UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549
_______________
FORM 10-Q
(Mark One)
[ X ]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 for the quarterly period ended September 30, 2005
OR
[ ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 for the transition period from ___________________ to ___________________
Commission file number: 1-13888
GRAFTECH INTERNATIONAL LTD.
(Exact name of registrant as specified in its charter)
Delaware
(State or other jurisdiction of
incorporation or organization)
06-1385548
(I.R.S. Employer
Identification Number)
1521 Concord Pike
Brandywine West, Suite 301
Wilmington, DE
(Address of principal executive offices)
19803
(Zip code)
Registrant’s telephone number, including area code: (302) 778-8227
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes [ X ]
No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes [ ]
No [ X ]
As of September 30, 2005, 97,776,354 shares of common stock, par value $.01 per share, were outstanding.
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION:
Item 1. Financial Statements:
Consolidated Balance Sheets at December 31, 2004 and September 30, 2005 (unaudited)
Page 3
Consolidated Statements of Operations for the Three Months and Nine Months ended September 30, 2004 and 2005 (unaudited)
Page 4
Consolidated Statements of Cash Flows for the Nine Months ended September 30, 2004 and 2005 (unaudited)
Page 5
Consolidated Statements of Stockholders’ Deficit for the Year ended December 31, 2004 and the Nine Months ended September 30, 2005 (unaudited)
Page 7
Notes to Consolidated Financial Statements (unaudited)
Page 8
Introduction to Part I, Item 2, and Part II, Item 1
Page 32
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Page 37
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Page 58
Item 4. Controls and Procedures
Page 62
PART II. OTHER INFORMATION:
Item 1. Legal Proceedings
Page 63
Item 6. Exhibits
SIGNATURE
Page 64
EXHIBIT INDEX
Page 65
2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
GRAFTECH INTERNATIONAL LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in millions, except share data)
(Unaudited)
See accompanying Notes to Consolidated Financial Statements
3
PART I (CONT’D)
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in millions, except share and per share data)
4
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in millions)
5
6
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ DEFICIT
7
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
These interim Consolidated Financial Statements are unaudited; however, in the opinion of management, they have been prepared in accordance with Rule 10-01 of Regulation S-X adopted by the SEC and reflect all adjustments (all of which are of a normal, recurring nature) which management considers necessary for a fair statement of financial position, results of operations and cash flows for the periods presented. These interim Consolidated Financial Statements should be read in conjunction with the audited Consolidated Financial Statements, including the accompanying Notes, contained in our Annual Report on Form 10-K for the year ended December 31, 2004 (the “Annual Report”). Results of operations for the three months and nine months ended September 30, 2005 are not necessarily indicative of the results of operations that may be expected for any other interim period or for the entire year ending December 31, 2005.
Certain amounts in the Consolidated Financial Statements for the three months and nine months ended September 30, 2004 and for the year ended December 31, 2004 have been reclassified to conform with current period presentation.
(2)
New Accounting Standards
On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Share-Based Payment (“SFAS 123(R)”). SFAS No. 123(R) revises SFAS No. 123, Accounting for Stock-Based Compensation, and requires companies to expense the fair value of employee stock options and other forms of stock-based compensation. Under SFAS No. 123(R), companies are to (1) use fair value to measure stock-based compensation awards and (2) cease using the “intrinsic value” method of accounting, which Accounting Principals Board Opinion (“APB”) 25 allowed and resulted in no expense for many awards of stock options for which the exercise price of the option equaled the price of the underlying stock at the grant date. In addition, SFAS No. 123(R) retains the modified grant date model from SFAS No. 123. Under that model, compensation cost is measured at the grant date and adjusted to reflect actual forfeitures and the outcome of certain conditions. The fair value of an award is not remeasured after its initial estimation on the grant date (except in the case of a liability award or if the award is modified). This Statement is effective for annual periods beginning after June 15, 2005. We will be required to adopt SFAS No. 123(R) in the first quarter of 2006. The actual impact of the adoption of SFAS No. 123(R) will depend upon the amount, nature and type of stock-based compensation awards outstanding upon implementation and that we may issue in the future. Based on the current stock-based compensation plans in effect, and awards issued, our estimated expense in 2006 for stock-based compensation is $7 million, $3 million of which relates to the 2005 restricted stock grants and $4 million of which relates to unvested stock options.
On August 31, 2005, the FASB staff issued FASB Staff Position (“FSP”) No. FAS 123(R)-1, Classification and Measurement of Freestanding Financial Instruments Originally Issued in Exchange for Employee Services under FASB Statement No. 123(R), which defers, at this time, the requirement of FASB Statement No. 123 (revised 2004), Share-Based Payment, that a freestanding financial instrument originally subject to SFAS 123(R) becomes subject to the
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recognition and measurement requirements of other applicable generally accepted accounting principles (“GAAP”) when the rights conveyed by the instrument to the holder are no longer dependent on the holder being an employee of the entity. It is the current Staff position that a freestanding financial instrument issued to an employee in exchange for past or future employee services that is subject to SFAS 123(R) or was subject to SFAS 123(R) upon initial adoption of that Statement shall continue to be subject to the recognition and measurement provisions of SFAS 123(R) throughout the life of the instrument, unless its terms are modified when the holder is no longer an employee. The guidance in this FSP supersedes FSP EITF 00-19-1, Application of EITF Issue No. 00-19 to Freestanding Financial Instruments Originally Issued as Employee Compensation, and amends paragraph 11(b) of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, and SFAS 133 Implementation Issue No. C3, Scope Exceptions: Exception Related to Share-Based Payment Arrangements. The adoption of this FSP will not have a significant impact on our consolidated results of operations or financial position.
In May 2005, the FASB directed the FASB staff to issue Application of Emerging Issues Task Force (“EITF”) Issue No. 00-19 to Freestanding Financial Instruments Originally Issued as Employee Compensation to clarify the application of EITF Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock. This FASB Staff Position clarifies that a requirement to deliver registered shares, in and of itself, will not result in liability classification for freestanding financial instruments originally issued as employee compensation. This clarification is consistent with the FASB’s intent in issuing SFAS No. 123(R), Share-Based Payment. The adoption of this Position will not have a significant impact on our consolidated results of operations or financial position.
SFAS No.133 Implementation Issue No. B39 was posted by the FASB in June 2005. This Issue addresses circumstances in which an embedded call option (including a prepayment option) that can accelerate the settlement of a hybrid instrument containing a debt host contract, would not be subject to the conditions in paragraph 13(b) of SFAS No. 133. The FASB concluded that the conditions in paragraph 13(b) do not apply to an embedded call option in a hybrid instrument containing a debt host contract if the right to accelerate the settlement of the debt can be exercised only by the debtor (issuer/borrower). Issue No. B39 will be effective for the first day of the first fiscal quarter beginning after December 15, 2005. The adoption of Issue No. B39 will not have any impact on our consolidated results of operations or financial position.
In May 2005, FASB issued SFAS No. 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3, which changes the requirements for the accounting for and reporting of a change in accounting principle. This Statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. This Statement requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. This Statement defines retrospective application as the application of a different accounting principle to prior accounting periods as if that principle had always been used or as the adjustment of
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previously issued financial statements to reflect a change in the reporting entity. This Statement also redefines restatement as the revising of previously issued financial statements to reflect the correction of an error. This Statement shall be effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We will adopt this Statement effective January 1, 2006. Based on our current evaluation of this Statement, we do not expect the adoption of SFAS No. 154 to have a significant impact on our consolidated results of operations or financial position.
In March 2005, the FASB issued FASB Interpretation (“FIN”) No. 47, Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143, which clarifies that the term “conditional asset retirement obligation” as used in SFAS No. 143, Accounting for Asset Retirement Obligations, 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. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and/or method of settlement. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. The fair value of a liability for the conditional asset retirement obligation should be recognized when incurred. Uncertainty about the timing and/or method of settlement of a conditional asset retirement obligation should be factored into the measurement of the liability when sufficient information exists. FIN No. 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN No. 47 is effective no later than the end of fiscal years ending after December 15, 2005. We will adopt this Interpretation effective December 31, 2005. The adoption of this Interpretation will not have a significant impact on our consolidated results of operations or financial position.
In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets - an amendment of APB Opinion No. 29. This Statement amends APB 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153 is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. We adopted this Statement effective July 1, 2005. The adoption of SFAS No. 153 did not have a significant impact on our consolidated results of operations or financial position.
On November 24, 2004, the FASB issued SFAS No. 151, Inventory Costs - an amendment of APB No. 43, Chapter 4, which is the result of its efforts to converge U.S. accounting standards for inventories with International Accounting Standards. SFAS No. 151 requires abnormal amounts of idle facility expense, freight, handling costs and wasted material (spillage) to be recognized as current-period charges. It also requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Therefore, we are required to adopt this Statement effective January 1, 2006. We are currently in the process of assessing the impact of the adoption of SFAS No. 151 on our consolidated results of operations and financial position.
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(3)
Stock-Based Compensation
At September 30, 2005, we had several stock-based compensation plans. We account for those plans under the recognition and measurement principles of ABP No. 25, Accounting for Stock issued to Employees, and related interpretations. Compensation expense associated with our restricted stock grants (see below for a description) has been recorded in the Consolidated Statements of Operation and in the stockholders’ deficit section of the Consolidated Balance Sheet. No compensation expense has been recognized for our time vesting options granted with exercise prices at not less than market price on the date of grant. If compensation expense for those plans was determined by the fair value method prescribed by SFAS No. 123, Accounting for Stock Based Compensation, our net income and earnings per share would have been decreased to the pro forma amounts indicated in the following table:
The GrafTech International Ltd. 2005 Equity Incentive Plan (“the 2005 Plan”) was approved in the second quarter of 2005. The 2005 Plan provides that the GrafTech Management Stock Incentive Plan (Original Version), Management Stock Incentive Plan (Senior Version), Management Stock Incentive Plan (Mid-Management Version), 1995 Equity Incentive Plan and 1996 Mid-Management Equity Incentive Plan (collectively, the “existing plans”) are frozen and will remain in effect only to the extent of awards outstanding under such existing plans on May 25, 2005. The 2005 Plan initially covers 4,800,000 shares. Shares under the existing plan are added to and become available for awards under the 2005 Plan to the extent (but only to the extent) that stock options or stock grants outstanding on May 25, 2005 under the existing plans expire or are canceled or forfeited before they are exercised or vest, respectively, and limited to the extent of the current outstanding awards.
In the second and third quarter of 2005, under the 2005 Plan, we granted 455,907 shares of restricted stock to employees at share prices ranging between $3.80-$5.24. Such grants are time-vested grants, vesting two years from the date of grant.
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In the third quarter of 2005, under the 2005 Plan, we granted 832,000 shares of restricted stock to employees at a share price of $5.94. Such grants are time-vested grants, with one-third of the grant vesting on the anniversary date of the grant in each of the next three years.
(4)
Earnings Per Share
Basic and diluted EPS are calculated based upon the provisions of SFAS No. 128, Earnings Per Share, and EITF No. 04-08, Accounting Issues Related to Certain Features of Contingently Convertible Debt and the Effects on Diluted Earnings Per Share, using the following data:
Basic earnings per common share are calculated by dividing net income by the weighted average number of common shares outstanding. Diluted earnings per share are calculated by dividing net income by the sum of the weighted average number of common shares outstanding plus the additional common shares that would have been outstanding if potentially dilutive securities, including those underlying the Debentures, had been issued. As a result of the net loss reported for the third quarter of 2004, 1,498,615 of potential common shares underlying dilutive securities have been excluded from the calculation of diluted earnings (loss) per share in the third quarter of 2004 because their effect would reduce the loss per share.
The calculation of weighted average common shares outstanding for the diluted calculation excludes consideration of stock options covering 4,146,862 and 3,616,367 shares in the third quarter of 2004 and 2005, respectively, and 4,061,875 and 9,538,959 shares in the first nine months of 2004 and 2005, respectively, because the exercise of these options would not have been dilutive for those periods due to the fact that the exercise prices were greater than the weighted average market price of our common stock for each of those periods.
