jr.
Director
Patricia C. Barron
/s/ DONALD R. CALDWELL
Donald R. Caldwell
/s/ ROBERT E. CHAPPELL
Robert E. Chappell
/s/ WILLIAM R. COOK
William R. Cook
/s/ EDWIN J. DELATTRE
Edwin J. Delattre
/s/ ROBERT P. HAUPTFUHRER
Robert P. Hauptfuhrer
/s/ ROBERT H. ROCK
Robert H. Rock
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