UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, 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 JUNE 30, 2006

 

OR

 

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

 

 

Commission File Number 1-13953

 

 

W. R. GRACE & CO.

 

Delaware

 

65-0773649

(State of Incorporation)

 

(I.R.S. Employer

Identification No.)

 

 

 

7500 Grace Drive

Columbia, Maryland 21044

(410) 531-4000

(Address and phone number of principal executive offices)

 

 

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    o

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

Large accelerated filer    o                                 Accelerated filer   x                           Non-accelerated filer    o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes    o                        No  x

68,258,065 shares of Common Stock, $0.01 par value, were outstanding at July 31, 2006.

 

 




 

W. R. GRACE & CO. AND SUBSIDIARIES

Table of Contents

 

 

 

Page No.

Part I.

Financial Information

 

 

 

 

 

 

Item 1.

 

Financial Statements

 

I - 1

 

 

 

 

 

 

 

Report of Independent Registered Public Accounting Firm

 

I - 2

 

 

 

 

 

 

 

Consolidated Statements of Operations

 

I - 3

 

 

 

 

 

 

 

Consolidated Statements of Cash Flows

 

I - 4

 

 

 

 

 

 

 

Consolidated Balance Sheets

 

I - 5

 

 

 

 

 

 

 

Consolidated Statements of Shareholders’ Equity (Deficit)

 

I - 6

 

 

 

 

 

 

 

Consolidated Statements of Comprehensive Income (Loss)

 

I - 6

 

 

 

 

 

 

 

Notes to Consolidated Financial Statements

 

I - 7 to I - 29

 

 

 

 

 

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

I - 30 to I - 46

 

 

 

 

 

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

 

I - 47 to I - 48

 

 

 

 

 

Item 4.

 

Controls and Procedures

 

I - 49

 

 

 

 

 

Part II.

Other Information

 

 

 

 

 

 

Item 1.

 

Legal Proceedings

 

II - 1

 

 

 

 

 

Item 1A.

 

Risk Factors

 

II - 1

 

 

 

 

 

Item 6.

 

Exhibits

 

II - 1

 




 

PART I.  FINANCIAL INFORMATION

Item 1.  FINANCIAL STATEMENTS

Review by Independent Registered Public Accounting Firm

A review of the interim consolidated financial statements included in this Quarterly Report on Form 10-Q for the three and six months ended June 30, 2006 and 2005 has been performed by PricewaterhouseCoopers LLP, the company’s independent registered public accounting firm. Their report on the interim consolidated financial statements follows.  This report is not considered a “report” within the meaning of Sections 7 and 11 of the Securities Act of 1933, and, therefore, the independent accountants’ liability under Section 11 does not extend to it.

I-1




Report of Independent Registered Public Accounting Firm

To the Shareholders and Board of Directors of W. R. Grace & Co.:

We have reviewed the accompanying consolidated balance sheet of W. R. Grace & Co. and its subsidiaries as of June 30, 2006, and the related consolidated statements of operations, shareholders’ equity (deficit) and comprehensive income (loss) for each of the three-month and six-month periods ended June 30, 2006 and June 30, 2005 and the consolidated statements of cash flows for the six-month periods ended June 30, 2006 and June 30, 2005. These interim financial statements are the responsibility of the Company’s management.

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should be made to the accompanying interim consolidated financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

The accompanying interim consolidated financial statements have been prepared assuming that the Company will continue as a going concern.  As discussed in Notes 1 and 2 to the interim consolidated financial statements, on April 2, 2001, the Company and substantially all of its domestic subsidiaries voluntarily filed for protection under Chapter 11 of the United States Bankruptcy Code, which raises substantial doubt about the Company’s ability to continue as a going concern in its present form.  Management’s intentions with respect to this matter are also described in Notes 1 and 2.  The accompanying interim consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2005, and the related consolidated statements of operations, cash flows, shareholders’ equity (deficit) and comprehensive income (loss) for the year then ended, management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005 and the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005; and in our report dated March 10, 2006, we expressed (i) an unqualified opinion on those consolidated financial statements with an explanatory paragraph relating to the Company’s ability to continue as a going concern and, (ii) unqualified opinions on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and on the effectiveness of the Company’s internal control over financial reporting. The consolidated financial statements and management’s assessment of the effectiveness of internal control over financial reporting referred to above are not presented herein. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2005, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived.

/s/ PricewaterhouseCoopers LLP

 

McLean, Virginia

 

August 8, 2006

 

 

I-2




W. R. Grace & Co. and Subsidiaries
Consolidated Statements of Operations (Unaudited)
In millions, except per share amounts

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Net sales

 

$

729.1

 

$

676.5

 

$

1,387.7

 

$

1,279.7

 

Cost of goods sold, exclusive of depreciation and amortization shown separately below

 

470.2

 

439.7

 

908.2

 

832.4

 

Selling, general and administrative expenses, exclusive of net pension expense and depreciation and amortization shown separately below

 

141.5

 

117.8

 

269.7

 

235.4

 

Depreciation and amortization

 

28.4

 

30.2

 

56.5

 

60.7

 

Research and development expenses

 

15.1

 

15.1

 

30.6

 

30.2

 

Net pension expense

 

16.8

 

19.5

 

31.6

 

37.1

 

Interest expense and related financing costs

 

19.9

 

13.3

 

35.7

 

27.9

 

Provision for environmental remediation

 

30.0

 

 

30.0

 

 

Other (income) expense

 

(13.9

)

(23.9

)

(15.8

)

(30.0

)

 

 

708.0

 

611.7

 

1,346.5

 

1,193.7

 

Income (loss) before Chapter 11 expenses, income taxes, and minority interest   

 

21.1

 

64.8

 

41.2

 

86.0

 

Chapter 11 expenses, net

 

(11.5

)

(4.6

)

(20.2

)

(10.6

)

Benefit from (provision for) income taxes

 

(3.3

)

(20.0

)

(7.8

)

(28.6

)

Minority interest in consolidated entities

 

(11.5

)

(7.5

)

(18.3

)

(11.0

)

Net income (loss)

 

$

(5.2

)

$

32.7

 

$

(5.1

)

$

35.8

 

Basic earnings (loss) per share:

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(0.08

)

$

0.49

 

$

(0.08

)

$

0.54

 

Weighted average number of basic shares

 

67.9

 

66.9

 

67.5

 

66.8

 

Diluted earnings (loss) per share:

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(0.08

)

$

0.49

 

$

(0.08

)

$

0.53

 

Weighted average number of diluted shares

 

67.9

 

67.2

 

67.5

 

67.3

 

 

The Notes to Consolidated Financial Statements are an integral part of these statements.

I-3




W. R. Grace & Co. and Subsidiaries
Consolidated Statements of Cash Flows (Unaudited)
In millions

 

 

Six Months Ended
June 30,

 

 

 

2006

 

2005

 

OPERATING ACTIVITIES

 

 

 

 

 

Net income (loss)

 

$

(5.1

)

$

35.8

 

Reconciliation to net cash provided by (used for) operating activities:

 

 

 

 

 

Chapter 11 expenses, net

 

20.2

 

10.6

 

(Benefit from) provision for income taxes

 

7.8

 

28.6

 

Minority interest in consolidated entities

 

18.3

 

11.0

 

Depreciation and amortization

 

56.5

 

60.7

 

Interest accrued on pre-petition liabilities subject to compromise

 

34.7

 

25.4

 

Net (gain) loss on sales of investments and disposals of assets

 

(2.8

)

(0.5

)

Net pension expense

 

31.6

 

37.1

 

Payments to fund defined benefit pension arrangements

 

(39.6

)

(13.2

)

Net income from life insurance policies

 

(1.7

)

(1.9

)

Provision for uncollectible receivables

 

0.5

 

0.9

 

Provision for environmental remediation

 

30.0

 

 

Payments under postretirement benefit plans

 

(6.5

)

(5.1

)

Expenditures for environmental remediation

 

(3.4

)

(3.0

)

Expenditures for retained obligations of divested businesses

 

(1.3

)

(0.5

)

Changes in assets and liabilities, excluding effect of businesses acquired/divested and foreign currency translation:

 

 

 

 

 

Working capital items (trade accounts receivable, inventories and accounts payable)

 

(86.2

)

(71.7

)

Other accruals and non-cash items

 

(7.2

)

(45.2

)

Net cash provided by (used for) operating activities before income taxes, Chapter 11 expenses and settlement of noncore contingencies

 

45.8

 

69.0

 

Cash paid to settle noncore contingencies

 

 

(119.7

)

Chapter 11 expenses paid

 

(16.9

)

(9.0

)

Income taxes paid, net of refunds

 

(17.8

)

(14.9

)

Net cash provided by (used for) operating activities

 

11.1

 

(74.6

)

INVESTING ACTIVITIES

 

 

 

 

 

Capital expenditures

 

(51.9

)

(36.8

)

Businesses acquired, net of cash acquired

 

(20.0

)

(2.5

)

Proceeds from termination of life insurance policies

 

 

14.8

 

Net investment in life insurance policies

 

(0.1

)

2.4

 

Proceeds from sales of investments and disposals of assets

 

7.2

 

1.9

 

Net cash provided by (used for) investing activities

 

(64.8

)

(20.2

)

FINANCING ACTIVITIES

 

 

 

 

 

Net payments of loans secured by cash value of life insurance policies

 

 

(0.6

)

Net (repayments) borrowings under credit arrangements

 

0.6

 

(1.2

)

Fees under debtor-in-possession credit facility

 

(1.1

)

(1.1

)

Proceeds from exercise of stock options

 

15.8

 

3.0

 

Net cash provided by (used for) financing activities

 

15.3

 

0.1

 

Effect of currency exchange rate changes on cash and cash equivalents

 

6.9

 

(11.7

)

Increase (decrease) in cash and cash equivalents

 

(31.5

)

(106.4

)

Cash and cash equivalents, beginning of period

 

474.7

 

510.4

 

Cash and cash equivalents, end of period

 

$

443.2

 

$

404.0

 

The Notes to Consolidated Financial Statements are an integral part of these statements.

I-4




W. R. Grace & Co. and Subsidiaries
Consolidated Balance Sheets (Unaudited)
In millions, except par value and shares



 

June 30,
2006

 

December 31,
2005

 

ASSETS

 

 

 

 

 

Current Assets

 

 

 

 

 

Cash and cash equivalents

 

$

443.2

 

$

474.7

 

Trade accounts receivable, less allowance of $4.6 (2005 - $5.0)

 

472.4

 

401.7

 

Inventories

 

309.3

 

278.3

 

Deferred income taxes

 

26.6

 

27.3

 

Other current assets

 

54.3

 

71.6

 

Total Current Assets

 

1,305.8

 

1,253.6

 

Properties and equipment, net of accumulated depreciation and amortization of $1,476.8 (2005 - $1,420.2)

 

640.2

 

632.9

 

Goodwill

 

103.6

 

103.9

 

Cash value of life insurance policies, net of policy loans

 

86.6

 

84.8

 

Deferred income taxes

 

726.4

 

703.9

 

Asbestos-related insurance

 

500.0

 

500.0

 

Other assets

 

249.1

 

238.1

 

Total Assets

 

$

3,611.7

 

$

3,517.2

 

LIABILITIES AND SHAREHOLDERS’ EQUITY (DEFICIT)

 

 

 

 

 

Liabilities Not Subject to Compromise

 

 

 

 

 

Current Liabilities

 

 

 

 

 

Debt payable within one year

 

$

3.2

 

$

2.3

 

Accounts payable

 

164.8

 

166.8

 

Income taxes payable

 

16.9

 

10.1

 

Other current liabilities

 

191.5

 

197.9

 

Total Current Liabilities

 

376.4

 

377.1

 

Debt payable after one year

 

0.4

 

0.4

 

Deferred income taxes

 

59.9

 

54.3

 

Minority interest in consolidated affiliates

 

55.7

 

36.4

 

Unfunded defined benefit pension liability

 

445.5

 

447.5

 

Other liabilities

 

38.6

 

41.7

 

Total Liabilities Not Subject to Compromise

 

976.5

 

957.4

 

Liabilities Subject to Compromise — Note 2

 

3,205.6

 

3,155.1

 

Total Liabilities

 

4,182.1

 

4,112.5

 

Commitments and Contingencies

 

 

 

 

 

Shareholders’ Equity (Deficit)

 

 

 

 

 

Common stock issued, par value $0.01; 300,000,000 shares authorized; outstanding: 2006 — 68,258,065 (2005 — 66,922,196)

 

0.8

 

0.8

 

Paid-in capital

 

423.2

 

423.4

 

Accumulated deficit

 

(511.0

)

(505.9

)

Treasury stock, at cost: shares: 2006 — 8,721,695; (2005 — 10,057,564)

 

(103.8

)

(119.7

)

Accumulated other comprehensive income (loss)

 

(379.6

)

(393.9

)

Total Shareholders’ Equity (Deficit)

 

(570.4

)

(595.3

)

Total Liabilities and Shareholders’ Equity (Deficit)

 

$

3,611.7

 

$

3,517.2

 

 

The Notes to Consolidated Financial Statements are an integral part of these statements.