The calculation of weighted average common shares outstanding for the diluted calculation also excludes the 13,570,560 shares underlying the Debentures for the three months and nine months ended September 30, 2004, as the effect would have been anti-dilutive.
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(5)
Segment Reporting
In accordance with SFAS No. 131, our businesses are segregated into the following reportable segments: Synthetic Graphite, which consists of graphite electrodes, cathodes and advanced graphite materials and related services, and Other, which consists of natural graphite, carbon electrodes and refractories and related services.
We evaluate the performance of our operating segments based on gross profit. Intersegment sales and transfers are not material. The accounting policies of the reportable segments are the same as those for our Consolidated Financial Statements as a whole.
The following tables summarize financial information concerning our reportable segments.
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(6)
Restructuring Charges and Impairment Losses
At September 30, 2005, the outstanding balance of our restructuring reserve was $4 million. We expect to make $1 million of these payments by the end of 2005, with the majority of the remaining payments to be paid by the end of 2007. The components of the balance at September 30, 2005 consisted primarily of:
Synthetic Graphite Segment:
•
$2 million related to the closure of our graphite electrode manufacturing operations in Caserta, Italy;
$1 million related to the closure of our graphite electrode manufacturing operations in Welland, Canada; and
Other Segment:
$1 million related primarily to remaining lease payments on our former corporate headquarters.
In the third quarter of 2005, we recorded a nominal charge associated with the phase out of our graphite electrode machining operations in Clarksville, Tennessee, scheduled for completion in the third quarter of 2006, and the closure of our administrative offices in Clarksville, scheduled for completion at the end of the first quarter of 2006. The total program cost is expected to be approximately $2 million and will be expensed and paid over the remainder of 2005 and 2006.
In the third quarter of 2004, we recorded a net restructuring benefit of $3 million, primarily due to a $4 million reduction in restructuring cost estimates associated with the closure of our graphite electrode operations in Caserta, Italy, partially offset by a $1 million charge relating primarily to severance programs and related benefits associated with the closure of our advanced graphite machining operations in Sheffield, United Kingdom.
During the second quarter of 2004, we recorded a $3 million charge primarily associated with the completion of severance agreements for approximately two-thirds of the employees terminated in connection with the closure of our Italian graphite electrode manufacturing facility.
During the first quarter of 2004, we recorded a $1 million charge primarily associated with changes in estimates related to U.S. voluntary and selective severance programs.
The restructuring accrual is included in other accrued liabilities and other long-term obligations on the Consolidated Balance Sheets. The following table summarizes year-to-date activity relating to the accrual:
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(7)
Other (Income) Expense, Net
The following table presents an analysis of other (income) expense, net:
We have non-dollar-denominated intercompany loans between GrafTech Finance and some of our foreign subsidiaries. At December 31, 2004 and September 30, 2005, the aggregate principal amount of these loans was $477 million and $422 million, respectively. These loans are subject to remeasurement gains and losses due to changes in currency exchange rates. A portion of these loans are deemed to be essentially permanent and, as a result, remeasurement gains and losses on these loans are recorded as a component of accumulated other comprehensive loss in the stockholders’ deficit section of the Consolidated Balance Sheets. The balance of these loans are deemed to be temporary and, as a result, remeasurement gains and losses on these loans are recorded as currency (gains) losses in other income (expense), net, on the Consolidated Statements of Operations. In the first nine months of 2004, we had a net total of $2 million of currency losses, including $3 million of exchange losses due to the remeasurement of intercompany loans and translation of financial statements of foreign subsidiaries which use the dollar as their functional currency. In the first nine months of 2005, we had a net total of $12 million of currency losses, majority of which pertains to exchange
15
losses due to the remeasurement of intercompany loans and translation of financial statements of foreign subsidiaries which use the dollar as their functional currency.
(8)
Benefit Plans
The components of our consolidated net pension and postretirement costs (benefits) are set forth in the following tables:
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(9)
Long-Term Debt and Liquidity
The following table presents our long-term debt:
*
Fair value adjustments for terminated hedge instruments will be amortized as a credit to interest expense over the remaining term of the Senior Notes.
**
Excludes the derivative liability relating to our redemption feature with a make-whole provision, which amounts to $4 million at December 31, 2004 and $1 million at September 30, 2005 and is included in other long-term obligations on the Consolidated Balance Sheets.
(10)
Inventories
Inventories are comprised of the following:
17
(11)
Interest Expense
The following table presents an analysis of interest expense:
During the first quarter of 2005, we terminated $15 million notional amount of undesignated swaps and paid a nominal fee. During the second quarter of 2005, we terminated $285 million notional amount of swaps and paid $5 million. As a result of these transactions, at September 30, 2005, we had $150 million notional amount of swaps for the remaining term of the Senior Notes.
During the first quarter of 2005, we sold $350 million notional amount of interest rate caps. As a result of these transactions, at September 30, 2005, we had interest rate caps for a notional amount of $150 million.
(12)
Income Taxes
The State of Ohio enacted a tax law change on June 30, 2005. The new law will phase out the current income/franchise tax over five years. Due to this change, the deferred tax asset associated with an Ohio state net operating loss is not expected to be fully recoverable. Therefore, we incurred a $1.6 million, non-cash, charge in the 2005 first nine months to record additional valuation allowance for the estimated net operating losses that will expire unutilized.
During the 2004 third quarter, we implemented a tax election that accelerated approximately $215 million of taxable income in the U.S. through a standard election that resulted in the utilization of approximately $26 million of deferred tax assets, of which approximately $20 million were foreign tax credits. This resulted in a non-cash tax charge of $25 million in third quarter 2004. During the 2005 third quarter, we completed and filed our U.S. federal income tax return that included the 2004 third quarter tax election. As a result of completing the return, we identified adjustments required to our 2004 estimates resulting in a $5 million tax benefit in the 2005 third quarter.
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(13)
Contingencies
Antitrust Investigations
In 1997, the DOJ and the EU Competition Authority commenced investigations into alleged violations of the antitrust laws in connection with the sale of graphite electrodes. The antitrust authorities in Canada, Japan and Korea subsequently began similar investigations. The EU Competition Authority also commenced an investigation into alleged antitrust violations in connection with the sale of specialty graphite. These antitrust investigations have been finally resolved. Several of the investigations resulted in the imposition of fines against us. These fines, or payments in accordance with a payment schedule in the case of the DOJ antitrust fine, have been timely paid. At December 31, 2004 and September 30, 2005, $43 million and $31 million remained in the reserve for liabilities and expenses in connection with these antitrust investigations and related lawsuits and claims, respectively. The reserve is unfunded and represents the remaining DOJ antitrust fine obligation with quarterly payments scheduled through January 2007.
Antitrust Lawsuits
Through September 30, 2005, except as described in the following paragraphs, we have settled or obtained dismissal of all of the civil antitrust lawsuits (including class action lawsuits) previously pending against us, certain civil antitrust lawsuits threatened against us and certain possible civil antitrust claims against us arising out of alleged antitrust violations occurring prior to the date of the relevant settlements in connection with the sale of graphite electrodes, carbon electrodes and bulk graphite products. All payments due have been timely paid.
In 1999 and 2000, we and other producers of graphite electrodes were served with three complaints commencing three separate civil antitrust lawsuits in the United States District Court for the Eastern District of Pennsylvania (“EDPA District Court”.) In March 2002, we were served with another complaint commencing a separate civil antitrust lawsuit in the EDPA District Court. These lawsuits are called the “foreign customer lawsuits.” The first complaint, entitled Ferromin International Trade Corporation, et al. v. UCAR International Inc., et al., was filed by 27 steelmakers and related parties, all but one of whom are located outside the U.S. The second complaint, entitled BHP New Zealand Ltd. et al. v. UCAR International Inc., et al. was filed by 4 steelmakers, all of whom are located outside the U.S. The third complaint, entitled Saudi Iron and Steel Company v. UCAR International Inc., et al., was filed by a steelmaker who is located outside the U.S. The fourth complaint, entitled Arbed, S.A., et al. v. Mitsubishi Corporation, et al., was filed by 5 steelmakers, all of whom are located outside the U.S. In each complaint, the plaintiffs allege that the defendants violated U.S. federal antitrust law in connection with the sale of graphite electrodes sold or sourced from the U.S. and those sold and sourced outside the U.S. The plaintiffs seek, among other things, an award of treble damages resulting from such alleged violations. We believe that we have strong defenses against claims alleging that purchases of graphite electrodes outside the U.S. are actionable under U.S. federal antitrust law. We filed motions to dismiss the first and second complaints. In June and July 2001, our motions to dismiss the first and second complaints were granted with respect to substantially all of the plaintiffs’ claims. The claims not dismissed relate to sales invoiced from
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the United States. Appeals were filed by the plaintiffs and the defendants with the U.S. Court of Appeals for the Third Circuit with regard to these dismissals. The U.S. Court of Appeals for the Third Circuit heard oral argument on these appeals on March 11, 2003. The third complaint was dismissed without prejudice to refile pending the resolution of such appeals. We filed a motion to stay the lawsuit commenced by the fourth complaint pending resolution of appeals in the other foreign customer lawsuits, and such motion was granted in July 2002. In June 2004, the U.S. Supreme Court issued its decision in the case of F. Hoffman-LaRoche v. Empagran S.A. et al., an antitrust case brought by foreign purchasers against the participants in an international vitamins cartel. Because of the relevance of this decision to the foreign customer lawsuits, the U.S. Court of Appeals for the Third Circuit reviewed the impact of this decision on the pending appeals in the foreign customer lawsuits. Subsequently, in August 2004, the U.S. Court of Appeals for the Third Circuit remanded the case to the EDPA District Court for its consideration of the impact of the Empagran decision on the foreign customer lawsuits.
We have been vigorously defending, and intend to continue to vigorously defend, against the foreign customer lawsuits as well as all threatened lawsuits and possible unasserted claims. We may at any time, however, settle these lawsuits as well as any threatened lawsuits and possible claims. It is possible that additional civil antitrust lawsuits seeking, among other things, to recover damages could be commenced against us in the U.S. and in other jurisdictions. We are currently not reserved for such matters.
Other Proceedings Against Us
We are involved in various other investigations, lawsuits, claims and other legal proceedings incidental to the conduct of our business. While it is not possible to determine the ultimate disposition of each of them, we do not believe that their ultimate disposition will have a material adverse effect on our financial position, results of operations or cash flows.
Product Warranties
We generally sell products with a limited warranty. We accrue for known warranty claims if a loss is probable and can be reasonably estimated. Claims accrued but not yet paid amounted to $1 million at December 31, 2004 and a nominal amount at September 30, 2005. The following table presents the activity in this accrual for the first nine months of 2005:
(14)
Financial Information About the Issuers and Guarantors of Our Debt Securities and Subsidiaries Whose Securities Secure the Senior Notes and Related Guarantees
On February 15, 2002, GrafTech Finance (“Finco”), a direct subsidiary of GTI (the “Parent”), issued $400 million aggregate principal amount of Senior Notes and, on May 6, 2002, $150 million aggregate principal amount of additional Senior Notes. All of the Senior Notes
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have been issued under a single Indenture and constitute a single class of debt securities. The Senior Notes mature on February 15, 2012. The Senior Notes have been guaranteed on a senior basis by the Parent and the following wholly-owned direct and indirect subsidiaries of the Parent: GrafTech Global, UCAR Carbon, UCAR International Trading Inc., UCAR Carbon Technology LLC, and UCAR Holdings V Inc. (“Holdings V”). The Parent, Finco and these subsidiaries together hold a substantial majority of our U.S. assets. Holdings V has no material assets or operations, and is being liquidated and dissolved.
