UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2005

OR

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

For the transition period from ___________ to __________
Commission file number 1-8142
 
ENGELHARD CORPORATION
(Exact name of registrant as specified in its charter)
 
DELAWARE
  
22-1586002
(State or other jurisdiction of incorporation or organization)
  
(I.R.S. Employer Identification No.)
     
101 WOOD AVENUE, ISELIN, NEW JERSEY
  
08830
(Address of principal executive offices)
  
(Zip Code)
     
Registrant’s telephone number, including area code
  
(732) 205-5000
     
Securities registered pursuant to Section 12(b) of the Act:
    
Title of each class
  
Name of each exchange on which registered
Common Stock, par value $1 per share
  
New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

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

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Yes x.  No o.

Indicate by check mark if 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 Act. (Check one):

Large accelerated filer x     Accelerated filer o     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

The aggregate market value of the registrant’s voting common stock held by non-affiliates of the registrant, based on the closing price on the New York Stock Exchange on June 30, 2005 was approximately $3,429,142,955.

As of February 28, 2006, 123,758,521 shares of common stock were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Part III incorporates certain information by reference to the Proxy Statement for the 2006 Annual Meeting of Shareholders, which will be filed by May 4, 2006.

1

TABLE OF CONTENTS
 
Item
  
Page
 
Part I
  
     
 
 
(a) General development of business
3
 
(b) Available information of Engelhard
3
 
(c) Segment and geographic area data
3-5, 77-80
 
(d) Description of business
3-5, 77-80
 
(e) Environmental matters
6-7
     
7
     
7
     
8
     
8-10
     
11
     
11
     
 
Part II
  
     
12
     
13-14
     
15-41
     
42-43
     
44-86, 89
     
90
     
90
     
 
Part III
  
     
11, 91
     
91
     
91-92
     
93
     
93
     
 
Part IV
  
     
94-112

 
PART I

ITEM 1.
BUSINESS

Engelhard Corporation (which, together with its subsidiaries, is collectively referred to as the Company) was formed under the laws of Delaware in 1938 and became a public company in 1981. The Company’s principal executive offices are located at 101 Wood Avenue, Iselin, NJ 08830 (telephone number (732) 205-5000).

The Company maintains a website, free of charge, at www.engelhard.com, which contains information about the Company, including links to the Company’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and related amendments, which are available as soon as reasonably practicable after such reports are filed or furnished electronically with the SEC. The Company’s website and the information contained in it shall not be deemed incorporated by reference in this Form 10-K.

On January 9, 2006, BASF Aktiengesellschaft (“BASF”), acting through its indirect wholly owned subsidiary Iron Acquisition Corporation, commenced an unsolicited tender offer (the “BASF Offer”) in which it offered to purchase all of the outstanding shares of the Company for $37.00 per share, subject to certain conditions. On January 23, 2006, the Company announced that the Company’s Board of Directors had voted unanimously to recommend that the Company’s stockholders reject the BASF Offer as inadequate and not in the best interests of the Company’s stockholders. The full text of the Board’s recommendation is contained in the Company’s Schedule 14D-9 filed with the SEC. In connection with the BASF Offer, BASF filed a preliminary proxy statement to solicit proxies from the Company’s stockholders to elect two BASF nominees to the Company’s Board of Directors at the 2006 Annual Meeting of Shareholders, and has indicated its intent to solicit written consents from the Company’s stockholders to amend the Company’s bylaws to expand the size of the Board and fill the newly created vacancies with BASF nominees. Copies of these filings by the Company and BASF with the SEC may be viewed on the SEC’s web site at www.sec.gov. A description of litigation filed against the Company and its directors that is related to the BASF Offer is described below under “Item 3. Legal Proceedings.”

The Company develops, manufactures and markets value-adding technologies based on surface and materials science for a wide spectrum of industrial customers. The Company also provides its technology segments, their customers and others with precious and base metals and related services.

The Company employed approximately 7,100 people as of January 1, 2006 and operates on a worldwide basis with corporate headquarters in the United States, and manufacturing facilities, mineral reserves and other operations in Asia, the European community, North America, the Russian Federation, South Africa and Brazil.

The Company’s businesses are organized into four reportable segments — Environmental Technologies, Process Technologies, Appearance and Performance Technologies and Materials Services.

Within the “All Other” category, sales to external customers and operating earnings are derived primarily from the Ventures business. The sale of precious metals accounted for under the LIFO method, royalty income, results from the Strategic Technologies group and other miscellaneous income and expense items not related to the reportable segments are included in the “All Other” category.

The following information on the Company is included by segment in Note 20, “Business Segment and Geographic Area Data,” of the Notes to Consolidated Financial Statements: net sales to external customers; operating earnings (loss); special charge (credit), net; depreciation, depletion and amortization; equity in earnings of affiliates; total assets; equity investments and capital expenditures. Interest income, interest expense and income taxes are included in total.