I-5




W. R. Grace & Co. and Subsidiaries
Consolidated Statements of Shareholders’ Equity (Deficit) (Unaudited)
In millions

 

 

Common
Stock and
Paid-in
Capital

 

Accumulated
Deficit

 

Treasury
Stock

 

Accumulated
Other
Comprehensive
Income (Loss)

 

Total
Shareholders’
Equity
(Deficit)

 

Balance, March 31, 2006

 

$

423.5

 

$

(505.8

)

$

(117.1

)

$

(393.5

)

$

(592.9

)

Net income (loss)

 

 

(5.2

)

 

 

(5.2

)

Stock plan activity

 

0.5

 

 

13.3

 

 

13.8

 

Other comprehensive income (loss)

 

 

 

 

13.9

 

13.9

 

Balance, June 30, 2006

 

$

424.0

 

$

(511.0

)

$

(103.8

)

$

(379.6

)

$

(570.4

)

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2005

 

$

424.2

 

$

(505.9

)

$

(119.7

)

$

(393.9

)

$

(595.3

)

Net income (loss)

 

 

(5.1

)

 

 

(5.1

)

Stock plan activity

 

(0.2

)

 

15.9

 

 

15.7

 

Other comprehensive income (loss)

 

 

 

 

14.3

 

14.3

 

Balance, June 30, 2006

 

$

424.0

 

$

(511.0

)

$

(103.8

)

$

(379.6

)

$

(570.4

)

 

W. R. Grace & Co. and Subsidiaries
Consolidated Statements of Comprehensive Income (Loss) (Unaudited)
In millions

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Net income (loss)

 

$

(5.2

)

$

32.7

 

$

(5.1

)

$

35.8

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss):

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustments

 

13.6

 

(9.4

)

14.6

 

(22.4

)

Commodity hedging activities

 

0.3

 

 

(0.3

)

 

Total other comprehensive income (loss)

 

13.9

 

(9.4

)

14.3

 

(22.4

)

Comprehensive income (loss)

 

$

8.7

 

$

23.3

 

$

9.2

 

$

13.4

 

 

The Notes to Consolidated Financial Statements are an integral part of these statements.

 

I-6




 

W. R. Grace & Co. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)

1.              Basis of Presentation and Summary of Significant Accounting and Financial Reporting Policies

W. R. Grace & Co., through its subsidiaries, is engaged in specialty chemicals and specialty materials businesses on a worldwide basis through two operating segments: “Grace Davison,” which includes silica- and alumina-based catalysts and materials used in a wide range of industrial applications; and “Grace Performance Chemicals,” which includes specialty chemicals and materials used in commercial and residential construction and in rigid food and beverage packaging.

W. R. Grace & Co. conducts substantially all of its business through a direct, wholly-owned subsidiary,
W. R. Grace & Co.-Conn. (“Grace-Conn.”). Grace-Conn. owns substantially all of the assets, properties and rights of W. R. Grace & Co. on a consolidated basis, either directly or through subsidiaries.

As used in these notes, the term “Company” refers to W. R. Grace & Co. The term “Grace” refers to the Company and/or one or more of its subsidiaries and, in certain cases, their respective predecessors.

Voluntary Bankruptcy Filing — During 2000 and the first quarter of 2001, Grace experienced several adverse developments in its asbestos-related litigation, including: a significant increase in personal injury claims, higher than expected costs to resolve personal injury and certain property damage claims, and class action lawsuits alleging damages from Zonolite Attic Insulation (“ZAI”) a former Grace attic insulation product.

After a thorough review of these developments, the Board of Directors concluded that a federal court-supervised bankruptcy process provided the best forum available to achieve fairness in resolving these claims and on April 2, 2001 (the “Filing Date”), Grace and 61 of its United States subsidiaries and affiliates, including Grace-Conn. (collectively, the “Debtors”), filed voluntary petitions for reorganization (the “Filing”) under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”). The cases were consolidated and are being jointly administered under case number 01-01139 (the “Chapter 11 Cases”). Grace’s non-U.S. subsidiaries and certain of its U.S. subsidiaries were not included in the Filing.

Under Chapter 11, the Debtors have continued to operate their businesses as debtors-in-possession under court protection from creditors and claimants, while using the Chapter 11 process to develop and implement a plan for addressing the asbestos-related claims. Since the Filing, all motions necessary to conduct normal business activities have been approved by the Bankruptcy Court. (See Note 2 for Chapter 11 Related Information.)

Basis of Presentation — The interim Consolidated Financial Statements presented herein are unaudited and should be read in conjunction with the Consolidated Financial Statements presented in the Company’s 2005 Annual Report on Form 10-K.  Such interim Consolidated Financial Statements reflect all adjustments that, in the opinion of management, are necessary for a fair presentation of the results of the interim periods presented; all such adjustments are of a normal recurring nature. Potential accounting adjustments discovered during normal reporting and accounting processes are evaluated on the basis of materiality, both individually and in the aggregate, and are recorded in the accounting period discovered, unless a restatement of a prior period is necessary. All significant intercompany accounts and transactions have been eliminated.

The results of operations for the three-month and six-month interim periods ended June 30, 2006 are not necessarily indicative of the results of operations for the year ending December 31, 2006.

Reclassifications Certain amounts in prior years’ Consolidated Financial Statements have been reclassified to conform to the 2006 presentation.

Use of Estimates The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires that management make estimates and assumptions affecting the assets and liabilities reported at the date of the Consolidated Financial Statements, and the revenues and expenses reported for the periods presented. Actual amounts could differ from those estimates, and the differences could be material.  Changes in estimates are recorded in the period identified. Grace’s accounting measurements that are most affected by management’s estimates of future events are:

I-7




·                  Contingent liabilities which depend on an assessment of the probability of loss and an estimate of ultimate resolution cost, such as asbestos-related matters (see Notes 2 and 3), environmental remediation (see Note 12), income taxes (see Note 12), and litigation (see Note 12);

·                  Pension and postretirement liabilities that depend on assumptions regarding discount rates and total returns on invested funds (see Note 13);

·                  Liabilities for employee incentive compensation and customer rebates that depend on estimates of future sales or earnings;

·                  Depreciation and amortization periods for long-lived assets, including property and equipment, intangible, and other assets that depend on utilization assessments, future product and production plans and expected sales and cash flows; and

·                  Realization values of various assets such as net deferred tax assets, trade receivables, inventories, insurance receivables, properties and equipment, and goodwill which depend on assessments of credit and other business risks, and projections of future income and cash flows.

The accuracy of these and other estimates may also be materially affected by the uncertainties arising under Grace’s Chapter 11 proceeding.

Effect of New Accounting Standards In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” an interpretation of FASB Statement No. 109 (“FIN 48”), which prescribes a recognition threshold and measurement attribute for tax positions taken or expected to be taken in tax returns. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.  Grace is required to adopt FIN 48 in the first quarter of 2007, and is currently evaluating the impact to its Consolidated Financial Statements.

In December 2004, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment,” to require companies to measure and recognize in operations the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value. The provisions of this standard are effective for Grace in 2006. Grace implemented SFAS 123(R) in the first quarter of 2006. Under the transition method selected by Grace, the modified prospective method, the only outstanding awards affected were stock appreciation rights granted to Grace’s former Chief Executive Officer. Grace measured the award at a fair value of $2.6 million using the Black-Scholes option pricing model at March 31, 2006 and recorded that amount as compensation cost (included in selling, general and administrative expenses) in the quarter ended March 31, 2006.  Grace recognized the $0.6 million decrease in fair value of the stock appreciation rights from March 31, 2006 to June 30, 2006 as a reduction of compensation costs in the quarter ended June 30, 2006. The cumulative effect of this new rule was $1.4 million at the beginning of the first quarter of 2006. Grace has not granted equity options or rights while in Chapter 11.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs — an Amendment of ARB No. 43, Chapter 4,” to provide clarification that abnormal amounts of idle facility expense, freight, handling costs, and wasted material be recognized as current-period costs. In addition, this standard requires that the allocation of fixed production overheads to the costs of inventory be based on the normal capacity of the production facilities.  Grace adopted this standard in 2006 and it has not had a material impact on Grace’s Consolidated Financial Statements.

2.     Chapter 11 Related Information

Plan of Reorganization On November 13, 2004 Grace filed a plan of reorganization, as well as several associated documents, including a disclosure statement, with the Bankruptcy Court.  On January 13, 2005, Grace filed an amended plan of reorganization (the “Plan”) and related documents to address certain objections of creditors and other interested parties. The Plan is supported by committees representing general unsecured creditors and equity holders, but is not supported by committees representing asbestos personal injury claimants and asbestos property damage claimants.

I-8




Under the terms of the Plan, a trust would be established under Section 524(g) of the Bankruptcy Code to which all pending and future asbestos-related claims would be channeled for resolution.  Grace has requested that the Bankruptcy Court conduct an estimation hearing to, among other things, determine the amount that would need to be paid into the trust on the effective date of the Plan to satisfy the estimated liability for all classes of asbestos claimants and trust administration costs and expenses over time. The Plan provides that Grace’s asbestos-related liabilities would be satisfied using cash and securities from Grace and third parties.

The Plan will become effective only after a vote of eligible creditors and with the approval of the Bankruptcy Court and the U.S. District Court for the District of Delaware. Votes on the Plan may not be solicited until the Bankruptcy Court approves the disclosure statement. The Bankruptcy Court has indicated that it will not consider the approval of the disclosure statement until after completion of estimation hearings on the amount of Grace’s asbestos-related liability. The Debtors have received extensions of their exclusive right to propose a plan of reorganization through September 11, 2006.

Under the terms of the Plan, claims would be satisfied under the Chapter 11 cases as follows:

Asbestos-Related Claims and Costs

A trust would be established under Section 524(g) of the Bankruptcy Code to which all pending and future asbestos-related claims would be channeled for resolution.  The trust would utilize specified trust distribution procedures to satisfy the following allowed asbestos-related claims and costs:

1.                           Personal injury claims that meet specified exposure and medical criteria (Personal Injury-Symptomatic Eligible or “PI-SE” Claims) In order to qualify for this class, claimants would have to prove that their health is impaired from meaningful exposure to asbestos-containing products formerly manufactured by Grace.

2.                           Personal injury claims that do not meet the exposure and medical criteria necessary to qualify as PI-SE Claims (Personal Injury-Asymptomatic and Other or “PI-AO” Claims) This class would contain all asbestos-related personal injury claims against Grace that do not meet the specific requirements to be PI-SE Claims, but do meet certain other specified exposure and medical criteria.

3.                           Property damage claims, including claims related to ZAI (“PD Claims”) — In order to qualify for this class, claimants would have to prove Grace liability for loss of property value or remediation costs related to products formerly manufactured by Grace that claimants allege contained asbestos.

4.                           Trust administration costs and legal expenses

The pending asbestos-related legal proceedings are described in “Asbestos-Related Litigation” (see Note 3). The claims arising from such proceedings would be subject to this classification process as part of the Plan.

The Bankruptcy Court has entered separate case management orders for estimating liability for pending and future personal injury claims and pending property damage claims, excluding ZAI claims. The case management orders originally contemplated that estimation hearings would take place in September 2006.  However, the Bankruptcy Court deferred the estimation process to provide the Debtors and the other stakeholders in the Chapter 11 proceeding with an opportunity to negotiate a resolution of all or a portion of the Debtors’ asbestos-related liabilities.  The Bankruptcy Court appointed a mediator to facilitate such negotiations that ultimately were unsuccessful.  As a result, the Bankruptcy Court has resumed the estimation process.  Trial dates for estimating liability for personal injury claims have been scheduled for June 2007.  Grace expects that hearings for the adjudication of property damage claims will take place during the first quarter of 2007.  The Debtors expect that the estimated liability will provide the basis for determining the Funding Amount to be paid into the trust on the effective date of the Plan.

Asbestos personal injury claimants, including both PI-SE and PI-AO claims, would have the option either to litigate their claims against the trust in federal court in Delaware or, if they meet specified eligibility criteria, accept a settlement amount based on the severity of their condition. Asbestos property damage claimants would be required to litigate their claims against the trust in federal court in Delaware. The Plan provides that, as a condition precedent to confirmation, the maximum estimated aggregate funding amount for all asbestos-related liabilities (PI-SE, PI-AO and PD including ZAI) and trust administration costs and expenses as determined by the Bankruptcy Court cannot exceed $1,613 million, which Grace believes would fund over $2 billion in claims, costs and expenses over time.