On January 22, 2004, the Parent issued $225 million aggregate principal amount of Debentures. The guarantors of the Debentures are the same as the guarantors of the Senior Notes, except for Parent (which is the issuer of the Debentures but a guarantor of the Senior Notes) and Finco (which is a guarantor of the Debentures but the issuer of the Senior Notes). The Parent and Finco are both obligors on the Senior Notes and the Debentures, although in different capacities.
The guarantors of the Senior Notes and the Debentures, solely in their respective capacities as such, are collectively called the “U.S. Guarantors.” Our other subsidiaries, which are not guarantors of either the Senior Notes or the Debentures, are called the “Non-Guarantors.”
All of the guarantees are unsecured, except that the guarantee of the Senior Notes by UCAR Carbon has been secured by a junior pledge of all of the shares of capital stock (constituting 97.5% of the outstanding shares of capital stock) of AET held by UCAR Carbon (called the “AET Pledged Stock”), subject to the limitation that in no event will the value of the pledged portion of the AET Pledged Stock exceed 19.99% of the principal amount of the then outstanding Senior Notes. All of the guarantees are full, unconditional and joint and several. Finco and each of the other U.S. Guarantors (other than the Parent) are 100% owned, directly or indirectly, by the Parent. All of the guarantees of the Senior Notes continue until the Senior Notes have been paid in full, and payment under such guarantees could be required immediately upon the occurrence of an event of default under the Senior Notes. All of the guarantees of the Debentures continue until the Debentures have been paid in full, and payment under such guarantees could be required immediately upon the occurrence of an event of default under the Debentures. If a guarantor makes a payment under its guarantee of the Senior Notes or the Debentures, it would have the right under certain circumstances to seek contribution from the other guarantors of the Senior Notes or the Debentures, respectively.
The following table sets forth condensed consolidating balance sheets at December 31, 2004 and September 30, 2005, condensed consolidating statements of operations for the third quarter of 2004 and first nine months and the third quarter of 2005 and first nine months, and condensed consolidating statements of cash flows for the first nine months of 2004 and the first nine months of 2005 of the Parent, Finco, all other U.S. Guarantors and the Non-Guarantors. Provisions in the Revolving Facility restrict the payment of dividends by our subsidiaries to the Parent. At September 30, 2005, retained earnings of our subsidiaries subject to such restrictions were approximately $706 million. Investments in subsidiaries are recorded on the equity basis.
21
Condensed Consolidating Balance Sheet
at December 31, 2004
22
at September 30, 2005
23
Condensed Consolidating Statements of Operations
for the Three Months Ended September 30, 2004
24
for the Three Months Ended September 30, 2005
25
for the Nine Months Ended September 30, 2004
26
for the Nine Months Ended September 30, 2005
27
Condensed Consolidating Statements of Cash Flows
28
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Unsecured intercompany term notes in an aggregate principal amount, at September 30, 2005, equal to $514 million and guarantees of those unsecured intercompany term notes, issued to GrafTech Finance by certain of our foreign subsidiaries have been pledged by GrafTech Finance to secure the Senior Notes, subject to the limitation that at no time will the combined value of the pledged portion of any foreign subsidiary’s unsecured intercompany term note and unsecured guarantee of unsecured intercompany term notes issued by other foreign subsidiaries exceed 19.99% of the principal amount of the then outstanding Senior Notes. As a result of this limitation, the principal amount of unsecured intercompany term notes pledged to secure the Senior Notes at September 30, 2005 equals $330 million, or about 76% of the principal amount of the outstanding Senior Notes. The remaining unsecured intercompany term notes held by GrafTech Finance in an aggregate principal amount at September 30, 2005 of $184 million and any pledged unsecured intercompany term notes that cease to be pledged due to a reduction in the principal amount of the then outstanding Senior Notes due to redemption, repurchase or other events, will not be subject to any pledge and will be available to satisfy the claims of creditors (including the lenders under the Revolving Facility, the holders of the Senior Notes and, pursuant to the subsidiary guarantee by GrafTech Finance of the Debentures, the holders of the Debentures) as their interests may appear. The Senior Notes prohibit the pledge of these unsecured intercompany term notes or related guarantees to secure any other debt or obligation.
As described above, the guarantee of the Senior Notes by UCAR Carbon has been secured by a pledge of all of the AET Pledged Stock, subject to the limitation that at no time will the value of the pledged portion of the AET Pledged Stock exceed 19.99% of the principal amount of the then outstanding Senior Notes.
Rule 3-16 of Regulation S-X adopted by the SEC provides that, for each of the registrant’s affiliates whose securities constitute a “substantial” portion of the collateral for registered securities, financial statements (that would be required to be filed if the affiliate were a registrant) must be filed with this Report. Under Rule 3-16(b), securities of a person will be deemed to constitute a “substantial” portion of the collateral if the aggregate principal amount, par value, or book value of securities as carried by the registrant, or the market value of such securities, whichever is the greatest, equals 20% or more of the principal amount of the registered securities. In this case, the pledges of the AET Pledged Stock and the unsecured intercompany term notes and related guarantees have been limited such that they will never be more than 19.99% of the principal amount of the then outstanding Senior Notes. Therefore, no such financial statements are required to be included in this Report.
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(15)
Subsequent Events
Since September 30, 2005, and prior to the issuance of this Report, we have initiated the following actions in an effort to reduce overhead costs and improve the cash flow of the global organization:
On October 6, 2005, we announced plans to relocate our Corporate Headquarters from Wilmington, Delaware to our Research & Development Center in Parma, Ohio. This relocation will be completed by March 15, 2006.
On October 19, 2005, we announced plans to eliminate and/or reduce certain administrative activities based in our Etoy, Switzerland office. This plan is expected to be completed by the end of the first quarter of 2006. Our Swiss subsidiary is the center of our global graphite electrode contract manufacturing operations and will continue in this capacity to plan, procure, source, fulfill and sell graphite electrode orders throughout the network. As a result of this initiative, within the next 12 months, we expect to incur approximately $2 million to $3 million in restructuring charges in the Consolidated Statement of Operations.
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Preliminary Notes
Important Terms. We use various terms to identify various matters. These terms help to simplify the presentation of information in this Report and are defined in the Notes to the Consolidated Financial Statements contained in the Annual Report.
Presentation of Financial, Market and Legal Data. We present our financial information on a consolidated basis. As a result, the financial information for Carbone Savoie and AET is consolidated on each line of the Consolidated Financial Statements and the equity of the other owners in those subsidiaries is reflected on the lines entitled “minority stockholders’ equity in consolidated entities” and “minority stockholders’ share of income.” We use the equity method to account for 50% or less owned interests.
References to cost in the context of our low cost advantages and strategies do not include the impact of special charges, expenses or credits, such as those related to investigations, lawsuits, claims, restructurings or impairments, or the impact of changes in accounting principles.
References to spot prices for graphite electrodes mean prices under individual purchase orders (not part of an annual or other extended purchase arrangement) for near term delivery for standard size graphite electrodes used in large electric arc steel melting furnaces (as distinct from, for example, a ladle furnace or a furnace producing non-ferrous metals).
Unless otherwise noted, references to productivity mean annual graphite electrode production volume (in metric tons) per graphite electrode employee or fixed cost per unit of output.
Unless otherwise specifically noted, market and market share data in this Report are our own estimates or derived from sources described in “Part I – Preliminary Notes – Presentation of Financial, Market and Legal Data” in the Annual Report, which description is incorporated herein by reference. Our estimates involve risks and uncertainties and are subject to change based on various factors, including those discussed under “Forward Looking Statements and Risks” in this Report and “Forward Looking Statements” and “Risk Factors” in the Annual Report. We cannot guarantee the accuracy or completeness of this market and market share data and have not independently verified it. None of the sources has consented to the disclosure or use of data in this Report.
Reference is made to the Annual Report for the definitions of “EAF,” “market shares,” major product lines,” “natural graphite products,” “capacity utilization rates” and “throughput.”
The GRAFTECH logo, GRAFCELL®, EGRAF®, GRAFOIL®, GRAFGUARD®, GRAFSHIELD® and SpreaderShield™ are our trademarks and trade names. This Report also contains trademarks and trade names belonging to other parties.
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We make available, free of charge, on or through our web site, copies of our proxy statements, our annual reports on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file them with, or furnish them to, the SEC. We maintain a web site at http://www.graftech.com. We have a Code of Conduct & Ethics which is intended to comply with, at a minimum, the listing standards of the NYSE as well as the Sarbanes-Oxley Act of 2002 and the SEC rules adopted thereunder. A copy of our Code of Conduct & Ethics is available on our web site. The information contained on our web site is not part of this Report.
Reference is made to the Annual Report for background information on various risks and contingencies and other matters related to circumstances affecting us and our industry.
Unless otherwise noted, when we refer to dollars, we mean U.S. dollars.
Neither any statement made in this Report nor any charge taken by us relating to any legal proceeding constitutes an admission as to any wrongdoing.
Forward Looking Statements and Risks. This Report contains forward looking statements. In addition, we or our representatives have made or may make forward looking statements on telephone or conference calls, by webcasts or emails, in person, in presentations or written materials, or otherwise. These include statements about such matters as: future production and sales of steel, aluminum, electronic devices, fuel cells and other products that incorporate or that are produced using our products; prices and sales of and demand for such products; future operational and financial performance of our businesses; strategic plans and business projects; impacts of regional and global economic conditions; interest rate management activities; deleveraging activities; rationalization, restructuring, realignment, strategic alliance, raw material and supply chain, technology development and collaboration, investment, acquisition, venture, operational, tax, financial and capital projects; legal matters; consulting projects; potential offerings, sales and other actions regarding debt or equity securities of us or our subsidiaries; and future asset sales, costs, working capital, revenues, business opportunities, debt levels, cash flows, cost savings and reductions, margins, earnings and growth. The words “will,” “may,” “plan,” “estimate,” “project,” “believe,” “anticipate,” “expect,” “intend,” “should,” “would,” “could,” “target,” “goal” and similar expressions identify some of these statements.
Actual future events and circumstances (including future results and trends) could differ materially from those set forth in these statements due to various factors. These factors include:
the possibility that additions to capacity for producing steel in electric arc furnaces may not occur or that increases in graphite electrode manufacturing capacity may occur, which may impact demand for or prices or sales volume of graphite electrodes;
the possibility that continued global consolidation of the world’s largest steel producers could impact our business or industry;
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the possibility that average graphite electrode revenue per metric ton in the future may be different than current spot prices due to changes in product mix, changes in currency exchange rates, changes in competitive market conditions or other factors;
the possibility that price increases, adjustments or surcharges may not be realized;
the possibility that economic or technological developments may adversely affect growth in the use of graphite cathodes in lieu of carbon, graphitic or semi-graphitic cathodes in the aluminum smelting process;
the possibility that additions to aluminum smelting capacity may not occur or that increases in production of cathodes by competitors may occur, which may impact demand for or prices or sales volume of cathodes;
the possibility of delays in or failure to achieve successful development and commercialization of new or improved electronic thermal management or other products or that they could be subsequently displaced by other products or technologies;
the possibility of delays in or failure to achieve widespread commercialization of proton exchange membrane (“PEM”) fuel cells which use our natural graphite-based products or that manufacturers of PEM fuel cells may obtain those products from other sources;
the possibility of delays in expanding or failure to expand our manufacturing capacity to meet growth in demand for existing, new or improved products, if any;
the possibility that we may be unable to protect our intellectual property or may infringe the intellectual property rights of others;
the occurrence of unanticipated events or circumstances relating to antitrust investigations, lawsuits or claims;
the possibility that the anticipated benefits from organizational and work process redesign or other system changes may be delayed or may not occur;
the possibility that our provision for income taxes and effective income tax rate or cash tax rate may fluctuate significantly due to changes in tax planning, tax laws, profitability and other factors;
the occurrence of unanticipated events or circumstances relating to health, safety or environmental compliance or remediation obligations or liabilities to third parties or relating to labor relations;
the possibility that taxes or other matters could be impacted by the American Job Creation Act of 2004;
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the possibility of changes in interest or currency exchange rates, in competitive conditions, or in inflation;
the possibility of failure to satisfy conditions or milestones under, or occurrence of breach of terms of, our strategic alliances with Alcan, Ballard Power Systems or others;
the possibility of changes in government funding of, or failure to satisfy eligibility conditions to, government grants;
the possibility that our high leverage, substantial debt and other obligations could limit our financial resources and ability to compete and may make us more vulnerable to adverse economic events;
the possibility that our outlook could be significantly impacted by, among other things, changes in interest rates by the U.S. Federal Reserve Board and the European Central Bank, changes in fiscal policies by the U.S. and other governments, developments in the Middle East, the occurrence of further terrorist acts and developments (including increases in security, insurance, data back-up, energy and transportation and other costs, transportation delays and continuing or increased economic uncertainty and weakness) resulting from terrorist acts and the war on terrorism;
the possibility that interruption in our major raw material, energy or utility supplies due to, among other things, natural disasters, process interruptions, actions by producers, and capacity limitations, may adversely affect our ability to manufacture and supply our products or result in higher costs;
the possibility of interruptions in production at our facilities due to, among other things, critical equipment failure, may adversely affect our ability to manufacture and supply our products or result in higher costs;
the possibility that a service provider to whom we outsource global information technology and finance and accounting business process services may fail to provide these services;
the possibility that we may not complete planned asset sales for amounts or at times anticipated or at all, or that we may not achieve the earnings that we provide as guidance from time to time;
the possibility that our internal controls over financial reporting may become inadequate because of changes in conditions or that the degree of compliance with our policies and procedures may deteriorate or that our internal controls may not operate effectively and therefore do not prevent or detect misstatements; and
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other risks and uncertainties, including those described elsewhere in this Report or our other SEC filings, as well as future decisions by us.
Occurrence of any of the events or circumstances described above could also have a material adverse effect on our business, financial condition, results of operations, cash flows or the market price of our common stock.
No assurance can be given that any future transaction about which forward looking statements may be made will be completed or as to the timing or terms of any such transaction.
All subsequent written and oral forward looking statements by or attributable to us or persons acting on our behalf are expressly qualified in their entirety by these factors. Except as otherwise required to be disclosed in periodic reports required to be filed by public companies with the SEC pursuant to the SEC’s rules, we have no duty to update these statements.
For a more complete discussion of these and other factors, see “Risk Factors” in the Annual Report.
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Item 2. Management’s Discussion and Analysis of Financial
Condition and Results of Operations
Global Economic Conditions and Outlook
We are impacted in varying degrees, both positively and negatively, as global, regional or country economic conditions fluctuate.
Synthetic Graphite. Graphite electrode demand is primarily linked with the global production of steel in an electric arc furnace and, to a lesser extent, with the total production of steel and certain other metals. During the first three quarters of 2005, global steel production and operating rates, excluding China, were lower than in the comparable prior year quarters, as most steel producers worked to reduce steel inventory levels. China’s steel production, however, has grown over 27% year-to-date and represents the single largest contributor to the growth in global steel demand. Although approximately 88% of Chinese steel production is Blast Oxygen Furnace (BOF) steel production, China is also the growth leader for new EAF steel production. Overall, EAF steel production capacity continues to grow, primarily driven by new EAF furnaces in China, and to a lesser extent, growth in Russia, the Middle East and North America.
The steel industry in most of our major markets continued operating at lower operating rates. We believe that these lower operating rates resulted in a reduction of steel inventories in the U.S. and, to a lesser extent, in other regions of the world. During the third quarter of 2005, U.S. steel inventories on hand dropped to their lowest levels in 18 months. We believe these lower inventory levels are a leading indicator of higher steel operating levels. We expect fourth quarter graphite electrode sales volume to be approximately 57,000 metric tons.
We expect average graphite electrode revenue per metric ton for 2005 to be at the low end of our guidance range of $2,900 to $3,000, excluding the impact of the weakening Euro. Based on currency exchange rates at September 30, 2005, we expect average graphite electrode revenue per metric ton for 2005 to be approximately $2,850. We anticipate virtually no spot business for the remainder of 2005.
We now expect that our 2005 graphite electrode production cost increases will be maintained at the low end of our previously communicated 2005 guidance of 10-12%.
The global graphite electrode pricing environment continues to improve as global demand for high quality, reliable graphite electrodes continues to grow. 2006 is expected to be one of the strongest years in over a decade for EAF new start-ups. These new furnaces are projected to add over 5% of EAF steel capacity over the course of 2006, primarily in China and Russia.
We have secured approximately 65% of our 2006 graphite electrode production costs, including 100% of our anticipated 2006 premium needle coke requirements, our most critical raw material. Although raw material pricing pressures remain persistently high, including new pressures from higher natural gas prices in North America, we have also identified productivity initiatives to help mitigate these rising 2006 production costs. These initiatives include the
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implementation of rationalization and productivity opportunities in our synthetic graphite facilities and continued streamlining, centralization and consolidation of our administrative activities. We believe these productivity and consolidation initiatives will contain our 2006 graphite electrode production cost increases to a range of 10% to 12%.
Our venture with Alcan, which is a 30% owner of our cathode business and which purchases cathodes from us under requirements contracts that remain in effect through 2006, continues to position us as the leading supplier of cathodes to the aluminum industry. We believe that, over the long term, demand for graphite cathodes will increase relative to other cathodes as new smelting furnaces are built, thereby reducing the current excess supply of graphite cathodes.
Other Segment. We expect increased blast furnace construction and refurbishment to lead to continuing strong demand for our carbon refractories in the various geographic markets through the end of 2005 and into 2006. We believe that overall long-term demand for our advanced carbon materials continues to increase with strong global economic growth. We continue to seek to drive productivity and cost improvements in these product lines.
We expect growing net sales of our ETM products and services. We have hired and are continuing to hire additional personnel in sales, marketing and research and development to support our growth. These resources will focus on the continued growth of our ETM business as we continue to leverage our successes to penetrate new customers and applications and identify new market opportunities including recent approvals for ETM solutions in liquid crystal displays (LCD) panels. We believe the LCD flat panel display segment, when coupled with the plasma display television segment, is expected to grow from about eight million units in 2004 to sixty million units by 2008. We now expect ETM sales of approximately $20 million in 2005, representing an almost 70% increase over 2004. Based on current orders and outlook, we expect a continued growth rate for 2006 ETM sales of at least 50% over 2005.
Overall. We expect our net sales to increase by over 5% in 2005 as compared to 2004. The 2005 cash tax rate is targeted to be less than 30%, and the 2005 effective tax rate is expected to be in the range of 38% to 40%. Capital expenditures are estimated to be approximately $45 million and depreciation expense is estimated to be about $38 million in 2005.
Our outlook could be significantly impacted by, among other things, factors described under “Preliminary Notes - Forward Looking Statements and Risks” in this Report. For a more complete discussion of these and other factors, see “Risk Factors” in the Annual Report.
Results of Operations
Three Months Ended September 30, 2005 as Compared to Three Months Ended September 30, 2004.
Consolidated. Net sales of $209 million in the third quarter of 2005 represented a $3 million, or 1%, increase from net sales of $206 million in the third quarter of 2004, due to increases in net sales of cathodes, natural graphite, carbon electrodes and advanced graphite
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materials, offset by decreases in net sales of both graphite electrodes and refractories. Net sales of cathodes increased $2 million, or 11%, due to a favorable sales mix in the third quarter of 2005 as compared to the third quarter of 2004. Net sales of natural graphite increased primarily due to an increase in ETM sales of $2 million, from $3 million in the third quarter of 2004 to $5 million in the third quarter of 2005. Net sales of carbon electrodes increased $2 million, or 19%, due to an increase in sales volumes. Net sales of advanced graphite materials increased $1 million, or 7%, due primarily to improved selling prices. Net sales of graphite electrodes decreased $3 million, of which $20 million was due to lower sales volumes and $4 million was due to a less favorable product mix, offset by an increase of $21 million due to higher average graphite electrode sales revenue per metric ton. Net sales of refractories decreased $1 million, or 13%, due to less favorable sales mix in the third quarter of 2005 as compared to the third quarter of 2004.
Cost of sales of $151 million in the third quarter of 2005 represented a $1 million, or 2%, decrease from cost of sales of $152 million in the third quarter of 2004 due to a decrease in cost of sales of graphite electrodes, offset by increases in cost of sales of cathodes, natural graphite and advanced graphite materials. The cost of sales of graphite electrodes decreased $8 million, or 9%, primarily due to lower sales volumes, which decreased costs by $14 million, offset by certain higher raw material costs of $4 million and the negative effect of changes in currency exchange rates of $2 million. Cost of sales of cathodes increased by $3 million, or 15%, due primarily to higher operating costs in the third quarter of 2005 as compared to the third quarter of 2004. Cost of sales of natural graphite materials increased $2 million, or 36%, primarily due to an increase in certain raw material costs and higher overhead costs. Cost of sales of carbon electrodes increased $1 million, or 6%, primarily due to increased sales volume. Cost of sales of refractories increased $1 million, or 11%, primarily due to a less favorable product mix.
As a result, gross profit in the third quarter of 2005 was $58 million, 9% or $4 million higher than $54 million for the third quarter of 2004. Gross margin was 28.0% of net sales in the third quarter of 2005 as compared to the 25.9% of net sales in the third quarter of 2004.
Research and development expenses were $3 million in the third quarter of 2005 and $2 million in the third quarter of 2004, with the increase primarily due to increased headcount to support growth in our ETM products and services.
Selling, administrative and other expenses were $23 million in the third quarter of 2005 and $25 million in the third quarter of 2004. The decrease of $2 million was primarily associated with lower Sarbanes-Oxley compliance costs of $1 million and lower costs of $1 million primarily associated with improved global business processes, including lower costs of information technology and lower costs for third party outsourcing.
Other (income) expense, net, was expense of $1 million in the third quarter of 2005 as compared to income of $2 million in the third quarter of 2004. The net increase in expense of $3 million was primarily due to the following:
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the sale of fixed assets pertaining primarily to the closure of our advanced graphite machining operations in Sheffield, United Kingdom resulting in $3 million of gain for the third quarter of 2004;
losses due to changes in currency exchange rates, primarily associated with Euro-denominated intercompany loans, increasing $3 million for the third quarter of 2005 as compared to the third quarter of 2004; offset by
a favorable change in the fair value adjustment on interest rate caps of $2 million for the third quarter of 2005 as compared to the third quarter of 2004; and
the net decrease in other costs of $1 million.
In the third quarter of 2005, we recorded a nominal charge associated with the phase out of our graphite electrode machining operations in Clarksville, Tennessee, scheduled for completion in the third quarter of 2006, and the closure of our administrative offices in Clarksville, scheduled for completion at the end of the first quarter of 2006. The total program cost is expected to be approximately $2 million and will be expensed and paid over the remainder of 2005 and 2006. We anticipate annualized cost savings of up to $3 million per year by the end of 2006. Our graphite electrode machining operations will be transferred to our graphite electrode facility in Monterrey, Mexico. Our administrative services will be transferred to our research and development facility in Parma, Ohio. We will continue to operate a warehouse and shipping facility at Clarksville after the machining operations closure.
We have had several restructuring charges and impairment losses during the past few years. The restructuring accrual is included in other accrued liabilities and other long-term obligations on the Consolidated Balance Sheets. The following table summarizes year-to-date activity relating to the accrual:
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It is also possible that we may, at any time, decide to permanently shut down certain remaining graphite electrode operations in Italy. Additionally, we are currently evaluating other productivity opportunities and initiatives to help mitigate rising production costs. As a result, we may in the future, record additional restructuring and/or impairment charges and incur additional exit costs.