I-9




The PI-SE Claims, the PD Claims and the related trust administration costs and expenses would be funded with (1) a payment of $512.5 million in cash (plus interest at 5.5% compounded annually from December 21, 2002) and nine million shares of common stock of Sealed Air Corporation (“Sealed Air”) to be made directly by Cryovac, Inc., a wholly owned subsidiary of Sealed Air, (“Cryovac”) to the asbestos trust pursuant to the terms of a settlement agreement resolving asbestos-related, successor liability and fraudulent transfer claims against Sealed Air and Cryovac and (2) Grace common stock. The number of shares of Grace common stock required to satisfy these claims will depend on the price of Grace common stock on the effective date of the Plan, liability measures approved by the Bankruptcy Court, and the value of the Sealed Air settlement, which changes daily with the accrual of interest and the trading value of Sealed Air common stock. The Sealed Air settlement agreement has been approved by the Bankruptcy Court, but remains subject to the fulfillment of specified conditions.

The PI-AO Claims would be funded with warrants exercisable for that number of shares of Grace common stock which, when added to the shares issued directly to the trust on the effective date of the Plan, would represent 50.1% of Grace’s voting securities. If the common stock issuable upon exercise of the warrants is insufficient to pay all PI-AO Claims (the liability for which is uncapped under the Plan), then Grace would pay any additional liabilities in cash.

The amounts to fund PI-SE Claims, PD Claims and the expense of trust administration would be capped at the amount determined by the Bankruptcy Court. Amounts required to fund PI-AO Claims would not be capped, so if the amount funded in respect thereof later proved to be inadequate, Grace would be responsible for contributing additional funds into the asbestos trust to satisfy PI-AO Claims.  Because of the number and nature of the uncertainties involved, Grace is unable to determine the extent to which, if any, the liability for PI-AO claims may exceed the amount funded into the trust in respect thereof.

Other Claims

The Plan provides that all allowed administrative or priority claims would be paid 100% in cash and all general unsecured claims, other than those covered by the asbestos trust, would be paid 85% in cash and 15% in Grace common stock. Grace estimates that claims with a recorded value of approximately $1,212 million, including interest accrued through June 30, 2006, would be satisfied in this manner at the effective date of the Plan. Grace would finance these payments with cash on hand, cash from Fresenius Medical Care Holdings, Inc. (“Fresenius”) paid in settlement of asbestos and other Grace-related claims, new Grace debt, and Grace common stock.  Grace would satisfy other non-asbestos related liabilities and claims (primarily certain environmental, tax, pension and retirement medical obligations) as they become due and payable over time using cash flow from operations, insurance proceeds from policies and settlement agreements covering asbestos-related liabilities, and new credit facilities. Proceeds from available product liability insurance applicable to asbestos-related claims would supplement operating cash flow to service new debt and liabilities not paid on the effective date of the Plan.

Effect on Grace Common Stock

The Plan provides that Grace common stock will remain outstanding at the effective date of the Plan, but that the interests of existing shareholders would be subject to dilution by additional shares of common stock issued under the Plan. In addition, in order to preserve significant tax benefits from net operating loss carryforwards (“NOLs”) and certain future deductions, which are subject to elimination or limitation in the event of a change in control (as defined by the Internal Revenue Code) of Grace, the Plan places restrictions on the purchase of Grace common stock. The restrictions would prohibit (without the consent of Grace), for a period of three years, a person or entity from acquiring more than 4.75% of the outstanding Grace common stock or, for those persons already holding more than 4.75%, prohibit them from increasing or decreasing their holdings. The Bankruptcy Court has also approved the trading restrictions described above, excluding the restriction on sales, until the effective date of the Plan.

I-10




Grace intends to address all pending and future asbestos-related claims and all other pre-petition claims as outlined in the Plan. However, Grace may not be successful in obtaining approval of the Plan by the Bankruptcy Court and other interested parties. For example, the asbestos creditors committees and future asbestos claimants representative have challenged the confirmability of the Plan, arguing that the Plan impairs the rights of asbestos creditors and impermissibly denies them voting rights, and have asserted that Grace’s asbestos-related liabilities exceed the fair value of Grace’s assets.  As a result of these challenges and other Bankruptcy Court rulings, a materially different plan of reorganization may ultimately be approved and, under the ultimate plan of reorganization, the interests of the Company’s shareholders could be substantially diluted or cancelled. The value of Grace common stock following a plan of reorganization, and the extent of any recovery by non-asbestos-related creditors, will depend principally on the allowed value of Grace’s asbestos-related claims as determined by the Bankruptcy Court.

Official Parties to Grace’s Chapter 11 Proceedings — Three creditors’ committees, two representing asbestos claimants and the third representing other unsecured creditors, and a committee representing shareholders, have been appointed in the Chapter 11 Cases. These committees, and a legal representative of future asbestos claimants, have the right to be heard on all matters that come before the Bankruptcy Court and are likely to play important roles in the Chapter 11 Cases. The Debtors are required to bear certain costs and expenses of the committees and of the future asbestos claimants’ representative, including those of their counsel and financial advisors.

Claims Filings — The Bankruptcy Court established a bar date of March 31, 2003 for claims of general unsecured creditors, asbestos-related property damage claims and medical monitoring claims related to asbestos. The bar date did not apply to asbestos-related personal injury claims or claims related to ZAI, which will be dealt with separately.

Approximately 14,900 proofs of claim were filed by the bar date. Of these claims, approximately 9,400 were non-asbestos related, approximately 4,300 were for asbestos-related property damage, and approximately 1,000 were for medical monitoring. The medical monitoring claims were made by individuals who allege exposure to asbestos through Grace’s products or operations. These claims, if sustained, would require Grace to fund ongoing health monitoring costs for qualified claimants. In addition, approximately 770 proofs of claim were filed after the bar date.

Approximately 7,000 of the non-asbestos related claims involve claims by employees or former employees for future retirement benefits such as pension and retiree medical coverage. Grace views most of these claims as contingent and has proposed a plan of reorganization that would retain such benefits. The other non-asbestos related claims include claims for payment of goods and services, taxes, product warranties, principal and interest under pre-petition credit facilities, amounts due under leases and other contracts, leases and other executory contracts rejected in the Bankruptcy Court, environmental remediation, indemnification or contribution to actual or potential co-defendants in asbestos-related and other litigation, pending non-asbestos-related litigation, and non-asbestos-related personal injury.

The Debtors have analyzed the claims as filed and have found that many are duplicates, represent the same claim filed against more than one of the Debtors, lack any supporting documentation, or provide insufficient supporting documentation. As of June 30, 2006, the Debtors had filed objections to approximately 5,400 claims (approximately 100 of which were subsequently withdrawn), approximately 3,950 of which were asbestos property damage claims. Of the 5,300 claims, approximately 2,300 have been expunged, approximately 200 have been resolved, approximately 1,900 have been withdrawn by claimants, and the remaining approximately 900 will be addressed through the claims objection process and the dispute resolution procedures approved by the Bankruptcy Court.

Grace believes that its recorded liabilities for claims subject to the bar date represent a reasonable estimate of the ultimate allowable amount for claims that are not in dispute or have been submitted with sufficient information to both evaluate the merit and estimate the value of the claim. The asbestos-related claims are considered as part of Grace’s overall asbestos liability and are being accounted for in accordance with the conditions precedent under the Plan, as described in “Accounting Impact” below. As claims are resolved, or where better information becomes available and is evaluated, Grace will make adjustments to the liabilities recorded in its financial statements as appropriate. Any such adjustments could be material to its consolidated financial position and results of operations.

I-11




Litigation Proceedings in Bankruptcy Court — In September 2000, Grace was named in a purported class action lawsuit filed in California Superior Court for the County of San Francisco, alleging that the 1996 reorganization involving a predecessor of Grace and Fresenius AG and the 1998 reorganization involving a predecessor of Grace and Sealed Air were fraudulent transfers. The Bankruptcy Court authorized the Official Committee of Asbestos Personal Injury Claimants and the Official Committee of Asbestos Property Damage Claimants to proceed with claims against Fresenius and Sealed Air and Cryovac on behalf of the Debtors’ bankruptcy estate.

On November 29, 2002, Sealed Air (and Cryovac) and Fresenius each announced that they had reached agreements in principle with such Committees to settle asbestos, successor liability and fraudulent transfer claims related to such transactions (the “litigation settlement agreements”). Under the terms of the Fresenius settlement, subject to the fulfillment of certain conditions, Fresenius would pay $115.0 million to the Debtors’ estate as directed by the Bankruptcy Court upon confirmation of the Debtors’ plan of reorganization. In July 2003, the Fresenius settlement was approved by the Bankruptcy Court. Under the terms of the Sealed Air settlement, subject to the fulfillment of certain conditions, Cryovac would make a payment of $512.5 million (plus interest at 5.5% compounded annually, commencing on December 21, 2002) and nine million shares of Sealed Air common stock (collectively valued at $1,087.7 million as of June 30, 2006), as directed by the Bankruptcy Court upon confirmation of the Debtors’ plan of reorganization. In June 2005, the Sealed Air settlement was approved by the Bankruptcy Court.

Debt Capital — All of the Debtors’ pre-petition debt is in default due to the Filing. The accompanying Consolidated Balance Sheets reflect the classification of the Debtors’ pre-petition debt within “liabilities subject to compromise.”

The Debtors have entered into a debtor-in-possession post-petition loan and security agreement with Bank of America, N.A. (the “DIP facility”) in the aggregate amount of $250 million.  The term of the DIP facility expires on April 1, 2008.

Accounting Impact — The accompanying Consolidated Financial Statements have been prepared in accordance with Statement of Position 90-7 (“SOP 90-7”), “Financial Reporting by Entities in Reorganization Under the Bankruptcy Code,” promulgated by the American Institute of Certified Public Accountants. SOP 90-7 requires that financial statements of debtors-in-possession be prepared on a going concern basis, which contemplates continuity of operations, realization of assets and liquidation of liabilities in the ordinary course of business.  However, as a result of the Filing, the realization of certain of the Debtors’ assets and the liquidation of certain of the Debtors’ liabilities are subject to significant uncertainty. While operating as debtors-in-possession, the Debtors may sell or otherwise dispose of assets and liquidate or settle liabilities for amounts other than those reflected in the Consolidated Financial Statements. Further, the ultimate plan of reorganization could materially change the amounts and classifications reported in the Consolidated Financial Statements.

Pursuant to SOP 90-7, Grace’s pre-petition liabilities that are subject to compromise are required to be reported separately on the balance sheet at an estimate of the amount that will ultimately be allowed by the Bankruptcy Court. As of June 30, 2006, such pre-petition liabilities include fixed obligations (such as debt and contractual commitments), as well as estimates of costs related to contingent liabilities (such as asbestos-related litigation, environmental remediation, and other claims). Obligations of Grace subsidiaries not covered by the Filing continue to be classified on the Consolidated Balance Sheets based upon maturity dates or the expected dates of payment. SOP 90-7 also requires separate reporting of certain expenses, realized gains and losses, and provisions for losses related to the Filing as reorganization items.

Grace has not recorded the benefit of any assets that may be available to fund asbestos-related and other liabilities under the litigation settlements with Sealed Air and Fresenius, as such agreements are subject to conditions which, although expected to be met, have not been satisfied and confirmed by the Bankruptcy Court. The value available under these litigation settlement agreements as measured at June 30, 2006, was $1,202.7 million comprised of $115.0 million in cash from Fresenius and $1,087.7 million in cash and stock from Cryovac. Payments under the Sealed Air settlement will be made directly to the asbestos trust by Cryovac, and will be accounted for as a satisfaction of a portion of Grace’s recorded asbestos-related liability and a credit to shareholder’s equity.

I-12




Grace’s Consolidated Balance Sheets separately identify the liabilities that are “subject to compromise” as a result of the Chapter 11 proceedings. In Grace’s case, “liabilities subject to compromise” represent pre-petition liabilities as determined under U.S. generally accepted accounting principles. Changes to the recorded amount of such liabilities will be based on developments in the Chapter 11 Cases and management’s assessment of the claim amounts that will ultimately be allowed by the Bankruptcy Court. Changes to pre-petition liabilities subsequent to the Filing Date reflect: 1) cash payments under approved court orders; 2) the terms of Grace’s proposed plan of reorganization, as discussed above, including the accrual of interest on pre-petition debt and other fixed obligations; 3) accruals for employee-related programs; and 4) changes in estimates related to other pre-petition contingent liabilities.

Components of liabilities subject to compromise are as follows:

 

(In millions)

 

June 30,
2006

 

December 31,
2005

 

Debt, pre-petition plus accrued interest

 

$

710.3

 

$

684.7

 

Asbestos-related liability

 

1,700.0

 

1,700.0

 

Income taxes

 

134.4

 

136.5

 

Environmental remediation

 

368.6

 

342.0

 

Postretirement benefits other than pension

 

92.0

 

101.3

 

Unfunded special pension arrangements

 

88.2

 

86.4

 

Retained obligations of divested businesses

 

16.9

 

18.1

 

Accounts payable

 

31.6

 

31.5

 

Other accrued liabilities

 

63.6

 

54.6

 

Total Liabilities Subject to Compromise

 

$

3,205.6

 

$

3,155.1

 

 

Note that the unfunded special pension arrangements reflected above exclude non-U.S. plans and qualified U.S. plans that became underfunded subsequent to the Filing. Contributions to qualified U.S. plans are subject to Bankruptcy Court approval.

Change in Liabilities Subject to Compromise

The following chart is a reconciliation of the changes in pre-filing date liability balances for the period from the Filing Date through June 30, 2006.

 

(In millions)

 

Cumulative
Since
Filing

 

Balance, Filing Date April 2, 2001

 

$

2,366.0

 

Cash disbursements and/or reclassifications under Bankruptcy Court orders:

 

 

 

Freight and distribution order

 

(5.7

)

Trade accounts payable order

 

(9.1

)

Settlements of noncore contingencies

 

(119.7

)

Other court orders including employee wages and benefits, sales and use tax, and customer programs

 

(312.0

)

Expense/(income) items:

 

 

 

Interest on pre-petition liabilities

 

238.3

 

Employee-related accruals

 

35.9

 

Change in estimate of asbestos-related contingencies

 

744.8

 

Change in estimate of environmental contingencies

 

295.6

 

Change in estimate of income tax contingencies

 

(2.8

)

Balance sheet reclassifications

 

(25.7

)

Balance, end of period

 

$

3,205.6

 

 

Additional liabilities subject to compromise may arise due to the rejection of executory contracts or unexpired leases, or as a result of the Bankruptcy Court’s allowance of contingent or disputed claims. Beginning January 1, 2006, Grace has agreed to pay interest on pre-petition bank debt at the prime rate quoted by Bloomberg, adjusted for periodic changes, and compounded quarterly. The effective rates for the three months and six months ended June 30, 2006 were 7.90% and 7.66%, respectively.  From the Filing Date through December 31, 2005, interest expense on pre-petition bank debt was accrued at a fixed annual rate of 6.09%, compounded quarterly.

Chapter 11 Expenses

 

(In millions)

 

Three Months Ended
June 30,

 

Six Months  Ended
June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Legal and financial advisory fees

 

$

13.3

 

$

6.2

 

$

24.1

 

$

14.0

 

Interest income

 

(1.8

)

(1.6

)

(3.9

)

(3.4

)

Chapter 11 expenses, net

 

$

11.5

 

$

4.6

 

$

20.2

 

$

10.6

 

 

Pursuant to SOP 90-7, interest income earned on the Debtors’ cash balances must be offset against Chapter 11 expenses.

I-13




Condensed Financial Information of the Debtors

W. R. Grace & Co. — Chapter 11 Filing Entities Debtor-in-Possession Statements of Operations
(In millions)

 

 

Six Months Ended
June 30,

 

 

 

2006

 

2005

 

Net sales, including intercompany

 

$

733.8

 

$

638.3

 

Cost of goods sold, including intercompany, exclusive of depreciation and amortization shown separately below

 

549.4

 

439.3

 

Selling, general and administrative expenses, exclusive of net pension expense and depreciation and amortization shown separately below

 

170.6

 

134.5

 

Research and development expenses

 

20.4

 

19.2

 

Depreciation and amortization

 

29.3

 

32.5

 

Net pension expense

 

23.2

 

26.7

 

Interest expense and related financing costs

 

35.6

 

27.5

 

Provision for environmental remediation

 

30.0

 

 

Other (income) expense

 

(28.5

)

(48.6

)

 

 

830.0

 

631.1

 

Income (loss) before Chapter 11 expenses, income taxes, and equity in net income of non-filing entities

 

(96.2

)

7.2

 

Chapter 11 expenses, net

 

(20.2

)

(10.4

)

Benefit from (provision for) income taxes

 

23.2

 

(8.7

)

Income (loss) before equity in net income of non-filing entities

 

(93.2

)

(11.9

)

Equity in net income of non-filing entities

 

88.1

 

47.7

 

Net income (loss)

 

$

(5.1

)

$

35.8

 

 

 

I-14




W. R. Grace & Co. —
Chapter 11 Filing Entities Debtor-in-Possession Condensed Statements of Cash Flows
(In millions)

 

 

 

Six Months Ended
June 30,

 

 

 

2006

 

2005

 

Operating Activities

 

 

 

 

 

Net income (loss)

 

$

(5.1

)

$

35.8

 

Reconciliation to net cash provided by (used for) operating activities:

 

 

 

 

 

Chapter 11 expenses, net

 

20.2

 

10.4

 

(Benefit from) provision for income taxes

 

(23.2

)

8.7

 

Equity in net income of non-filing entities

 

(88.1

)

(47.7

)

Depreciation and amortization

 

29.3

 

32.5

 

Interest on pre-petition liabilities subject to compromise

 

34.7

 

25.4

 

Provision for environmental remediation

 

30.0

 

 

Other non-cash items, net

 

1.1

 

(1.9

)

Contributions to defined benefit pension plans

 

(32.8

)

(8.3

)

Cash paid to settle noncore contingencies

 

 

(119.7

)

Changes in other assets and liabilities, excluding the effect of businesses acquired/divested

 

(54.4

)

(79.5

)

Net cash provided by (used for) operating activities

 

(88.3

)

(144.3

)

Investing Activities

 

 

 

 

 

Capital expenditures

 

(40.1

)

(23.7

)

Loan repayments and other

 

46.6

 

64.9

 

Net cash provided by (used for) investing activities

 

6.5

 

41.2

 

Net cash provided by (used for) financing activities

 

(1.1

)

(1.7

)

Net increase (decrease) in cash and cash equivalents

 

(82.9

)

(104.8

)

Cash and cash equivalents, beginning of period

 

269.2

 

340.0

 

Cash and cash equivalents, end of period

 

$

186.3

 

$

235.2

 

 

I-15




 

W. R. Grace & Co. —
Chapter 11 Filing Entities Debtor-in-Possession Balance Sheets
(In millions)

 

 

June 30,
2006

 

December 31,
2005

 

ASSETS

 

 

 

 

 

Current Assets

 

 

 

 

 

Cash and cash equivalents

 

$

186.3

 

$

269.2

 

Trade accounts receivable, net

 

142.4

 

108.0

 

Receivables from non-filing entities, net

 

68.1

 

62.3

 

Inventories

 

85.9

 

86.8

 

Other current assets

 

39.9

 

53.5

 

Total Current Assets

 

522.6

 

579.8

 

Properties and equipment, net

 

384.3

 

378.9

 

Cash value of life insurance policies, net of policy loans

 

86.6

 

84.8

 

Deferred income taxes

 

723.4

 

701.0

 

Asbestos-related insurance

 

500.0

 

500.0

 

Loans receivable from non-filing entities, net

 

279.3

 

306.9

 

Investment in non-filing entities

 

642.4

 

527.9

 

Other assets

 

82.8

 

79.3

 

Total Assets

 

$

3,221.4

 

$

3,158.6

 

LIABILITIES AND SHAREHOLDERS’ EQUITY (DEFICIT)

 

 

 

 

 

Liabilities Not Subject to Compromise

 

 

 

 

 

Current liabilities

 

$

171.9

 

$

187.3

 

Minority interest in consolidated affiliates

 

49.9

 

32.6

 

Other liabilities

 

364.4

 

378.9

 

Total Liabilities Not Subject to Compromise

 

586.2

 

598.8

 

Liabilities Subject to Compromise

 

3,205.6

 

3,155.1

 

Total Liabilities

 

3,791.8

 

3,753.9

 

Shareholders’ Equity (Deficit)

 

(570.4

)

(595.3

)

Total Liabilities and Shareholders’ Equity (Deficit)

 

$

3,221.4

 

$

3,158.6

 

 

In addition to Grace’s financial reporting obligations as prescribed by the U.S. Securities and Exchange Commission, the Debtors are also required, under the rules and regulations of the Bankruptcy Code, to periodically file certain statements and schedules and a monthly operating report with the Bankruptcy Court. This information is available to the public through the Bankruptcy Court. This information is prepared in a format that may not be comparable to information in Grace’s quarterly and annual financial statements as filed with the SEC. The monthly operating reports are not audited, do not purport to represent the financial position or results of operations of Grace on a consolidated basis, and should not be relied on for such purposes.

3.              Asbestos-Related Litigation

Grace is a defendant in property damage and personal injury lawsuits relating to previously sold asbestos-containing products. As of the Filing Date, Grace was a defendant in 65,656 asbestos-related lawsuits, 17 involving claims for property damage (one of which has since been dismissed), and the remainder involving 129,191 claims for personal injury. Due to the Filing, holders of asbestos-related claims are stayed from continuing to prosecute pending litigation and from commencing new lawsuits against the Debtors. Separate creditors’ committees representing the interests of property damage and personal injury claimants, and a legal representative of future personal injury claimants, have been appointed in the Chapter 11 Cases. Grace’s obligations with respect to present and future claims will be determined through the Chapter 11 process.

Property Damage Litigation The plaintiffs in asbestos property damage lawsuits generally seek to have the defendants pay for the cost of removing, containing or repairing the asbestos-containing materials in the affected buildings. Each property damage case is unique in that the age, type, size and use of the building, and the difficulty of asbestos abatement, if necessary, vary from structure to structure. Information regarding product identification, the amount of product in the building, the age, type, size and use of the building, the legal status of the claimant, the jurisdictional history of prior cases and the court in which the case is pending has provided meaningful guidance as to the range of potential costs.

Out of 380 asbestos property damage cases (which involved thousands of buildings) filed prior to the Filing Date, 140 were dismissed without payment of any damages or settlement amounts; judgments were entered in favor of Grace in nine cases (excluding cases settled following appeals of judgments in favor of Grace); judgments were entered in favor of the plaintiffs in eight cases (one of which is on appeal) for a total of $86.1 million; 207 property damage cases were settled for a total of $696.8 million; and 16 cases remain outstanding (including the one on appeal). Of the 16 remaining cases, eight relate to ZAI and eight relate to a number of former asbestos-containing products (two of which also are alleged to involve ZAI).

I-16




Approximately 4,300 additional property damage claims were filed prior to the March 31, 2003 claims bar date established by the Bankruptcy Court. (The bar date did not apply to ZAI claims.) Such claims were reviewed in detail by Grace, categorized into claims with sufficient information to be evaluated or claims that require additional information and, where sufficient information existed, the estimated cost of resolution was considered as part of Grace’s recorded asbestos-related liability. (Approximately 200 claims did not contain sufficient information to permit an evaluation.) Grace has objected to virtually all property damage claims on a number of different bases, including: no authorization to file a claim; the claim was previously settled or adjudicated; no or insufficient documentation; failure to identify a Grace product; the expiration of the applicable statute of limitations and/or statute of repose, and/or laches; and a defense that the product in place is not hazardous. As of July 31, 2006, following the reclassification, withdrawal or expungement of claims, approximately 850 property damage claims remain outstanding.

Eight of the ZAI cases were filed as purported class action lawsuits in 2000 and 2001. In addition, eight lawsuits were filed as purported class actions in 2004 and 2005 with respect to persons and homes in Canada. These cases seek damages and equitable relief, including the removal, replacement and/or disposal of all such insulation. The plaintiffs assert that this product is in millions of homes and that the cost of removal could be several thousand dollars per home. As a result of the Filing, the eight U.S. cases have been transferred to the Bankruptcy Court.  Based on Grace’s investigation of the claims described in these lawsuits, and testing and analysis of this product by Grace and others, Grace believes that the product was and continues to be safe for its intended purpose and poses little or no threat to human health. The plaintiffs in the ZAI lawsuits (and the U.S. government in the Montana criminal proceeding described in Note 12) dispute Grace’s position on the safety of ZAI. In July 2002, the Bankruptcy Court approved special counsel to represent, at the Debtors’ expense, the ZAI claimants in a proceeding to determine certain threshold scientific issues regarding ZAI. On October 18, 2004, the Bankruptcy Court held a hearing on motions filed by the parties to address a number of important legal and factual issues regarding the ZAI claims, and has taken the motions under advisement. No decision has yet been rendered.  Grace’s recorded asbestos-related liability at June 30, 2006 assumes the risk of loss from ZAI litigation is not probable.  If Grace’s view as to risk of loss were not sustained, management believes the cost to resolve the matter would be material.

Personal Injury Litigation Asbestos personal injury claimants allege adverse health effects from exposure to asbestos-containing products formerly manufactured by Grace. Claims are generally similar to each other, differing primarily in the type of asbestos-related illness allegedly suffered by the plaintiff. Grace’s cost to resolve such claims has been influenced by numerous variables, including the solvency of other former producers of asbestos containing products, cross-claims by co-defendants, the rate at which new claims are filed, the jurisdiction in which the claims are filed, and the defense and disposition costs associated with these claims.

Cumulatively through the Filing Date, 16,354 asbestos personal injury lawsuits involving approximately 35,720 claims were dismissed without payment of any damages or settlement amounts (primarily on the basis that Grace products were not involved) and approximately 55,489 lawsuits involving approximately 163,698 claims were disposed of (through settlements and judgments) for a total of $645.6 million.  As of the Filing Date, 129,191 claims for personal injury were pending against Grace. Grace believes that a substantial number of additional personal injury claims would have been received between the Filing Date and June 30, 2006 had such claims not been stayed by the Bankruptcy Court.