Average total debt outstanding was $731 million in the third quarter of 2005 as compared to $678 million in the third quarter of 2004. The average interest rate was 6.9% in the third quarter of 2005 as compared to 5.3% in the third quarter of 2004. These average rates represent the average rates on total debt outstanding and include the benefits, if any, of our interest rate swaps.
The provision for income taxes was a charge of $2 million during the 2005 third quarter as compared to a charge of $31 million in the 2004 third quarter. The effective income tax rate was approximately 11% in the 2005 third quarter as compared to approximately 141% in the 2004 third quarter. During the 2004 third quarter, we implemented a tax election that accelerated
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approximately $215 million of taxable income in the U.S. through a standard election that resulted in the utilization of approximately $26 million of deferred tax assets, of which approximately $20 million were foreign tax credits. This resulted in a non-cash tax charge of $25 million in the 2004 third quarter and resulting higher effective tax rate in 2004. During the 2005 third quarter, we completed and filed our U.S. federal income tax return that included the 2004 third quarter tax election. As a result of completing the return, we identified adjustments required to our 2004 estimates resulting in a $5 million tax benefit in the 2005 third quarter and resulting lower effective tax rate for 2005.
As a result of the matters described above, net income was $16 million in the third quarter of 2005 as compared to net loss of $10 million in the third quarter of 2004.
Synthetic Graphite Segment. Net sales amounted to $184 million in the third quarter of 2005 and in the third quarter of 2004. Net sales of graphite electrodes decreased $3 million, offset by an increase in net sales of cathodes of $2 million and an increase in net sales of advanced graphite materials of $1 million.
Net sales of graphite electrodes decreased, primarily due to lower sales volumes and a less favorable product mix, partially offset by higher average graphite electrode sales revenue per metric ton. Volume of graphite electrodes sold was 47,900 metric tons in the third quarter of 2005 as compared to 55,800 metric tons in the third quarter of 2004. The lower volumes of graphite electrodes sold represented a decrease of $20 million in net sales. Additionally, a less favorable product mix reduced net sales by $4 million. The higher average sales revenue per metric ton represented an increase of $21 million in net sales, with nominal amounts attributable to changes in currency exchange rates. Average sales revenue per metric ton of graphite electrodes in the third quarter of 2005 was $2,835 as compared to the average in the third quarter of 2004 of $2,501. Net sales of cathodes increased $2 million primarily due to a favorable sales mix in the third quarter of 2005 as compared to the third quarter of 2004. Net sales of advanced graphite materials increased $1 million, primarily due to improved pricing in the third quarter of 2005 as compared to the third quarter of 2004.
Cost of sales of $132 million in the third quarter of 2005 represented a $5 million, or 4%, decrease from cost of sales of $137 million in the third quarter of 2004. The cost of sales of graphite electrodes decreased $8 million, or 9%, primarily due to lower sales volumes, which decreased costs by $14 million, partially offset by certain higher raw material costs of $4 million and the negative effect of changes in currency exchange rates of $2 million. Cost of sales of cathodes increased by $3 million, or 15%, due primarily to higher operating costs in the third quarter of 2005 as compared to the third quarter of 2004.
As a result, gross profit in the third quarter of 2005 was $52 million, 11% or $5 million higher than the $47 million in the third quarter of 2004. Gross margin was 28.2% of net sales in the third quarter of 2005 as compared to 25.5% of net sales in the third quarter of 2004.
Other Segment. Net sales of $25 million in the third quarter of 2005 represented a $3 million, or 9%, increase from net sales of $22 million in the third quarter of 2004. Nets sales of natural graphite increased primarily due to an increase in ETM net sales of $2 million, from $3
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million in the third quarter of 2004 to $5 million in the third quarter of 2005. Net sales of carbon electrodes increased $2 million primarily due to increased sales volume. Refractories experienced a less favorable sales mix in the third quarter of 2005 as compared to the third quarter of 2004, thereby offsetting the above increases by $1 million.
Cost of sales of $19 million in the third quarter of 2005 represented a $4 million, or 15%, increase from cost of sales of $15 million in the third quarter of 2004. Cost of sales of natural graphite materials increased $2 million, or 36%, primarily due to an increase in certain raw material costs and higher overhead costs. Cost of sales of carbon electrodes increased $1 million, or 6%, primarily due to increased sales volume. Cost of sales of refractories increased $1 million, or 11%, primarily due to a less favorable product mix.
As a result, gross profit in the third quarter of 2005 was $6 million, 3% or $1 million lower than the $7 million in the third quarter of 2004. Gross margin was 25.8% of net sales in the third quarter of 2005 as compared to 29.2% of net sales in the third quarter of 2004.
Nine Months Ended September 30, 2005 as Compared to Nine Months Ended September 30, 2004.
Consolidated. Net sales of $640 million in the first nine months of 2005 represented a $24 million, or 4%, increase from net sales of $616 million in the first nine months of 2004, due to increases in net sales across all product lines. Advanced graphite materials net sales increased $9 million, or 15%, due to higher sales volumes. Net sales of cathodes increased $6 million, or 8%, due equally to higher sales volumes, a more favorable product mix and the favorable effect of change in currency exchange rates. Nets sales of natural graphite increased $4 million primarily due to an increase in ETM net sales of $6 million, from $8 million in the first nine months of 2004 to $14 million in the first nine months of 2005, offset by decreases in other natural graphite sales, primarily relating to softer automotive end markets and conditions. Net sales of carbon electrodes increased $3 million, or 12%, primarily due to increased volumes. The remaining increases were primarily within graphite electrodes and were due to higher average graphite electrode sales revenue per metric ton, offset by lower sales volumes and a less favorable product mix.
Cost of sales of $476 million in the first nine months of 2005 represented a $13 million, or 3%, increase from cost of sales of $463 million in the first nine months of 2004. Cost of sales of cathodes increased $12 million primarily due to the negative impact of changes in currency exchange rates of $3 million and $9 million consisting primarily of higher operating costs.. The cost of sales of advanced graphite materials increased $6 million, or 15%, primarily due to higher sales volumes. The cost of sales of carbon electrodes increased $3 million, or 13%, primarily due to higher sales volumes. The cost of sales of refractories increased $1 million due primarily to a less favorable product mix. The remaining increases in cost of sales were primarily within natural graphite materials and were primarily due to an increase in certain raw material costs and higher overhead costs. Cost of sales of graphite electrodes offset the above increases by $13 million primarily due to lower sales volumes, which decreased costs by $36
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million, offset by certain higher raw material costs of $11 million, the negative effect of changes in currency exchange rates of $9 million, and other costs of $3 million.
As a result, gross profit in the first nine months of 2005 was $164 million, 7% or $11 million higher than the $153 million in the first nine months of 2004. Gross margin was 25.7% of net sales in the first nine months of 2005 as compared to the 24.8% of net sales in the first nine months of 2004.
Research and development expense was $7 million in the first nine months of 2005 and $6 million in the first nine months of 2004, with the increase primarily due to increased headcount to support growth in our ETM products and services.
Selling, administrative and other expenses were $74 million in the first nine months of 2005 and $68 million in the first nine months of 2004. The increase was due primarily to higher selling expenses of $2 million associated with higher net sales, $3 million associated with Sarbanes-Oxley compliance efforts, and $1 million in other costs.
Other (income) expense, net, was expense of $13 million in the first nine months of 2005 as compared to expense of $18 million in the first nine months of 2004. The net decrease in expense of $5 million was primarily due to the following:
the reduction of $43 million of Senior Notes outstanding (due to debt for equity exchanges and repurchases for cash) in the first nine months of 2004 resulting in a $6 million loss;
a decrease if $4 million in legal, environmental and other related costs;
a favorable change in the fair value adjustment on interest rate caps of $3 million for the first nine months of 2005 as compared to the first nine months of 2004;
a favorable change in the fair value adjustment on the Debenture redemption make-whole provision of $3 million for the first nine months of 2005 as compared to the first nine months of 2004; offset by
losses due to changes in currency exchange rates, primarily associated with Euro-denominated intercompany loans, which increased $10 million for the first nine months of 2005 as compared to the first nine months of 2004; and
the net increase in other costs of $1 million.
In the first nine months of 2005, we recorded a nominal charge associated with the phase out of our graphite electrode machining operations in Clarksville, Tennessee, scheduled for completion in the third quarter of 2006, and the closure of our administrative offices in Clarksville, scheduled for completion at the end of the first quarter of 2006. The total program cost is expected to be approximately $2 million and will be expensed and paid over the remainder of 2005 and 2006. We anticipate annualized cost savings of up to $3 million per year
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by the end of 2006. Our graphite electrode machining operations will be transferred to our graphite electrode facility in Monterrey, Mexico. Our administrative services will be transferred to our research and development facility in Parma, Ohio. We will continue to operate a warehouse and shipping facility at Clarksville after the machining operations closure.
Restructuring charges were $1 million in the first nine months of 2004. We recorded a $3 million charge primarily associated with the completion of severance agreements for approximately two-thirds of the employees terminated in connection with the closure of our graphite electrode manufacturing facility in Caserta, Italy. We also recorded a $1 million charge associated with changes in estimates for the U.S. voluntary and selective severance programs. Additionally, we recorded a $1 million charge relating primarily to severance benefits associated with the closure of our advanced graphite machining operations in Sheffield, United Kingdom. These charges were offset by a $4 million reduction in restructuring cost estimates associated with changes in estimates of costs pertaining to the closure of our graphite electrode manufacturing operations in Caserta, Italy.
We recorded a $1 million charge for additional potential liabilities and expenses in connection with antitrust investigations and related lawsuits and claims in the first nine months of 2004. This charge was offset by a gain due to the refund of €10 million ($12 million based on currency exchange rates then in effect) that we received from the EU Competition Authority as a result of the reduction of the EU antitrust fine to €42 million, plus accrued interest of €7.7 million (which was calculated at a rate of 8.04% per annum), an aggregate of about $59 million at currency exchange rates in effect at the time the decision on the appeal was issued.
Average total debt outstanding was $703 million in the first nine months of 2005 as compared to $675 million in the first nine months of 2004. The average interest rate was 6.8% in the first nine months of 2005 as compared to 5.5% in the first nine months of 2004. These average rates represent the average rates on total debt outstanding and include the benefits, if any, of our interest rate swaps.
We recorded interest income in the first nine months of 2004 of $1 million primarily attributable to interest earned on cash proceeds from the issuance and sale of the Debentures.
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The provision for income taxes was a charge of $9 million in the 2005 first nine months as compared to a charge of $36 million in the 2004 first nine months. The effective income tax rate was approximately 28% in the 2005 first nine months as compared to approximately 80% in the 2004 first nine months.
During the 2004 third quarter, we implemented a tax election that accelerated approximately $215 million of taxable income in the U.S. through a standard election that resulted in the utilization of approximately $26 million of deferred tax assets, of which approximately $20 million were foreign tax credits. This resulted in a non-cash tax charge of $25 million in the 2004 first nine months and resulting higher effective tax rate for 2004. The effective rate in the 2004 first nine months was also impacted by a benefit from the EU Competition Authority refund, which was non-taxable in the U.S., and by nondeductible expenses associated with certain restructuring charges.
During the 2005 third quarter, we completed and filed our U.S. federal income tax return that included the 2004 third quarter tax election. As a result of completing the return, we identified adjustments required to our 2004 estimates resulting in a $5 million tax benefit in the 2005 third quarter and resulting lower effective tax rate for 2005
As a result of the matters described above, net income was $23 million in the first nine months of 2005 as compared to net income of $8 million in the first nine months of 2004.