Asbestos-Related Liability The total recorded asbestos-related liability balance as of June 30, 2006 and December 31, 2005 was $1,700.0 million and is included in “liabilities subject to compromise” in the accompanying Consolidated Balance Sheets.  Grace adjusted its asbestos-related liability in the fourth quarter of 2004 based on its proposed plan of reorganization as discussed in Note 2. The amount recorded at June 30, 2006 includes the $1,613 million maximum amount reflected as a condition precedent to the Plan and $87 million related to pre-Chapter 11 contractual settlements and judgments included in general unsecured claims.

Under the Plan, Grace is requesting that the Bankruptcy Court determine the aggregate dollar amount, on a net present value basis, that must be funded on the effective date of the Plan into an asbestos trust (established under Section 524(g) of the Bankruptcy Code) to pay all allowed pending and future asbestos-related personal injury and property damage claims (including ZAI) and related trust administration costs and expenses on the later of the effective date of the Plan or when allowed (the “Funding Amount”). It is a condition to confirmation of the Plan that the Bankruptcy Court shall conclude that the Funding Amount is not greater than $1,613 million. This amount, which should be sufficient to fund over $2 billion in pending and future claims, is based in part on Grace’s evaluation of (1) existing but unresolved personal injury and property damage claims, (2) actuarially-based estimates of future personal injury claims, (3) the risk of loss from ZAI litigation, (4) proposed claim payments reflected in the Plan, and (5) the cost of the trust administration and litigation. This amount may not be consistent with what the Bankruptcy Court may conclude would be a sufficient Funding Amount.

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The Bankruptcy Court has entered separate case management orders for estimating liability for pending and future personal injury claims and pending property damage claims, excluding ZAI claims. The case management orders originally contemplated that estimation hearings would take place in September 2006.  However, the Bankruptcy Court deferred the estimation process to provide the Debtors and the other stakeholders in the Chapter 11 proceeding with an opportunity to negotiate a resolution of all or a portion of the Debtors’ asbestos-related liabilities.  The Bankruptcy Court appointed a mediator to facilitate such negotiations that ultimately were unsuccessful.  As a result, the Bankruptcy Court has resumed the estimation process.  The Debtors expect that the estimated liability will provide the basis for determining the Funding Amount to be paid into the trust on the effective date of the Plan.

For personal injury claims, the Bankruptcy Court has ordered that all claimants with claims pending as of the Filing Date must complete detailed questionnaires providing information on, among other things, their medical condition, including diagnostic support, exposure to Grace and non-Grace asbestos-containing products, employment history, and pending lawsuits against other companies.

Approximately 60,000 questionnaires were returned in response to the July 12, 2006 deadline.  From a preliminary examination, Grace believes that a substantial percentage of the submitted questionnaires provide insufficient or incomplete responses, and has requested that the Bankruptcy Court issue an order to compel the asbestos personal injury claimants to cure these deficiencies.  The Bankruptcy Court also has indicated that it will set a bar date for asbestos personal injury claims pending as of the Filing Date (other than settled but unpaid claims).

Grace expects the estimation process for personal injury claims will include the compilation of data from the questionnaires, review and analysis of such data by experts, the preparation of expert reports, including estimates of the number of personal injury claims expected to be filed in the future, and depositions of witnesses and other pretrial discovery proceedings.  Grace expects the process to conclude in a three-week trial scheduled for June 2007.

For property damage claims, the case management order provides that estimation will be preceded by litigation on certain common threshold issues affecting a substantial majority of claims. Such litigation will consist of determining, among other things, (1) whether asbestos-containing products formerly manufactured by Grace are hazardous in place, (2) the date by which building owners knew or should have known of the reported hazards of asbestos-containing materials in their buildings, which would provide the basis for a statute of limitations defense, and (3) the evidentiary admissibility of certain asbestos testing methodologies. During the period preceding the estimation hearing, Grace will also ask the Bankruptcy Court to rule on Grace’s specific objections to individual claims and groups of claims. Claims not resolved or expunged through the common issue litigation or the objection process would be the subject of an estimation hearing that Grace expects will take place during the first quarter of 2007.

The Funding Amount will be primarily a function of the number of estimated allowed property damage and personal injury claims, and the amount payable per claim. Through the estimation process, Grace will seek to demonstrate that most claims should not be allowed because they fail to establish any material property damage, health impairment or significant occupational exposure to asbestos from Grace’s operations or products. If the Bankruptcy Court agrees with Grace’s position on the number of, and the amounts to be paid in respect of, allowed personal injury and property damage claims, then Grace believes that the Funding Amount could be less than $1,613 million. However, this outcome is highly uncertain and will depend on a number of Bankruptcy Court rulings favorable to Grace’s position.

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Conversely, the asbestos claimants committees and the future claimants representative continue to assert that Grace’s asbestos-related liabilities are substantially higher than $1,613 million, and in fact are in excess of Grace’s business value.  If the Court accepts the position of the asbestos claimants committees, then any plan of reorganization likely would result in the loss of all or substantially all equity value by current shareholders. Therefore, due to the significant uncertainties of this process and asbestos litigation generally, Grace is not able to estimate a probable Funding Amount that would be accepted by the Bankruptcy Court.

However, as Grace is willing to proceed with confirmation of the Plan with a Funding Amount of up to $1,613 million (assuming that other conditions precedent to confirmation of the Plan are satisfied, including the availability of the payment from Cryovac directly to the asbestos trust under the settlement agreement described in Note 2), during the fourth quarter of 2004, Grace accrued a charge of $714.8 million to increase its recorded asbestos-related liability to reflect the maximum amount allowed as a condition precedent under the Plan. This amount, plus $87.0 million for pre-Chapter 11 contractual settlements and judgments, brings the total recorded asbestos-related liability as of June 30, 2006 and December 31, 2005 to $1,700 million. Any differences between the Plan as filed and as approved for confirmation could fundamentally change the accounting measurement of Grace’s asbestos-related liability and that change could be material.

Insurance Rights — Grace previously purchased insurance policies that provide coverage for years 1962 to 1985 with respect to asbestos-related lawsuits and claims. Since 1985, insurance coverage for asbestos-related liabilities has not been commercially available to Grace.

With one exception, coverage disputes regarding Grace’s primary insurance policies have been settled, and the settlement amounts paid in full. Grace’s excess coverage is for loss above certain levels.  The levels vary from policy to policy, creating “layers” of excess coverage, some of which are triggered before others. As of June 30, 2006, after subtracting previous reimbursements by insurers and allowing for discounts pursuant to certain settlement agreements, there remains approximately $959 million of excess coverage from more than 54 presently solvent insurers.

Grace has entered into settlement agreements with various excess insurance carriers. These settlements involve amounts paid and to be paid to Grace. The unpaid maximum aggregate amount for settled insurers available under these settlement agreements is approximately $476 million.  With respect to asbestos-related personal injury claims, the settlement agreements generally require that the claims be spread over the claimant’s exposure period and that each insurer pay a pro rata portion of each claim based on the amount of coverage provided during each year of the total exposure period.

Presently, Grace has no agreements in place with insurers with respect to approximately $483 million of excess coverage, which is at layers of coverage that have not yet been triggered, but certain layers would be triggered if the Plan were approved at the recorded asbestos-related liability of $1,700 million. Grace believes that any allowed ZAI claims also would be covered under the settlement agreements and unsettled policies discussed above to the extent they relate to installations of ZAI occurring after July 1, 1973.

In addition to the approximately $959 million of excess coverage with solvent insurers, Grace has approximately $318 million of excess coverage with insolvent or non-paying insurance carriers. Non-paying carriers are those that, although technically solvent, are not currently meeting their obligations to pay claims. Grace has filed and continues to file claims in the insolvency proceedings of insolvent carriers. Grace is currently receiving distributions from some of these insolvent carriers and expects to receive distributions in the future. Settlement amounts are recorded as income when received.

Grace estimates that, assuming an ultimate payout of asbestos-related claims equal to the recorded liability of $1,700 million, it should be entitled to approximately $500 million, on a net present value basis, of insurance recovery.

4. Acquisitions and Joint Ventures

In June 2006, Grace acquired the custom catalyst manufacturing assets of Basell, USA, as well as Basell’s components business for cash consideration of $20.0 million.  The manufacturing assets and the results of operations of the acquired business have been included as part of the Grace Davison operating segment since the date of acquisition.

I-19




During the first six months of 2005, Grace completed two acquisitions for a total cash cost of $2.5 million as follows:

·                  In February 2005, Grace acquired certain assets of Midland Dexter Venezuela, S.A. (“Midevensa”). Midevensa supplies coatings and sealants for rigid packaging in the local and export markets of Latin America.

·                  In March 2005, Grace acquired certain assets relating to the concrete admixtures business of Perstorp Peramin AB (“Perstorp”) located in Sweden. Perstorp supplies specialty chemicals and materials to the construction industry in Sweden and other Northern European countries.

5. Other (Income) Expense

Components of other (income) expense are as follows:

 

Other (Income) Expense
(In millions)

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Income from insurance settlements

 

$

(6.9

)

$

(20.3

)

$

(6.9

)

$

(20.3

)

COLI income, net

 

(0.5

)

(0.6

)

(1.7

)

(1.9

)

Interest income

 

(1.6

)

(0.9

)

(3.0

)

(1.6

)

Net (gain) loss on sales of investments and disposals of assets

 

(4.6

)

0.4

 

(2.8

)

(0.5

)

Currency translation — intercompany loan

 

(10.7

)

16.5

 

(13.7

)

31.4

 

Value of currency contracts

 

10.7

 

(16.7

)

13.5

 

(31.2

)

Other currency transaction effects

 

1.7

 

0.3

 

2.7

 

0.5

 

Other miscellaneous income

 

(2.0

)

(2.6

)

(3.9

)

(6.4

)

Total other (income) expense

 

$

(13.9

)

$

(23.9

)

$

(15.8

)

$

(30.0

)

 

6. Other Balance Sheet Accounts

 

(In millions)

 

June 30,
2006

 

December 31,
2005

 

Inventories

 

 

 

 

 

Raw materials

 

$

73.2

 

$

67.3

 

In process

 

37.8

 

32.8

 

Finished products

 

207.4

 

210.8

 

General merchandise

 

32.5

 

33.2

 

Less: Adjustment of certain inventories to a last-in/first-out (LIFO) basis

 

(41.6

)

(65.8

)

 

 

$

309.3

 

$

278.3

 

Other Assets

 

 

 

 

 

Deferred pension costs

 

$

115.0

 

$

108.8

 

Deferred charges

 

11.8

 

20.8

 

Long-term receivables, less allowances of $0.8 (2005 - $0.7)

 

7.5

 

7.6

 

Patents, licenses and other intangible assets, net

 

101.6

 

87.6

 

Pension-unamortized prior service cost

 

12.7

 

12.7

 

Investments in unconsolidated affiliates and other

 

0.5

 

0.6

 

 

 

$

249.1

 

$

238.1

 

Other Current Liabilities

 

 

 

 

 

Accrued compensation

 

$

65.6

 

$

70.4

 

Deferred tax liability

 

0.9

 

0.8

 

Customer volume rebates

 

29.4

 

35.4

 

Accrued commissions

 

10.5

 

11.1

 

Accrued reorganization fees

 

21.4

 

18.0

 

Other accrued liabilities

 

63.7

 

62.2

 

 

 

$

191.5

 

$

197.9

 

 

Accrued compensation in the table above includes current amounts due through June 30, 2007 under the annual and long-term incentive programs. Other liabilities in the Consolidated Balance Sheet includes amounts expected to be paid under these programs after July 1, 2007.

7.              Life Insurance

Grace is the beneficiary of corporate-owned life insurance (“COLI”) policies on certain current and former employees with a net cash surrender value of $86.6 million and $84.8 million at June 30, 2006 and December 31, 2005, respectively. The policies were acquired to fund various employee benefit programs and other long-term liabilities and are structured to provide cash flow (primarily tax-free) over an extended number of years.

I-20




The following tables summarize activity in these policies for the six months ended June 30, 2006 and 2005, and the components of net cash value at June 30, 2006 and December 31, 2005:

Life Insurance — Activity Summary
(In millions) 

 

Six Months Ended
June 30,

 

 

 

2006

 

2005

 

Earnings on policy assets

 

$

2.4

 

$

4.1

 

Interest on policy loans

 

(0.7

)

(2.2

)

Policy loan repayments

 

 

0.6

 

Proceeds from termination of life insurance policies

 

 

(14.8

)

Net investing activity

 

0.1

 

(2.4

)

Change in net cash value

 

$

1.8

 

$

(14.7

)

Tax-free proceeds received

 

$

0.2

 

$

2.4

 

 

Components of Net Cash Value
(In millions)

 

June 30,
2006

 

December 31,
2005

 

Gross cash value

 

$

111.5

 

$

109.2

 

Principal — policy loans

 

(23.7

)

(23.7

)

Accrued interest — policy loans

 

(1.2

)

(0.7

)

Net cash value

 

$

86.6

 

$

84.8

 

Insurance benefits in force

 

$

197.2

 

$

196.3

 

 

Grace’s financial statements display income statement activity and balance sheet amounts on a net basis, reflecting the contractual interdependency of policy assets and liabilities.

In January 2005, Grace surrendered and terminated most of its other COLI policies and received approximately $14.8 million of net cash value from the termination.

8.              Debt

Components of Debt
(In millions)

 

June 30,
2006

 

December 31,
2005

 

Debt payable within one year

 

 

 

 

 

Other short-term borrowings

 

$

3.2

 

$

2.3

 

Debt payable after one year

 

 

 

 

 

Other long-term borrowings

 

$

0.4

 

$

0.4

 

Debt Subject to Compromise

 

 

 

 

 

Bank borrowings

 

$

500.0

 

$

500.0

 

Other borrowings

 

14.0

 

14.3

 

Accrued interest

 

196.3

 

170.4

 

 

 

$

710.3

 

$

684.7

 

Annualized weighted average interest rates on total debt

 

7.6

%

6.1

%

 

In April 2001, the Debtors entered into the DIP facility for a two-year term in the aggregate amount of $250 million. The DIP facility is secured by a priority lien on substantially all assets of the Debtors with the exclusion of foreign stock holdings, and bears interest based on the London Interbank Offered Rate (LIBOR). The Debtors have extended the term of the DIP facility through April 1, 2008. Grace had no outstanding borrowings under the DIP facility as of June 30, 2006; however, $42.1 million of standby letters of credit were issued and outstanding under the facility. The letters of credit, which reduce available funds under the facility, were issued primarily for trade-related matters such as performance bonds, and certain insurance and environmental matters.

9.              Shareholders’ Equity (Deficit)

Under its Certificate of Incorporation, the Company is authorized to issue 300,000,000 shares of common stock, $0.01 par value. Of the common stock unissued at June 30, 2006, approximately 5,253,838 shares were reserved for issuance pursuant to stock options and other stock incentives. Since the Filing Date, Grace has not granted any stock options.

For additional information, see Notes 15 and 17 to the Consolidated Financial Statements in Grace’s 2005 Form 10-K.

10.             Earnings (Loss) Per Share

The following table shows a reconciliation of the numerators and denominators used in calculating basic and diluted earnings (loss) per share.

Earnings (Loss) Per Share
(In millions, except per share amounts)

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Numerators

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(5.2

)

$

32.7

 

$

(5.1

)

$

35.8

 

Denominators

 

 

 

 

 

 

 

 

 

Weighted average common shares— basic calculation

 

67.9

 

66.9

 

67.5

 

66.8

 

Dilutive effect of employee stock options

 

 

0.3

 

 

0.5

 

Weighted average common shares—diluted calculation

 

67.9

 

67.2

 

67.5

 

67.3

 

Basic earnings (loss) per share

 

$

(0.08

)

$

0.49

 

$

(0.08

)

$

0.54

 

Diluted earnings (loss) per share

 

$

(0.08

)

$

0.49

 

$

(0.08

)

$

0.53

 

 

As a result of the net losses recorded for the three months and six months ended June 30, 2006, approximately 500,000 and 400,000, respectively, of employee compensation-related shares issuable under stock options were excluded from the diluted loss per share calculation because their effect would have been antidilutive.

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11.             Comprehensive Income (Loss)

The tables below present the pre-tax, tax and after tax components of Grace’s other comprehensive income (loss) for the three months and six months ended June 30, 2006 and 2005:

Three Months Ended June 30, 2006
(In millions)

 

Pre-Tax
Amount

 

Tax
Expense

 

After-
Tax
Amount

 

Commodity hedging activities

 

$

0.5

 

$

(0.2

)

$

0.3

 

Foreign currency translation adjustments

 

13.6

 

 

13.6

 

Other comprehensive income (loss)

 

$

14.1

 

$

(0.2

)

$

13.9

 

 

Six Months Ended June 30, 2006
(In millions)

 

Pre-Tax
Amount

 

Tax
Benefit

 

After-
Tax
Amount

 

Commodity hedging activities

 

$

(0.4

)

$

0.1

 

$

(0.3

)

Foreign currency translation adjustments

 

14.6

 

 

14.6

 

Other comprehensive income (loss)

 

$

14.2

 

$

0.1

 

$

14.3

 

 

Three Months Ended June 30, 2005
(In millions)

 

Pre-Tax
Amount

 

Tax
Benefit

 

After-
Tax
Amount

 

Foreign currency translation adjustments

 

$

(9.4

)

$

 

$

(9.4

)

Other comprehensive income (loss)

 

$

(9.4

)

$

 

$

(9.4

)

 

Six Months Ended June 30, 2005
(In millions)

 

Pre-Tax
Amount

 

Tax
Benefit

 

After-
Tax
Amount

 

Foreign currency translation adjustments

 

$

(22.4

)

$

 

$

(22.4

)

Other comprehensive income (loss)

 

$

(22.4

)

$

 

$

(22.4

)

 

From time to time, Grace enters into derivatives such as forward contracts or option contracts directly with natural gas suppliers, and fixed-rate swaps with financial institutions to mitigate the risk of volatility of natural gas prices in the United States.  Under fixed-rate swaps, Grace locks in a fixed rate with a financial institution for future natural gas purchases, purchases its natural gas from a supplier at the prevailing market rate, and settles with the bank for any difference in the rates, thereby “swapping” a variable rate for a fixed rate.  During the first six months of 2006, Grace purchased forward contracts, swaps and options for a portion of its expected natural gas requirements. The outstanding swaps and options were treated as effective cash flow hedges for accounting purposes and revalued at the end of each of the first two quarters of 2006, with corresponding adjustments to other comprehensive income (loss).

The following table presents the components of Grace’s accumulated other comprehensive income (loss) at June 30, 2006 and December 31, 2005:

Components of Accumulated Other Comprehensive Income (Loss)
(In millions)

 

June 30,
2006

 

December 31,
2005

 

Commodity hedging (net of tax)

 

$

(0.3

)

$

 

Minimum pension liability (net of tax)

 

(362.7

)

(362.7

)

Foreign currency translation

 

(16.6

)

(31.2

)

Accumulated other comprehensive income (loss)

 

$

(379.6

)

$

(393.9

)

 

Grace is a global enterprise which operates in over 40 countries with local currency generally deemed to be the functional currency for accounting purposes. The foreign currency translation amount represents the adjustments necessary to translate the balance sheets valued in local currencies to the U.S. dollar as of the end of each period presented, and to translate revenues and expenses at average exchange rates for each period presented.

The decline in equity market returns in 2000-2002, coupled with a decline in interest rates from 2000-2004, as well as updated assumptions for expected life-spans and the longevity of Grace’s active work force, created a shortfall between the accounting measurement of Grace’s obligations under certain of its qualified pension plans for U.S. employees and the market value of dedicated pension assets. This condition required Grace to record a minimum pension liability for these plans equal to the funding shortfall and to offset related deferred costs against shareholders’ equity (deficit) at December 31, 2005.

12.             Commitments and Contingent Liabilities

Asbestos-Related Litigation See Note 3

Environmental Remediation Grace is subject to loss contingencies resulting from extensive and evolving federal, state, local and foreign environmental laws and regulations relating to the generation, storage, handling, discharge and disposition of hazardous wastes and other materials. Grace accrues for anticipated costs associated with investigative and remediation efforts where an assessment has indicated that a probable liability has been incurred and the cost can be reasonably estimated. These accruals do not take into account any discounting for the time value of money.

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Grace’s environmental liabilities are reassessed whenever circumstances become better defined or remediation efforts and their costs can be better estimated. These liabilities are evaluated based on currently available information, including the progress of remedial investigation at each site, the current status of discussions with regulatory authorities regarding the method and extent of remediation at each site, existing technology, prior experience in contaminated site remediation and the apportionment of costs among potentially responsible parties. Grace expects that the funding of environmental remediation activities will be affected by the Chapter 11 proceedings.

At June 30, 2006, Grace’s estimated liability for environmental investigative and remediation costs totaled $368.6 million, as compared with $342.0 million at December 31, 2005. The amount is based on funding and/or remediation agreements in place and Grace’s best estimate of its cost for sites not subject to a formal remediation plan. Grace’s estimated environmental liabilities are included in “liabilities subject to compromise” in the accompanying Consolidated Balance Sheets.

For the period ended June 30, 2006, Grace recorded pre-tax charges of $30.0 million for environmental matters.  Of the pre-tax charges, $28.0 million was in connection with a cost recovery lawsuit brought by the U.S. Government and was necessary based on a recent communication from the U.S. Department of Justice delineating asserted reimbursable spending during the 2002 through 2005 period, as described below.  The remainder of the pre-tax charges were attributable to the ongoing review of recorded environmental liabilities.

Net cash expenditures charged against previously established reserves for the six months ended June 30, 2006 and 2005 were $3.4 million and $24.4 million, respectively.  The decrease in the liability in 2005 was primarily due to a settlement payment of $21.4 million related to a formerly owned site, which was approved by the Bankruptcy Court.

Vermiculite Related Matters

EPA Lawsuit — In November 1999, Region 8 of the Environmental Protection Agency (“EPA”) began an investigation into alleged excessive levels of asbestos-related disease in the Libby population related to Grace’s former mining activities in Libby, Montana. This investigation led the EPA to undertake additional investigative activity and to carry out response actions in and around Libby. On March 30, 2001, the EPA filed a lawsuit in U.S. District Court for the District of Montana, Missoula Division (United States v. W. R. Grace & Company et al.) under the Comprehensive Environmental Response, Compensation and Liability Act for the recovery of costs allegedly incurred by the United States in response to the release or threatened release of asbestos in the Libby, Montana area relating to such former mining activities. These costs include cleaning and/or demolition of contaminated buildings, excavation and removal of contaminated soil, health screening of Libby residents and former mine workers, and investigation and monitoring costs. In this action, the EPA also sought a declaration of Grace’s liability that would be binding in future actions to recover further response costs.

In December 2002, the District Court granted the United States’ motion for partial summary judgment on a number of issues that limited Grace’s ability to challenge the EPA’s response actions. In January 2003, a trial was held on the remainder of the issues, which primarily involved the reasonableness and adequacy of documentation of the EPA’s cost recovery claims through December 31, 2001. On August 28, 2003, the District Court issued a ruling in favor of the United States that requires Grace to reimburse the government for $54.5 million (plus interest) in costs expended through December 2001, and for all appropriate future costs to complete the remediation activities. The Ninth Circuit Court of Appeals upheld the District Court’s rulings.  Grace has appealed this case to the U.S. Supreme Court.

Grace’s total estimated liability for vermiculite-related remediation, including the $54.5 million mentioned above and the cost of remediation of vermiculite processing sites outside of Libby, at June 30, 2006 and December 31, 2005 was $255.4 million and $226.2 million, respectively.  The estimate at June 30, 2006 includes $118.0 million for asserted reimbursable costs covering 2002 through 2005 based on recent information received from the U.S. Government, an increase of $28.0 million over Grace’s estimate for the same period at December 31, 2005.  The current estimate does not include the cost to remediate the Grace-owned mine site at Libby, which is not currently estimable. Grace’s estimate of costs is based on U.S. Government spending data through December 31, 2005, public comments regarding the EPA’s spending plans, discussions of spending forecasts with EPA representatives, analysis of other information made available from the EPA, and evaluation of probable remediation costs at vermiculite processing sites. However, the EPA’s cost estimates have increased regularly and substantially over the course of this remediation. Consequently, as the EPA’s spending on these matters increases, Grace’s liability for remediation will increase.

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Montana Criminal Proceeding On February 7, 2005, the United States Department of Justice announced the unsealing of a grand jury indictment against Grace and seven current or former senior level employees (United States of America v. W. R. Grace & Co. et al) relating to Grace’s former vermiculite mining and processing activities in Libby, Montana.  The indictment accuses the defendants of (1) conspiracy to violate environmental laws and obstruct federal agency proceedings; (2) violations of the federal Clean Air Act; and (3) obstruction of justice. The U.S. District Court for the District of Montana has entered a scheduling order setting a trial date of September 11, 2006.  In July 2006, the Court dismissed a portion of the conspiracy count of a superseding indictment alleging conspiracy to knowingly endanger residents of the Libby area and others in violation of the Clean Air Act.

Grace purchased the Libby mine in 1963 and operated it until 1990; vermiculite processing activities continued until 1992. The grand jury charges that the conspiracy took place from 1976 to 2002.  According to the U.S. Department of Justice, Grace could be subject to fines in an amount equal to twice the after-tax profit earned from its Libby operations or twice the alleged loss suffered by victims, plus additional amounts for restitution to victims. The indictment alleges that such after tax profits were $140 million. Grace has categorically denied any criminal wrongdoing and intends to vigorously defend itself at trial.

The U.S. Bankruptcy Court previously granted Grace’s request to advance legal and defense costs to the employees, subject to a reimbursement obligation if it is later determined that the employees did not meet the standards for indemnification set forth under the appropriate state corporate law. For the six months ended June 30, 2006 and 2005, total expense for Grace and the employees was $27.2 million and $8.7 million respectively, which amounts are included in selling, general and administrative expenses in the accompanying Consolidated Statements of Operations.