Synthetic Graphite Segment. Net sales of $562 million in the first nine months of 2005 represented a $16 million, or 3%, increase from net sales of $546 million in the first nine months of 2004. Advanced graphite materials net sales increased $9 million due primarily to higher sales volumes. Net sales of cathodes increased $6 million due equally to higher sales volumes, a more favorable product mix and the favorable effect of exchange rates. Net sales of graphite electrodes increased $1 million primarily due to higher average graphite electrode sales revenue per metric ton, offset by lower sales volumes and a less favorable product mix. The higher average sales revenue per metric ton represented an increase of $62 million in net sales, approximately $2 million of which was attributable to changes in currency exchange rates. The average sales revenue per metric ton of graphite electrodes in the first nine months of 2005 was $2,833 as compared to the average in the first nine months of 2004 of $2,498. Volume of graphite electrodes sold was 143,400 metric tons in the first nine months of 2005 as compared to 162,200 metric tons in the first nine months of 2004. The lower volumes of graphite electrodes sold represented a decrease of $47 million in net sales. Remaining decreases amounted to $14 million and related primarily to the effect of a less favorable product mix.
Cost of sales of $415 million in the first nine months of 2005 represented a $5 million, or 1%, increase from cost of sales of $410 million in the first nine months of 2004. Cost of sales of
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cathodes increased $12 million primarily due to the negative impact of changes in currency exchange rates of $3 million and $9 million consisting primarily of higher operating costs. The cost of sales of advanced graphite materials increased $6 million, or 15%, primarily due to higher sales volumes. Cost of sales of graphite electrodes offset the above increases by $13 million primarily due to lower sales volumes, which decreased costs by $36 million, partially offset by certain higher raw material costs of $11 million, the negative effect of changes in currency exchange rates of $9 million, and other costs of $3 million.
As a result, gross profit in the first nine months of 2005 was $147 million, 8% or $11 million higher than the $136 million in the first nine months of 2004. Gross margin was 26.1% of net sales in the first nine months of 2005 as compared to 24.9% of net sales in the first nine months of 2004.
Other Segment. Net sales of $78 million in the first nine months of 2005 represented an $8 million, or 11%, increase from net sales of $70 million in the first nine months of 2004. Net sales of natural graphite increased $4 million primarily due to an increase in ETM net sales of $6 million, from $8 million in the first nine months of 2004 to $14 million in the first nine months of 2005, partially offset by decreases in sales of other natural graphite products, primarily relating to softer automotive end markets and conditions. The remaining increase in net sales was primarily due to an increase in net sales of carbon electrodes, primarily due to increased volumes.
Cost of sales of $61 million in the first nine months of 2005 represented an $8 million, or 14%, increase from cost of sales of $53 million in the first nine months of 2004. The cost of sales of carbon electrodes increased $3 million, or 13%, primarily due to higher sales volumes. The cost of sales of refractories increased $1 million due primarily to a less favorable product mix. The remaining increase in cost of sales was primarily due to an increase in costs of sales of natural graphite and was primarily due to an increase in certain raw material costs and higher overhead costs.
As a result, gross profit was $17 million in the 2004 and the first nine months of 2005. Gross margin was 22.3% of net sales in the first nine months of 2005 as compared to 24.2% of net sales in the first nine months of 2004, due primarily to an unfavorable product mix of refractories and various other costs.
Effects of Inflation
We incur costs in the U.S. and each of the six, non-U.S. countries in which we have a manufacturing facility. In general, our results of operations, cash flows and financial condition are affected by the effects of inflation on our costs incurred in each of these countries. See “Currency Translation and Transactions” for a further discussion of highly inflationary countries.
During the past three years, we experienced higher freight, energy and other raw material costs primarily due to substantial increases in regional and worldwide market prices of natural gas and other petroleum-based raw materials. We seek to mitigate the effects of those increases on our cost of sales through improved operating efficiencies, higher prices for our products and
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ongoing cost savings, and, in some cases, fixed price or derivative hedging contracts. We have in the past entered into, and may in the future enter into, natural gas hedge contracts to effectively fix our direct and indirect natural gas cost exposure in North America. We currently do not have any natural gas derivative contracts. In addition, we have entered into, and may in the future enter into additional, short duration fixed rate purchase contracts with certain of our natural gas suppliers in order to mitigate seasonal increases in our natural gas costs. We cannot assure you that future increases in our costs will not occur or exceed the rate of inflation or the amounts, if any, by which we may be able to increase prices for our products.
Currency Translation and Transactions
We account for our non-U.S. subsidiaries under SFAS No. 52, Foreign Currency Translation. Accordingly, except for highly inflationary countries, the assets and liabilities of our non-U.S. subsidiaries are translated into dollars for consolidation and reporting purposes. Foreign currency translation adjustments are generally recorded as part of stockholders’ deficit and identified as part of accumulated other comprehensive loss on the Consolidated Balance Sheets until such time as their operations are sold or substantially or completely liquidated.
Highly inflationary economies are defined as having cumulative inflation of about 100% or more over a period of three calendar years. In general, the financial statements of foreign operations in highly inflationary economies are remeasured as if the functional currency of their economic environments were the dollar and translation gains and losses relating to these foreign operations are included in other (income) expense, net, on the Consolidated Statements of Operations rather than as part of stockholders’ deficit on the Consolidated Balance Sheets. We have subsidiaries in Russia, Mexico, Brazil and other countries which have had in the past, and may have in the future, highly inflationary economies.
We account for our Mexican and Russian subsidiaries using the dollar as their functional currency, as sales and purchases for each subsidiary are predominantly dollar-denominated. Our remaining subsidiaries use their local currency as their functional currency.
We also record foreign currency transaction gains and losses as part of other (income) expense, net.
Significant changes in currency exchange rates impacting us are described under “Effects of Changes in Currency Exchange Rates” and “Results of Operations – Items Affecting Us as a Whole.”
Effects of Changes in Currency Exchange Rates
We incur costs in dollars and the currency of each of the six non-U.S. countries in which we have a manufacturing facility, and we sell our products in multiple currencies. In general, our results of operations, cash flows and financial condition are affected by changes in currency exchange rates affecting these currencies relative to the dollar and, to a limited extent, each other.
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When the currencies of non-U.S. countries in which we have a manufacturing facility decline (or increase) in value relative to the dollar, this has the effect of reducing (or increasing) the dollar equivalent cost of sales and other expenses with respect to those facilities. This effect is, however, partially offset by the cost of petroleum coke, a principal raw material used by us, which is priced in dollars. In certain countries where we have manufacturing facilities, and in certain instances where we price our products for sale in export markets, we sell in currencies other than the dollar. Accordingly, when these currencies increase (or decline) in value relative to the dollar, this has the effect of increasing (or reducing) net sales. The result of these effects is to increase (or decrease) operating profit and net income.
Many of the non-U.S. countries in which we have a manufacturing facility have been subject to significant economic changes, which have significantly impacted currency exchange rates. We cannot predict changes in currency exchange rates in the future or whether those changes will have net positive or negative impacts on our net sales, cost of sales or net income. We cannot assure you that we would be able to mitigate any adverse effects of such changes.
During the first nine months of 2005, the average exchange rate of the Euro, the South African Rand, the Brazilian Real and the Mexican Peso increased about 4%, 5%, 18% and 3%, respectively, when compared to the average exchange rate for the first nine months of 2004.
In the case of net sales of graphite electrodes, the impact of these events was an increase of about $2 million in the first nine months of 2005 as compared to the first nine months of 2004. In the case of cost of sales of graphite electrodes, the impact of these events was an increase of about $9 million in the first nine months of 2005 as compared to the first nine months of 2004. The impact of these events on net sales of cathodes was an increase of about $2 million in the first nine months of 2005 as compared to the first nine months of 2004. The impact of these events on cost of sales of cathodes was an increase of about $3 million in the first nine months of 2005 as compared to the first nine months of 2004.
We have non-dollar denominated intercompany loans between GrafTech Finance and some of our foreign subsidiaries. At September 30, 2005, the aggregate principal amount of these loans was $422 million. These loans are subject to remeasurement gains and losses due to changes in currency exchange rates. A portion of these loans are deemed to be essentially permanent and, as a result, remeasurement gains and losses on these loans are recorded as a component of accumulated other comprehensive loss in the stockholders’ deficit section of the Consolidated Balance Sheets. The balance of these loans are deemed to be temporary and, as a result, remeasurement gains and losses on these loans are recorded as currency (gains) losses in other (income) expense, net, on the Consolidated Statements of Operations. In the first nine months of 2004, we had a net total of $2 million in currency losses, including $3 million of exchange losses due to the remeasurement of intercompany loans and translation of financial statements of foreign subsidiaries which use the dollar as their functional currency. In the first nine months of 2005, we had a net total of $12 million in currency losses, majority of which pertains to exchange losses due to the remeasurement of intercompany loans and translation of financial statements of foreign subsidiaries which use the dollar as their functional currency. To manage certain exposures to specific financial market risks caused by changes in currency
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exchange rates, we use various financial instruments as described under “Item 3 –Qualitative and Quantitative Disclosures about Market Risk.”
Liquidity and Capital Resources
Our sources of funds have consisted principally of invested capital, cash flow from operations and debt and equity financings. Our uses of those funds (other than for operations) have consisted principally of debt reduction, capital expenditures, payment of fines, liabilities and expenses in connection with antitrust investigations, lawsuits and claims, payment of restructuring costs, pension and post-retirement contributions and payments and other obligations.
We are highly leveraged and have other substantial obligations. At September 30, 2005, we had total debt of $720 million, cash and cash equivalents of $6 million and a stockholders’ deficit of $40 million.
As part of our cash management activities, we seek to manage accounts receivable credit risk, collections, and accounts payable and payments thereof to seek to maximize our free cash at any given time and minimize accounts receivable losses. During the third quarter of 2005, certain subsidiaries sold receivables totaling $5 million, at a cost lower than the cost to borrow a comparable amount for a comparable period under the Revolving Facility. Proceeds of the sale of receivables were used to reduce debt. If we had not sold such receivables, our accounts receivable and our debt would have been about $5 million higher at September 30, 2005. All such receivables were sold without recourse, and no amount of accounts receivable sold remained on the Consolidated Balance Sheet at September 30, 2005.
We use cash and cash equivalents, funds available under the Revolving Facility, subject to continued compliance with the financial covenants and representations under the Revolving Facility, as well as cash flow from operations as our primary sources of liquidity. The Revolving Facility provides for maximum borrowings of up to $215 million. At September 30, 2005, $157 million was available (after consideration of outstanding revolving and swingline loans of $50 million and outstanding letters of credit of $8 million). It is possible that our future ability to borrow under the Revolving Facility may effectively be less because of the impact of additional borrowings upon our compliance with the maximum net senior secured debt leverage ratio permitted or minimum interest coverage ratio required under the Revolving Facility.
At September 30, 2005, we were in compliance with all financial and other covenants contained in the Senior Notes, the Debentures and the Revolving Facility, as applicable. Based on expected operating results and expected cash flows, we expect to be in compliance with these covenants over the next twelve months. If we were to believe that we would not continue to comply with these covenants, we would seek an appropriate waiver or amendment from the lenders thereunder. We cannot assure you that we would be able to obtain such waiver or amendment on acceptable terms or at all.
At September 30, 2005, 28% (or $203 million) of our total debt, excluding the fair value adjustments to debt and unamortized bond premium, consists of variable rate obligations. Such
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amount includes $150 million notional amount of Senior Notes, $50 million outstanding under the Revolving Facility and $3 million of other debt. At September 30, 2005, $150 million of our $435 million notional amount of Senior Notes outstanding was converted into variable rate debt. At September 30, 2005, the variable interest with respect to our swaps, was calculated based on the six month LIBOR, set in advance on August 16, 2005 at 4.03%, plus 5.7967%.
At September 30, 2005, we also had interest rate caps for a total notional amount of $150 million through August 2007. These instruments effectively cap our interest rate exposure, represented by the net impact of our swaps on the Senior Notes, to no greater than 11.3% per annum.
At September 30, 2005, the Revolving Facility had an effective interest rate of 6.5%, our $435 million principal amount of Senior Notes (together with our swaps) had an effective rate of 10.1% and our $225 million principal amount of Debentures had a fixed rate of 1.625%. We estimate interest expense to be approximately $52 million for 2005.
We continue to implement interest rate management initiatives to seek to minimize interest expense and optimize the risk in our portfolio of fixed and variable interest rate obligations as described under “Item 3 –Quantitative and Qualitative Disclosures about Market Risk” in this Report.
Cash Flow and Plans to Manage Liquidity. As a result of our significant leverage and other substantial obligations, our business strategies include efforts to enhance our capital structure by further reducing our gross obligations. Accordingly, we have placed the highest priority on accelerating the amount and speed of cash generated every day. Our efforts include leveraging our unique global manufacturing network by driving higher utilization rates and more productivity from our existing assets, accelerating commercialization initiatives across all of our businesses and realizing other global efficiencies. In addition, we may from time to time and at any time exchange or purchase Senior Notes or Debentures in open market or privately negotiated transactions, opportunistically on terms that we believe to be favorable. We also continue to evaluate other opportunities to reduce our obligations, including the obligations associated with our U.S. defined benefit plan, which was frozen in 2003. We intend to continue to sell real estate, non-strategic businesses and certain other non-strategic assets. Such sales could result in impairment charges. We cannot assure you if or when we will be able to complete these sales or that we will realize proceeds therefrom that meet our current expectations.
Our high leverage and other substantial obligations could have a material impact on our liquidity. Cash flow from operations services payment of our debt and other obligations, thereby reducing funds available to us for other purposes.
We believe that the long-term fundamentals of our business continue to be sound. Accordingly, although we cannot assure you that such will be the case, we believe that, based on our expected cash flow from operations, our existing capital resources, and taking into account our working capital needs and our efforts to reduce costs, improve efficiencies and product
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quality, and accelerate commercialization of new products and cash flow, we will be able to manage our liquidity to permit us to service our debt and meet our obligations when due.
Cash Flows. In general, during the first nine months of 2004 and 2005, we used cash in operating activities (including payments related to restructurings and antitrust investigations, lawsuits and claims) as well as for capital expenditures. Financing for these uses was provided primarily by our incurrence of long-term and short-term debt.
Cash Flow Used in Operating Activities. Cash flow used in operating activities was $20 million in the first nine months of 2005 and $142 million in the first nine months of 2004, an improvement of $122 million.
Cash used in operating activities was $20 million in the first nine months of 2005. Net income, after adding back the net effect from non-cash items, amounted to $58 million. Such income was used in operating activities as follows: a reduction in payables of $36 million primarily due to timing of payment patterns, including our semi-annual interest payments on the Senior Notes and the Debentures, an increase in inventories of $42 million, necessary to enhance the reliability and stability of our graphite electrode network, increase productivity and reduce overtime and distribution costs and an increase of $1 million in other current assets offset by a decrease in accounts receivables of $26 million due to improved collection efforts and, to a lesser extent, the factoring of accounts receivables.
Other uses in the first nine months of 2005 consisted of $12 million of payments for antitrust investigations and related lawsuits and claims, $5 million of restructuring costs related to severance and related payments and $8 million of other payments consisting primarily of pension and post-retirement contributions and payments.
Cash used in operating activities was $142 million in the first nine months of 2004. Net income, after adding back the net effect from non-cash items, amounted to $72 million. Such income was used in operating activities as follows: a reduction in payables of $35 million primarily due to timing of payment patterns (including our semi-annual interest payment on the Senior Notes), an increase in accounts receivables of $56 million primarily from the discontinuance of accounts receivable factoring, and an increase in inventories of $7 million in anticipation of increased demand.
Other uses in the first nine months of 2004 consisted primarily of $80 million of payments for antitrust investigations and related lawsuits and claims, $15 million of restructuring costs related to severance and related payments and $21 million of other payments consisting primarily of pension and post retirement contributions and payments.
Cash Flow Used in Investing Activities. Cash flow used in investing activities was $34 million in the first nine months of 2005 and $26 million in the first nine months of 2004. The majority of such investing activities consisted of capital expenditures.
Capital expenditures amounted to $36 million for the first nine months of 2005 and related primarily to graphite electrode productivity and production stability initiatives and other
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essential capital maintenance. Such uses were offset primarily by $2 million in proceeds from the sale of derivative instruments.
Virtually all of such investing activities for the first nine months of 2004 consisted of capital expenditures. Capital expenditures in the first nine months of 2004 related primarily to the expansion of graphite electrode manufacturing capacity, including expansion of our graphite electrode manufacturing facilities in Spain, implementation of J.D. Edwards information systems and essential capital maintenance. Such uses were offset by $6 million in proceeds from the sale of assets, due primarily to the closure of our advanced graphite machining operations in Sheffield, United Kingdom.
Cash Flow Provided by Financing Activities. Cash flow provided by financing activities was $38 million in the first nine months of 2005 and $194 million in the first nine months of 2004.
During the first nine months of 2005, we borrowed $122 million under the Revolving Facility, borrowed $1 million of other short-term debt and made payments of $72 million against the Revolving Facility. We used these net borrowings to fund working capital requirements, primarily inventory that we have replenished and built in anticipation of stronger demand. In the first nine months of 2005, we also paid $5 million of financing costs in conjunction with the refinancing of the Revolving Facility and $8 million in connection with the sale of interest rate swaps.
Overall debt increased in the first nine months of 2004 due to the issuance and sale of the Debentures. During the first nine months of 2004, we received gross proceeds of $225 million (less issuance costs of $7 million) from the issuance and sale of the Debentures. We used a portion of these proceeds to repay term loans of $21 million outstanding under the Senior Facilities. We also used these proceeds to make a provisional payment to the EU Competition Authority against the EU antitrust fine and to replace cash previously provided by factoring of accounts receivable. In addition, we purchased $8 million aggregate principal amount of Senior Notes, plus accrued interest, for $9 million in cash. Proceeds from the exercise of stock options amounted to $7 million.
Restrictions on Dividends and Stock Repurchases
A description of the restrictions on our ability to pay dividends and our ability to repurchase common stock is set forth under “Item 5 – Dividend Policies and Restrictions” in the Annual Report.
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Recent Accounting Pronouncements
On December 16, 2004, the FASB issued SFAS No. 123(R), Share-Based Payment (“SFAS 123(R)”). SFAS No. 123(R) revises SFAS No. 123; Accounting for Stock-Based Compensation, and requires companies to expense the fair value of employee stock options and other forms of stock-based compensation. Under SFAS No. 123(R), companies are to (1) use fair value to measure stock-based compensation awards and (2) cease using the “intrinsic value” method of accounting, which APB No. 25 allowed and resulted in no expense for many awards of stock options for which the exercise price of the option equaled the price of the underlying stock at the grant date. In addition, SFAS No. 123(R) retains the modified grant date model from SFAS No. 123. Under that model, compensation cost is measured at the grant date and adjusted to reflect actual forfeitures and the outcome of certain conditions. The fair value of an award is not remeasured after its initial estimation on the grant date (except in the case of a liability award or if the award is modified). This Statement is effective for annual periods beginning after June 15, 2005. We will be required to adopt SFAS No. 123(R) in the first quarter of 2006. The actual impact of the adoption of SFAS No. 123(R) will depend upon the amount, nature and type of stock-based compensation awards outstanding upon implementation and that we may issue in the future. Based on the current stock-based compensation plans in effect and awards issued, our estimated expense in 2006 for stock-based compensation is $7 million, $3 million of which relates to the 2005 restricted stock grants and $4 million of which relates to unvested stock options.
A full description of recent accounting pronouncements is set forth under “New Accounting Standards” in Note 2 to the Notes to the Consolidated Financial Statements contained in this Report, and such description is incorporated herein by reference.
Description of Our Financing Structure
The description of the Revolving Facility, the Senior Notes and the Debentures set forth under “Long-Term Debt and Liquidity” and “Subsequent Events” in the Annual Report is incorporated by reference, subject to the additional or different information set forth in this Report.
Revolving Facility
On February 8, 2005, we entered into an Amended and Restated Credit Agreement among GTI, GrafTech Finance, GrafTech Global, the LC Subsidiaries from time to time party thereto, the lenders from time to time party thereto and JP Morgan Chase Bank, N.A., as Administrative Agent, Collateral Agent and Issuing Bank.
As amended and restated, the Credit Agreement provides for, among other things, an extension until July 15, 2010 of the maturity of the Revolving Facility, lower interest rates, less restrictive financial covenants, additional flexibility for investments and acquisitions and, subject to certain conditions (including a maximum senior secured leverage ratio test), an accordion feature that permits GrafTech Finance to establish additional credit facilities thereunder in an aggregate amount, together with the Revolving Facility, of up to $425 million.
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The Revolving Facility provides for revolving and swingline loans to GrafTech Finance and issuance of letters of credit for the account of GrafTech Finance and other designated subsidiaries from time to time in an aggregate principal and stated amount at any time not to exceed $215 million. Loans and letters of credit may be denominated in dollars, euros and certain other currencies and are available for working capital and other general corporate purposes.
The interest rate applicable to the Revolving Facility is, at our option, either LIBOR plus a margin ranging from 1.25% to 2.25% (depending on our leverage ratio or our senior unsecured (or corporate or implied issuer) rating) or, in the case of dollar denominated loans, the alternate base rate plus a margin ranging from 0.25% to 1.25% (depending on such ratio or rating). The alternate base rate is the higher of (i) the prime rate announced by JP Morgan Chase Bank, N.A. or (ii) the federal fund effective rate plus 0.50%. GrafTech Finance pays a per annum fee ranging from 0.250% to 0.500% (depending on such ratio or rating) on the undrawn portion of the commitments under the Revolving Facility.
Senior Notes
GrafTech Finance currently has $435 million aggregate principal amount of Senior Notes outstanding. Interest on the Senior Notes is payable semi-annually on February 15 and August 15 of each year at the rate of 10.25% per annum. The Senior Notes mature on February 15, 2012.
Unsecured intercompany term notes in an aggregate principal amount, at September 30, 2005, equal to $514 million issued by our operating subsidiaries in Mexico, South Africa and Switzerland and our holding company subsidiary in France and guarantees of those unsecured intercompany term notes by our principal foreign subsidiaries have been pledged by GrafTech Finance to secure the Senior Notes, subject to the limitation that at no time will the combined value of the pledged portion of any foreign subsidiary’s unsecured intercompany term note and unsecured guarantee of unsecured intercompany term notes issued by other foreign subsidiaries exceed 19.99% of the principal amount of the then outstanding Senior Notes. As a result of this limitation, the principal amount of unsecured intercompany term notes pledged to secure the Senior Notes at September 30, 2005 equals $330 million, or about 76% of the principal amount of the outstanding Senior Notes. The remaining unsecured intercompany term notes held by GrafTech Finance in an aggregate principal amount at September 30, 2005 of $184 million and any pledged unsecured intercompany term notes that cease to be pledged due to a reduction in the principal amount of the then outstanding Senior Notes due to redemption, repurchase or other events, will not be subject to any pledge and will be available to satisfy the claims of creditors of GrafTech Finance (including the lenders under the Revolving Facility, the holders of the Senior Notes and the holders of the Debentures) as their interests may appear. The Senior Notes prohibit the pledge of these unsecured intercompany term notes or related guarantees to secure any other debt or obligation.
Our operating subsidiary in Russia, Carbone Savoie, AET and certain immaterial domestic and foreign operating and holding companies are neither guarantors of the secured
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intercompany revolving note of our Swiss subsidiary that is pledged to secure the Revolving Facility nor guarantors of the Senior Notes or the unsecured intercompany term notes pledged to secure the Senior Notes, nor guarantors of the Debentures. At December 31, 2004 and September 30, 2005, the aggregate combined book value of their assets was about $185 million and $208 million, respectively, and their debt and liabilities totaled $74 million (including intercompany trade and other miscellaneous liabilities of $19 million) and $86 million (including intercompany trade and other miscellaneous liabilities of $59 million), respectively. For the first nine months of 2005, their aggregate combined net loss was $2 million and for the first nine months of 2004 their aggregate combined net income was nil. For the first nine months of 2005 and first nine months of 2004, their aggregate combined net source of cash from operations was about $24 million and $4 million, respectively.