Grace is unable to assess whether the indictment, or any conviction resulting therefrom, will have a material adverse effect on the results of operations or financial condition of Grace or affect Grace’s bankruptcy proceedings. However, Grace expects legal fees for this matter could range from $10 million to $20 million per quarter through the trial.  Grace intends to expense such costs as they are incurred.

New Jersey Lawsuit — On June 1, 2005, the New Jersey Department of Environmental Protection (“DEP”) filed a lawsuit against Grace and two former employees seeking civil penalties for alleged misrepresentations and false statements made in a Preliminary Assessment/Site Investigation Report and Negative Declarations submitted by Grace to the DEP in 1995 pursuant to the New Jersey Industrial Site Recovery Act. Grace submitted the Report, which was prepared by an independent environmental consultant, in connection with the closing of Grace’s former plant in Hamilton Township, New Jersey. Grace is also aware that the State of New Jersey and U.S. Department of Justice each are conducting criminal investigations related to Grace’s former operations of such plant.

Grace purchased the Hamilton plant assets in 1963 and ceased operations in 1994. During the operating period, Grace produced spray-on fire protection products and vermiculite-based products at this plant. The current property owners are conducting remediation activities as directed by the EPA.  The property owners and the EPA have filed proofs of claim against Grace in the amount of approximately $4 million with respect to the Hamilton plant site.

Grace is unable at this time to assess the effect of this lawsuit or the pending criminal investigations on Grace’s results of operations, cash flows, or liquidity, or on its bankruptcy proceeding.

Non-Vermiculite Related Matters

At June 30, 2006 and December 31, 2005, Grace’s estimated liability for remediation of sites not related to its former vermiculite mining and processing activities was $113.2 million and $115.8 million, respectively. This liability relates to Grace’s current and former operations, including its share of liability for off-site disposal at facilities where it has been identified as a potentially responsible party.  Grace’s estimated liability is based upon an evaluation of claims for which sufficient information was available. As Grace receives new information and continues its claims evaluation process, its estimated liability may change materially.

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Tax Matters - On May 19, 2005, Grace received a revised examination report (the “1993-1996 Examination Report”) from the Internal Revenue Service (the “IRS”) for the 1993-1996 tax periods asserting, in the aggregate, approximately $77.3 million of proposed tax adjustments, plus accrued interest. The most significant issue addressed in the 1993-1996 Examination Report concerns interest deductions claimed with respect to corporate-owned life insurance (“COLI”) policies. Grace reached an agreement with the IRS with respect to all proposed tax adjustments in the Examination Report (including settlement of COLI) with the exception of approximately $7.0 million of proposed adjustments relating to research and development credits. On April 14, 2005, Grace made a $90 million payment to the IRS with respect to federal taxes and accrued interest for the 1993-1996 tax periods, consistent with the revised Examination Report. On June 17, 2005, Grace filed its protest with respect to the R&D matter with the IRS Office of Appeals.  Grace  has been engaged in negotiations with the IRS with respect to this matter during the second quarter of 2006.

As a consequence of having determined federal tax adjustments for the 1990-1996 tax periods, Grace became liable for additional state taxes plus interest accrued thereon. Grace’s estimate for state taxes and interest to be paid for these years is approximately $18.3 million, of which it has already paid approximately $6.3 million. The remainder is expected to be paid in accordance with Grace’s bankruptcy proceedings.

In June 2006, Grace received revised examination reports for the 1988-1989 and 1997-2001 tax periods, collectively, the “Examination Reports” from the IRS asserting, in the aggregate, approximately $32.5 million of net additional tax plus accrued interest.  The most significant issue addressed in the Examination Reports concerns the carryback of a specified liability loss from the 1998 tax period to the 1989 taxable year.  Since Grace was in a net operating loss position for all but two of the other tax periods covered in the audit, most of the other issues addressed in the Examination Reports if determined adversely to Grace should not result in any cash tax liability but rather would impact the amount of certain tax attributes claimed by Grace in those tax periods such as losses and credits.  On May 25, 2006, Grace  filed a protest with the IRS Office of Appeals with respect to the ten year carryback issue as well as certain computational issues.

Grace’s federal tax returns covering 2002 and later years are open for future examination by the IRS. Grace believes that its recorded tax liability is adequate to cover the impact of probable tax return adjustments at June 30, 2006.

The IRS has assessed additional federal income tax withholding and Federal Insurance Contributions Act taxes plus interest and related penalties for calendar years 1993 through 1998 against a Grace subsidiary that formerly operated a temporary staffing business for nurses and other health care personnel. The assessments, aggregating $61.9 million, were made in connection with a meal and incidental expense per diem plan for traveling health care personnel, which was in effect through 1999, the year in which Grace sold the business.  (The statute of limitations has expired with respect to 1999.) The IRS contends that certain per diem reimbursements should have been treated as wages subject to employment taxes and federal income tax withholding. Grace contends that its per diem and expense allowance plans were in accordance with statutory and regulatory requirements, as well as other published guidance from the IRS. Grace has a right to indemnification from its former partner in the business for approximately 36% of any tax liability (including interest thereon) for the period from July 1996 through December 1998. The matter is currently pending in the United States Court of Claims. Grace has agreed with the Department of Justice and the IRS on a settlement amount and certain other terms that would resolve the matter.  The settlement is subject to the execution of written closing agreements with the IRS and the Department of Justice, and to Bankruptcy Court approval.  Grace believes that its recorded tax liability is adequate to cover the impact of this matter at June 30, 2006.

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Under federal income tax law, a corporation is generally permitted to deduct from taxable income in any year net operating losses (“NOL”) carried forward from prior years.  Grace’s ability to deduct NOL carryforwards could be subject to a significant limitation if it were to undergo an ownership change for purposes of Section 382 of the Internal Revenue Code of 1986, as amended, during or as a result of its Chapter 11 cases.  During the course of the bankruptcy proceeding, the Bankruptcy Court entered an order that places certain limitations on trading in Grace’s common stock or options convertible into common stock.  Pursuant to these limitations, the Company intends to object to any purchase of the Company’s stock or options that would potentially contribute to an “ownership change” for purposes of Section 382.  However, Grace can provide no assurance that these limitations will prevent an ownership change or that our ability to utilize net operating loss carryforwards may not be significantly limited as a result of Grace’s reorganization.

Purchase Commitments — Grace engages in purchase commitments to minimize the volatility of major components of direct manufacturing costs including natural gas, certain metals, asphalt, amines and other materials.  Such commitments are for quantities that Grace fully expects to use in its normal operations.

Guarantees and Indemnification Obligations  Grace is a party to many contracts containing guarantees and indemnification obligations. These contracts primarily consist of:

·                  Contracts providing for the sale of a former business unit or product line in which Grace has agreed to indemnify the buyer against liabilities arising prior to the closing of the transaction, including environmental liabilities. These liabilities are included in “liabilities subject to compromise” in the accompanying Consolidated Balance Sheets.

·                  Guarantees of real property lease obligations of third parties, typically arising out of (a) leases entered into by former subsidiaries of Grace, or (b) the assignment or sublease of a lease by Grace to a third party. These obligations are included in “liabilities subject to compromise” in the accompanying Consolidated Balance Sheets.

·                  Licenses of intellectual property by Grace to third parties in which Grace has agreed to indemnify the licensee against third party infringement claims.

·                  Contracts entered into with third party consultants, independent contractors, and other service providers in which Grace has agreed to indemnify such parties against certain liabilities in connection with their performance. Based on historical experience and the likelihood that such parties will ever make a claim against Grace, such indemnification obligations are immaterial.

·                  Product warranties with respect to certain products sold to customers in the ordinary course of business. These warranties typically provide that product will conform to specifications. Grace generally does not establish a liability for product warranty based on a percentage of sales or other formula. Grace accrues a warranty liability on a transaction-specific basis depending on the individual facts and circumstances related to each sale. Both the liability and annual expense related to product warranties are immaterial to the Consolidated Financial Statements.

Financial Assurances — Financial assurances have been established for a variety of purposes, including insurance and environmental matters, asbestos settlements and appeals, trade-related commitments and other matters.  At June 30, 2006, Grace had gross financial assurances issued and outstanding of $267.4 million, comprised of $135.0 million of surety bonds issued by various insurance companies, and $132.4 million of standby letters of credit and other financial assurances issued by various banks. As discussed in Note 8, $42.1 million of these financial assurances have been issued under the DIP facility.

Accounting for Contingencies Although the outcome of each of the matters discussed above cannot be predicted with certainty, Grace has assessed its risk and has made accounting estimates as required under U.S. generally accepted accounting principles. As a result of the Filing, claims related to certain of the items discussed above will be addressed as part of Grace’s Chapter 11 proceedings. Accruals recorded for such contingencies have been included in “liabilities subject to compromise” in the accompanying Consolidated Balance Sheets. The amounts of these liabilities as ultimately determined through the Chapter 11 proceedings could be materially different from amounts recorded at June 30, 2006.

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13.             Pension Plans and Other Postretirement Benefit Plans

Pension Plans — Grace maintains defined benefit pension plans covering employees of certain units who meet age and service requirements. Benefits are generally based on final average salary and years of service. Grace funds its U.S. qualified pension plans (“U.S. qualified pension plans”) in accordance with U.S. federal laws and regulations. Non-U.S. pension plans (“non-U.S. pension plans”) are funded under a variety of methods, as required under local laws and customs.

Grace also provides, through nonqualified plans, supplemental pension benefits in excess of U.S. qualified pension plan limits imposed by federal tax law. These plans cover officers and higher-level employees and serve to increase the combined pension amount to the level that they otherwise would have received under the U.S. qualified pension plans in the absence of such limits. The nonqualified plans are unfunded and Grace pays the costs of benefits as they are incurred.

At the December 31, 2005 measurement date for Grace’s defined benefit pension plans (the “Plans”), the accumulated benefit obligation (“ABO”) was approximately $1,386 million as measured under U.S. generally accepted accounting principles. At June 30, 2006, Grace’s recorded pension liability for underfunded plans was $533.7 million ($445.5 million included in liabilities not subject to compromise and $88.2 million related to supplemental pension benefits, included in “liabilities subject to compromise”). The recorded liability reflects 1) the shortfall between dedicated assets and the ABO of underfunded plans ($310.3 million); and 2) the ABO of pay-as-you-go plans ($223.4 million).

Postretirement Benefits Other Than Pensions Grace provides postretirement health care and life insurance benefits (referred to as other post-employment benefits or “OPEB”) for retired employees of certain U.S. business units and certain divested units.  The postretirement medical plan provides various levels of benefits to employees hired before 1991 and who retire from Grace after age 55 with at least 10 years of service.  These plans are unfunded and Grace pays a portion of the costs of benefits under these plans as they are incurred. Grace applies SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions,” which requires that the future costs of postretirement health care and life insurance benefits be accrued over the employees’ years of service.

Retirees and beneficiaries covered by the postretirement medical plan are required to contribute a minimum of 40% of the calculated premium for that coverage. During 2002, per capita costs under the retiree medical plans exceeded caps on the amount Grace was required to contribute under a 1993 amendment to the plan. As a result, for 2003 and future years, retirees will bear 100% of any increase in premium costs.

For 2006 measurement purposes, per capita costs, before retiree contributions, were assumed to initially increase at a rate of 8.5%.  The rate is assumed to decrease gradually to 5.0% through 2010 and remain at that level thereafter.  A one percentage point increase or decrease in assumed health care medical cost trend rates would have a negligible impact on Grace’s postretirement benefit obligations.

The components of net periodic benefit cost (income) for the three months and six months ended June 30, 2006 and 2005 are as follows:

 

Components of Net Periodic Benefit Cost (Income) 
(In millions)

 

Three Months Ended June 30,

 

 

 

2006

 

2005

 

 

 

Pension

 

 

 

Pension

 

 

 

 

 

U.S.

 

Non-U.S.

 

OPEB

 

U.S.

 

Non-U.S.

 

OPEB

 

Service cost

 

$

3.8

 

$

2.1

 

$

0.1

 

$

4.0

 

$

1.9

 

$

0.2

 

Interest cost

 

14.6

 

4.3

 

0.9

 

14.6

 

4.3

 

1.2

 

Expected return on plan assets

 

(12.6

)

(4.5

)

 

(12.8

)

(3.9

)

 

Amortization of prior service cost

 

0.6

 

0.2

 

(2.0

)

1.3

 

0.2

 

(3.2

)

Amortization of unrecognized actuarial loss

 

6.2

 

2.1

 

(0.2

)

6.3

 

1.9

 

0.4

 

Net curtailment and settlement loss

 

 

 

 

0.1

 

1.6

 

 

Net periodic benefit cost (income)

 

$

12.6

 

$

4.2

 

$

(1.2

)

$

13.5

 

$

6.0

 

$

(1.4

)

 

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Components of Net Periodic Benefit Cost (Income)
(In millions)

 

Six Months Ended June 30,

 

 

 

2006

 

2005

 

 

 

Pension

 

 

 

Pension

 

 

 

 

 

U.S.