Debentures
GTI currently has $225 million aggregate principal amount of Debentures outstanding. Interest on the Debentures is payable semi-annually on January 15 and July 15 of each year, commencing July 15, 2004, at the rate of 1.625% per annum. The Debentures mature on January 15, 2024, unless earlier converted, redeemed or required to be repurchased.
Antitrust Litigation Against Us
In 1997, the DOJ and the EU Competition Authority commenced investigations into alleged violations of the antitrust laws in connection with the sale of graphite electrodes. The antitrust authorities in Canada, Japan and Korea subsequently began similar investigations. The EU Competition Authority also commenced an investigation into alleged antitrust violations in connection with the sale of specialty graphite. These antitrust investigations have been finally resolved. Several of the investigations resulted in the imposition of fines against us. These fines, or payments in accordance with a payment schedule in the case of the DOJ antitrust fine, have been timely paid.
We have settled virtually all of the civil antitrust lawsuits (including class action lawsuits) previously pending against us, certain civil antitrust lawsuits threatened against us and certain possible civil antitrust claims against us arising out of alleged antitrust violations occurring prior to the date of the relevant settlement in connection with the sale of graphite electrodes, carbon electrodes and bulk graphite products. All settlement payments due have been timely paid. There remain, however, certain pending claims as well as pending lawsuits in the U.S. relating to the sale of graphite electrodes sold to foreign customers. It is also possible that additional antitrust lawsuits and claims could be asserted against us in the U.S. or other jurisdictions. We are currently not reserved for such matters.
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Item 3. Quantitative and Qualitative Disclosures about Market Risk
We are exposed to market risks primarily from changes in interest rates, currency exchange rates, commercial energy rates and changes to the fair value of the redemption option and related make-whole provision under the Debentures. We routinely enter into various transactions that have been authorized according to documented policies and procedures to manage these well-defined risks. These transactions relate primarily to financial instruments described below. Since the counterparties to these financial instruments are large commercial banks and similar financial institutions, we do not believe that we are exposed to material counterparty credit risk. We do not use financial instruments for trading purposes.
Our exposure to changes in interest rates results primarily from floating rate long-term debt tied to LIBOR or euro LIBOR. Our exposure to changes in currency exchange rates results primarily from:
sales made by our subsidiaries in currencies other than local currencies;
raw material purchases made by our foreign subsidiaries in currencies other than local currencies; and
investments in and intercompany loans to our foreign subsidiaries and our share of the earnings of those subsidiaries, to the extent denominated in currencies other than the dollar.
Our exposure to changes in energy costs results primarily from the purchase of natural gas and electricity for use in our manufacturing operations. Our exposure to changes in the fair value of the redemption make-whole option results primarily from changes in the closing price of our common stock during each quarterly period.
Interest Rate Risk Management. We implement interest rate management initiatives to seek to minimize our interest expense and optimize the risk in our portfolio of fixed and variable interest rate obligations. Use of these initiatives is allowed under the Senior Notes and the Revolving Facility. We have interest rate swaps that effectively convert a portion of our fixed rate debt (represented by the Senior Notes) into variable rate debt.
At December 31, 2004, we had swaps for a notional amount of $450 million. At December 31, 2004, $435 million (out of our total outstanding $450 million notional amount) of interest rate swaps were designated as hedging the exposure to changes in the fair value of the related debt (called a fair value hedge). The related debt for those swaps is the Senior Notes, of which $435 million aggregate principal amount was outstanding at December 31, 2004.
During the first quarter of 2005, we sold $15 million notional amount of undesignated swaps and paid a nominal fee. Additionally, we sold $150 million notional amount of our fair value hedge swaps and paid $3 million in cash. Immediately thereafter, we repurchased $150 million notional amount of fair value hedge swaps with a different counterparty. During the second quarter of 2005, we sold $285 million notional amount of swaps and paid $5 million. As
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a result of these transactions, we now hold $150 million notional amount of swaps related to the Senior Notes.
At December 31, 2004 and September 30, 2005 (excluding the offsetting value of our interest rate caps), the principal value of our debt was reduced by $10 million and $4 million, respectively, as a result of our fair value hedges. The market values of those interest rate swaps, excluding changes in value resulting from accrued interest payable or receivable from the counterparty, are currently recorded as part of other long-term obligations on the Consolidated Balance Sheets. Accrued interest receivable from or payable to the counterparty is recorded as a component of interest expense on the Consolidated Statement of Operations.
Such interest rate swaps have effectively converted a portion of our fixed rate debt (represented by the Senior Notes) into variable rate debt. At December 31, 2004, such variable interest rate was calculated based on the six month LIBOR rate as of the date of payment plus 5.7940%, calculated in arrears. At September 30, 2005, such variable interest rate was calculated based on six month LIBOR, set in advance on August 16, 2005 at 4.03%, plus 5.7967%.
All of our swaps are valued monthly, and we are required to provide cash collateral to the counterparty to the extent that the fair market value of the swap liability, net of the fair market value of our interest rate caps, exceeds a specific threshold. At December 31, 2004 and September 30, 2005, all of our swaps were with one counterparty and this threshold was $15 million. We were not required to provide any cash collateral at December 31, 2004 or September 30, 2005.
When we sell a fair value hedge swap, the gain or loss is amortized as a credit or charge to interest expense over the remaining term of the Senior Notes. When we effectively reduce the outstanding principal amount of the Senior Notes (through debt-for-equity exchanges, repurchases or otherwise), the related portion of such credit or charge is accelerated and recorded in the period in which such reduction occurs. At December 31, 2004 and September 30, 2005, the principal value of our debt was increased by $25 million and $15 million, respectively, as a result of gains realized from previously sold swaps. The net impact of current and terminated hedge instruments was a $15 million and an $11 million increase in the fair value of our debt at December 31, 2004 and September 30, 2005, respectively, and was recorded on the Consolidated Balance Sheets on the line entitled “fair value adjustments for hedge instruments.”
Interest rate swaps reduced our interest expense by approximately $14 million in the first nine months of 2004. The reduction was due to the benefit from current interest rate swaps in the amount of $9 million, $2 million of amortization of fair value adjustments for previously sold interest rate swaps and $3 million due to the acceleration of the amortization of fair value adjustments for previously sold interest rate swaps due to a reduction of Senior Notes.
Interest rate swaps reduced our interest expense by $3 million in the first nine months of 2005. The reduction was due to the benefit from current interest rate swaps in the amount of $2 million and the amortization of fair value adjustments for previously sold interest rate swaps of $1 million.
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We enter into agreements with financial institutions that are intended to limit our exposure to incurrence of additional interest expense due to increases in variable interest rates. These instruments effectively cap a portion of our exposure to such additional interest, represented by the net impact of increases in interest rates on our swaps related to the Senior Notes, to no greater than 11.3% per annum. At December 31, 2004, we had interest rate caps for a notional amount of $500 million. During the first nine months of 2005, we sold $350 million notional amount of caps and received a nominal amount. As a result, at September 30, 2005, we had interest rate caps for a notional amount of $150 million. All of our interest rate caps are marked-to-market monthly. Gains and losses are recorded in other (income) expense, net, on the Consolidated Statements of Operations. The fair value adjustment on caps was a $2 million loss for the third quarter of 2004, a nominal gain for the third quarter of 2005, a $4 million loss for the first nine months of 2004 and a $1 million loss for the first nine months of 2005.
Currency Rate Management. We enter into foreign currency instruments to attempt to manage exposure to changes in currency exchange rates. These foreign currency instruments, which include, but are not limited to, forward exchange contracts and purchased currency options, attempt to hedge global currency exposures, net, relating to euro-denominated debt and identifiable foreign currency receivables, payables and commitments held by our foreign and domestic subsidiaries. Forward exchange contracts are agreements to exchange different currencies at a specified future date and at a specified rate. Purchased foreign currency options are instruments, which give the holder the right, but not the obligation, to exchange different currencies at a specified rate at a specified date or over a range of specified dates. The result is the creation of a range in which a best and worst price is defined, while minimizing option cost. Forward exchange contracts and purchased currency options are carried at market value.
The notional amount of open foreign exchange contracts, used by us to minimize foreign currency exposure against euro depreciation, was $54 million at December 31, 2004. In the first nine months of 2005, we sold all open foreign exchange contracts. As a result, in the first nine months of 2005, we received $2 million and recognized a gain of $1 million which was recorded in other (income) expense, net, on the Consolidated Statement of Operations. At September 30, 2005, we had no such contracts outstanding.
Commercial Energy Rate Management. We currently do not have any natural gas derivative or other commercial energy rate contracts. We have entered, and may in the future enter into additional, short duration fixed rate purchase contracts with certain of our natural gas suppliers in order to mitigate seasonal increases in our natural gas costs.
Derivative Liability Associated with the Debentures. The redemption make-whole option is accounted for separately from the underlying debt and recorded as a derivative financial instrument. The embedded derivative financial instrument was classified as a derivative liability upon issuance and is included in the other long-term obligations in the Consolidated Balance Sheet. At each balance sheet date, we adjust the redemption make-whole option to its estimated fair value. Upon issuance at January 22, 2004, the estimated fair value of our derivative liability was $6 million. At December 31, 2004, the estimated fair value of our derivative liability was $4 million. At September 30, 2005, the estimated fair value of our derivative liability was $1
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million. We estimate the fair value of the redemption make-whole option using a financial model that uses several assumptions, including historical stock price volatility, risk-free interest rates, remaining maturity and the closing price of our common stock. We believe that the assumption that has the greatest impact on the determination of fair value is the closing price of our common stock during each quarterly period.
Sensitivity Analysis. We used a sensitivity analysis to assess the potential effect of changes in currency exchange rates on gross margin, changes in interest rates on interest expense and changes in the more relevant variables (particularly our current stock price, historical stock price volatility and borrowing costs) on the Debenture redemption make-whole option for the first nine months of 2005. Based on this analysis, a hypothetical 10% increase or decrease in such variables, or in the case of currencies a hypothetical weakening or strengthening, would have had the following impact:
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Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this Report and, based on that evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that these controls and procedures are effective at the reasonable assurance level.
Disclosure controls and procedures are our controls that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Changes in Internal Controls Over Financial Reporting
Management’s evaluation of disclosure controls and procedures did not identify any change in our internal controls over financial reporting that occurred during the quarter ended September 30, 2005 that has materially affected or is reasonably likely to materially affect our internal control over financial reporting.
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PART II. OTHER INFORMATION
The information required in response to this Item is set forth under “Contingencies” in Note 13 to the Notes to the Consolidated Financial Statements contained in this Report, and such description is incorporated herein by reference.
The exhibits listed in the following table have been filed as part of this Report.
Exhibit
Number
Description of Exhibit
10.1.01
First Amendment to Amended and Restated Credit Agreement dated as of February 8, 2005 among GrafTech International Ltd., GrafTech Global Enterprises Inc., GrafTech Finance Inc., the LC Subsidiaries from time to time party thereto, the Lenders from time to time party thereto, and JPMorgan Chase Bank, N.A., as Administrative Agent.
31.1
Certification pursuant to Rule 13a-14(a) under the Exchange Act by Craig S. Shular, Chief Executive Officer & President.
31.2
Certification pursuant to Rule 13a-14(a) under the Exchange Act by Corrado F. De Gasperis, Vice President, Chief Financial Officer & Chief Information Officer.
32.1
Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Craig S. Shular, Chief Executive Officer & President.
32.2
Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Corrado F. De Gasperis, Vice President, Chief Financial Officer & Chief Information Officer.
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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: November 4, 2005
By:/s/ Corrado F. DeGasperis
Corrado F. De Gasperis
Vice President, Chief Financial Officer & Chief Information Officer (Principal Accounting Officer)
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