 

Non-U.S.

 

OPEB

 

U.S.

 

Non-U.S.

 

OPEB

 

Service cost

 

$

8.1

 

$

4.1

 

$

0.2

 

$

8.2

 

$

3.8

 

$

0.4

 

Interest cost

 

29.1

 

8.5

 

2.0

 

29.0

 

8.7

 

2.4

 

Expected return on plan assets

 

(26.5

)

(8.8

)

 

(25.6

)

(7.9

)

 

Amortization of prior service cost

 

1.2

 

0.3

 

(5.2

)

2.6

 

0.4

 

(6.4

)

Amortization of unrecognized actuarial loss

 

11.5

 

4.1

 

0.2

 

11.4

 

3.8

 

0.8

 

Net curtailment and settlement loss

 

 

 

 

1.1

 

1.6

 

 

Net periodic benefit cost (income)

 

$

23.4

 

$

8.2

 

$

(2.8

)

$

26.7

 

$

10.4

 

$

(2.8

)

 

Plan Contributions and Funding — Subject to the approval of the Bankruptcy Court, Grace intends to satisfy its obligations under the Plans and to comply with all of the requirements of the Employee Retirement Income Security Act of 1974.  On June 16, 2006, Grace obtained Bankruptcy Court approval to fund minimum required payments of approximately $106 million for the period from July 2006 through January 2007.  In that regard, Grace contributed approximately $20 million in July 2006 to the trusts that hold assets of the Plans.  However, there can be no assurance that the Bankruptcy Court will continue to approve arrangements to satisfy the funding needs of the Plans. Contributions to non-U.S. plans are not subject to Bankruptcy Court approval and Grace intends to fund such plans based on actuarial and trustee recommendations.

Grace plans to pay benefits as they become due under virtually all pay-as-you-go plans and to maintain compliance with federal funding laws for its U.S. qualified pension plans.

14.             Operating Segment Information

Grace is a global producer of specialty chemicals and materials. It generates revenues from two operating segments: Grace Davison, which includes silica- and alumina-based catalysts and materials used in a wide range of industrial applications; and Grace Performance Chemicals, which includes specialty chemicals and materials used in commercial and residential construction and in rigid food and beverage packaging. Intersegment sales, eliminated in consolidation, are not material.  The table below presents information related to Grace’s operating segments for the three months and six months ended June 30, 2006 and 2005, respectively. Only those corporate expenses directly related to the operating segments are allocated for reporting purposes. All remaining corporate items are reported separately and labeled as such.

Operating Segment Data
(In millions)

 

Three Months
Ended
June 30,

 

Six Months
Ended
June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Net Sales

 

 

 

 

 

 

 

 

 

Grace Davison

 

$

380.3

 

$

358.9

 

$

736.7

 

$

693.6

 

Grace Performance Chemicals

 

348.8

 

317.6

 

651.0

 

586.1

 

Total

 

$

729.1

 

$

676.5

 

$

1,387.7

 

$

1,279.7

 

Pre-tax Operating Income

 

 

 

 

 

 

 

 

 

Grace Davison

 

$

46.3

 

$

43.1

 

$

82.3

 

$

80.8

 

Grace Performance Chemicals

 

53.1

 

45.7

 

87.3

 

73.0

 

Corporate costs

 

(28.7

)

(32.2

)

(51.1

)

(57.5

)

Total

 

$

70.7

 

$

56.6

 

$

118.5

 

$

96.3

 

 

Corporate costs include expenses of corporate headquarters functions incurred in support of core operations, such as corporate financial and legal services, human resources management, communications and regulatory affairs. Corporate costs also include certain pension and postretirement benefits, including the amortization of deferred costs that are considered a core operating expense but not allocated to operating segments.

The following table presents information related to the geographic areas in which Grace operated for the three months and six months ended June 30, 2006 and 2005, respectively.

Geographic Area Data
(In millions)

 

Three Months
Ended
June 30,

 

Six Months
Ended
June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Net Sales

 

 

 

 

 

 

 

 

 

United States

 

$

267.5

 

$

249.0

 

$

506.8

 

$

475.9

 

Canada and Puerto Rico

 

25.5

 

31.9

 

66.1

 

65.2

 

Total North America

 

$

293.0

 

$

280.9

 

$

572.9

 

$

541.1

 

Germany

 

35.1

 

30.0

 

65.4

 

58.5

 

Europe, other than Germany

 

233.9

 

214.7

 

450.6

 

407.4

 

Total Europe

 

$

269.0

 

$

244.7

 

$

516.0

 

$

465.9

 

Asia Pacific

 

128.4

 

117.6

 

226.7

 

205.7

 

Latin America

 

38.7

 

33.3

 

72.1

 

67.0

 

Total

 

$

729.1

 

$

676.5

 

$

1,387.7

 

$

1,279.7

                              

 

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The pre-tax operating income for Grace’s operating segments for the three months and six months ended June 30, 2006 and 2005, respectively, is reconciled below to income (loss) before Chapter 11 expenses, income taxes, and minority interest presented in the accompanying Consolidated Statements of Operations.

 

Reconciliation of Operating Segment Data to Financial Statements
(In millions)

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Pre-tax operating income — core operations

 

$

70.7

 

$

56.6

 

$

118.5

 

$

96.3

 

Minority interest

 

11.5

 

7.5

 

18.3

 

11.0

 

Net gain (loss) on sales of investments and disposals of assets

 

4.6

 

(0.4

)

2.8

 

0.5

 

Provision for environmental remediation

 

(30.0

)

 

(30.0

)

 

Interest expense and related financing costs

 

(19.9

)

(13.3

)

(35.7

)

(27.9

)

Other, net

 

(15.8

)

14.4

 

(32.7

)

6.1

 

Income (loss) before Chapter 11 expenses, income taxes, and minority
interest

 

$

21.1

 

$

64.8

 

$

41.2

 

$

86.0

 

 

Minority interest primarily pertains to Advanced Refining Technologies LLC (“ART”), a joint venture between Grace and Chevron Products Company where Grace has a 55% economic interest.

 

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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Financial Summary for June 30, 2006

Following is a summary analysis of key financial measures of our performance for the three months and six months ended June 30, 2006 compared with the prior year periods.

 

·                     Sales increased 7.8% and 8.4% for the three months and six months ended June 30, 2006, respectively, primarily as a result of higher sales volume in all geographic regions, improved product mix, and selling price increases in response to cost inflation.

·                     Net results for each period has been primarily affected by: 1) the results of our businesses – which is categorized as “core operations”; and 2) the impact of legal contingencies and other nonoperating liabilities – which is categorized as “noncore activities”.

·                     Net loss was $5.2 million for the three months ended June 30, 2006, compared with net income of $32.7 million for the three months ended June 30, 2005.  Net loss was $5.1 million for the six months ended June 30, 2006, compared with net income of $35.8 for the six months ended June 30, 2005.  The second quarter and year-to-date net loss is attributable to a $30.0 million increase in the estimated liability for environmental remediation, principally related to the former vermiculite mining operation in Montana, and to $24.3 million ($53.1 million for the six months ended June 30, 2006) of expense for Chapter 11, litigation and other matters not related to core operations. 

·                     Pre-tax income from core operations increased 24.9% and 23.1% for the three months and six months ended June 30, 2006, respectively, primarily attributable to higher sales volume in all geographic regions and higher selling prices to partially offset cost inflation, and from lower overall pension costs.

·                     Pre-tax operating income of our Grace Performance Chemicals operating segment increased 16.2% and 19.6% for the three months and six months ended June 30, 2006, respectively, attributable principally to higher sales of commercial construction products.

·                     Pre-tax operating income of our Grace Davison operating segment increased 7.4% and 1.9% for the three months and six months ended June 30, 2006, respectively, attributable primarily to higher sales of specialty materials and catalysts used in refining, chemical, and industrial applications.

·                     Operating cash flow for the six months ended June 30, 2006 was $11.1 million compared with a negative $74.6 million for the prior year period. The higher cash flow is attributable to improved operating results in 2006 and the non-recurrence of $119.7 million paid to settle tax and environmental contingencies in the prior year period.

·                     Pre-tax loss from noncore activities was $42.8 million in the second quarter of 2006 compared with pre-tax income of $13.1 million in the prior year quarter.  The pre-tax loss from noncore activities was $62.9 million year-to-date in 2006 compared with pre-tax income of $5.0 million in the prior year period.  The second quarter and year-to-date changes are principally due to revised estimates of environmental remediation costs of $30.0 million, and higher legal defense costs of $18.5 million, both related to issues arising from Grace’s former vermiculite mining operations in Montana.  Pre-tax income from noncore activities in the prior year periods is primarily attributable to gains recorded from insurance recoveries on pre-Chapter 11 environmental and asbestos-related costs.

We are attempting to resolve noncore liabilities and contingencies through our Chapter 11 proceeding. Our noncore liabilities include asbestos-related litigation, environmental remediation, tax disputes and business litigation. Our operating statements include periodic adjustments to account for changes in estimates of such liabilities and developments in our Chapter 11 proceeding. These liabilities and contingencies may result in continued volatility in net results in the future.

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Description of Core Business

 

We are engaged in specialty chemicals and specialty materials businesses on a worldwide basis through our two operating segments:

 

Grace Davison includes:

·                     Catalysts and chemical additives used by petroleum refiners, including fluid catalytic cracking, or FCC, catalysts, that help to “crack” the hydrocarbon chain in distilled crude oil to produce transportation fuels, such as gasoline and diesel fuels, and other petroleum-based products, and FCC additives used to reduce sulfur in gasoline, maximize propylene production from refinery FCC units, and reduce emissions of sulfur oxides, nitrogen oxides and carbon monoxide from refinery FCC units;

·                     Hydroprocessing catalysts used by petroleum refiners in process reactors to upgrade heavy oils into lighter, more useful products by removing impurities such as nitrogen, sulfur and heavy metals, allowing less expensive feedstocks to be used in the petroleum refining process;

·                     Specialty catalysts, including polyolefin catalysts and catalyst supports that are essential components in the manufacture of polyethylene and polypropylene resins, and other chemical catalysts used in a variety of industrial, environmental and consumer applications;

·                     Silica-based and silica-alumina-based engineered materials used in:

·                    industrial markets, such as coatings, plastics and rubber, precision investment casting, refractory, insulating glass windows, desiccants, and gas and liquids purification;

·                    consumer applications, such as food products, toothpaste, pharmaceutical and personal care products, and the processing of edible oils and beverages;

·                    digital media coatings on ink jet papers; and

·                     Silica-based materials and chromatography columns, instruments, consumables and accessories used in life and analytical sciences applications.

We conduct our hydroprocessing catalyst business through Advanced Refining Technologies, LLC, or ART, our joint venture with Chevron Products Company.  We report 100% of the revenues of our ART joint venture, but only receive 55% of the income after the minority interest is allocated to Chevron.

 

Key external factors for our FCC catalysts and hydroprocessing catalysts are the economics of the petroleum refining industry, specifically the impacts of demand for transportation fuels and petrochemical products, and crude oil supply.

 

Sales of our other three Grace Davison product groups are affected by general economic conditions including the underlying growth rate of targeted end-use applications.

 

Grace Performance Chemicals, or GPC, includes: 

·                     Construction materials and systems, including concrete admixtures and fibers used to improve the durability and working properties of concrete, additives used in cement processing to improve energy efficiency and enhance the characteristics of finished cement, waterproofing materials used in commercial and residential construction and renovation to protect buildings from water penetration, and fireproofing materials used to protect buildings from structural failure in the event of fire; and

·                     Packaging technologies, primarily specialty sealants and coatings used in rigid food and beverage packages, including can and closure sealants used to seal and enhance the shelf life of can and bottle contents, and coatings for cans and closures that prevent metal corrosion, protect package contents from the influence of metal and ensure proper adhesion of sealing compounds.

Construction products sales are affected by non-residential construction activity and, to a lesser extent, residential construction activity, which tend to lag the general economy in both decline and recovery. Waterproofing products sales are also significantly affected by residential renovation activity. A significant portion of our sales of construction products are in the U.S., so we are strongly influenced by the level of U.S. construction activity.

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Our packaging technologies sales are affected by general economic conditions globally as well as an ongoing shift in demand from metal and glass to plastic packaging for foods and beverages. This shift is causing a decline in can sealant usage, but provides opportunities for closure sealants and other products for plastic packaging.

 

Global scope – We operate our business on a global scale with more than 60% of our revenue and 40% of our operating properties outside the United States. Our business is conducted in more than 40 countries and in more than 20 currencies. Our operating segments are managed on a global basis, serving global markets, with currency fluctuations in relation to the U.S. dollar affecting reported earnings, net assets and cash flows.

 

The table below shows the sales in each of our operating segments, and domestic and international sales, as a percentage of our total sales.

 

Percentage of Total Grace Sales

 

Three Months Ended June 30,

 

Six Months Ended June 30,

 

 

 

2006

 

2005