Environmental Technologies

The Environmental Technologies segment markets cost-effective compliance with environmental regulations, enabled by sophisticated emission-control technologies and systems. The segment also provides other products made from precious metals, as well as thermal spray and coating technologies.

Environmental catalysts are used in applications such as the abatement of carbon monoxide, oxides of nitrogen and hydrocarbon emissions from gasoline and diesel vehicles. These catalysts also are used to remove
 
 
 odors, fumes and pollutants associated with a variety of process industries, co-generation and gas-turbine power generation, household appliances and lawn and garden power tools.

The products of the Environmental Technologies segment compete in the marketplace on the basis of value, performance and cost. No single competitor is dominant in the markets in which this segment operates.

The manufacturing operations of the Environmental Technologies segment are carried out in the United States, Italy, Germany, India, South Africa, Brazil, China, Thailand, Sweden and the United Kingdom, with equity investments located in South Korea and the United States. Although not included in this segment, the Japanese mobile-source environmental markets are served by the Company’s N.E. Chemcat equity joint venture. The products are sold principally through the Company’s sales organizations or those of its equity investments, supplemented by independent distributors and representatives.

Principal raw materials used by the Environmental Technologies segment include precious metals (primarily platinum group metals), procured by the Materials Services segment and/or supplied by customers, substrates and a variety of minerals and chemicals that are generally available.

As of January 1, 2006, the Environmental Technologies segment had approximately 1,800 employees worldwide. Most hourly employees are not covered by collective bargaining agreements. Employee relations have generally been good.

Process Technologies

The Process Technologies segment enables customers to make their processes more productive, efficient, environmentally sound and safer through the supply of advanced chemical-process catalysts, additives and sorbents.

Process Technologies’ chemical-process catalysts are used in the manufacture of a variety of products and intermediates made by chemical, petrochemical, pharmaceutical and agricultural chemical producers. In addition, they are used in the production of polypropylene, which is used in a wide range of products, including food packaging, carpets, toys and automobile bumpers. Sorbents are used to purify and decolorize naturally occurring fats and oils for the manufacture of shortenings, margarines and cooking oils. Petroleum catalysts and additives are used by refiners to provide economies in petroleum processing and to meet increasingly stringent fuel-quality requirements. The segment’s catalyst products are based on the Company’s proprietary technology and often are application-specific.

The products of the Process Technologies segment compete in the marketplace on the basis of value, performance and cost. No single competitor is dominant in the markets in which this segment operates.

The manufacturing operations of the segment are carried out in the United States, Italy, The Netherlands, China and Spain. The products are sold principally through the Company’s sales organizations supplemented by independent representatives.

The principal raw materials used by the segment include metals, procured by the Materials Services segment and from third parties; kaolin-based intermediates supplied by the Appearance and Performance Technologies segment; and a variety of other minerals and chemicals that are generally readily available. The segment also uses certain raw materials that are sourced primarily from China.

As of January 1, 2006, the Process Technologies segment had approximately 2,400 employees worldwide. Most hourly employees are covered by collective bargaining agreements. Employee relations have generally been good.

Appearance and Performance Technologies

The Appearance and Performance Technologies segment provides effect materials, personal care active ingredients, paper coating and pigment extenders and performance additives that enable its customers to market enhanced image and functionality in their products. This segment serves a broad array of end markets, including cosmetics, personal care, coatings, plastic, automotive, construction and paper. The segment’s products help
 
 
 customers improve the look, functionality, performance and overall cost of their products. In addition, the segment is the internal supply source of precursors for most of the Company’s advanced petroleum-refining catalysts.

The segment’s principal products include special-effect materials and films, personal care actives, color pigments and dispersions, paper coatings and pigment extenders and specialty performance additives. The segment’s special-effect pigments and film provide a range of aesthetic and functional effects in coatings, personal care and cosmetic products, packaging, plastics, inks, glitter, gift wrap, textiles and other applications. Personal care materials include materials used for skin care delivery systems and active ingredients. Color pigments include a broad range of organic and inorganic products, dispersions and universal colorants. Kaolin products are used as coating and pigment extenders to improve the opacity, brightness, gloss and printability of coated and uncoated papers. Specialty performance additives are used to improve the functionality, appearance and value of liquid and powder coatings, plastics, rubber, adhesives, inks, concrete and cosmetics.

The products of the Appearance and Performance Technologies segment compete in the marketplace on the basis of value, performance and cost. No single competitor is dominant in the markets in which this segment operates.

The manufacturing operations of the segment are carried out in the United States, South Korea, China, France and Finland. Subsidiary sales and distribution centers are located in France, Hong Kong, Japan, Mexico and The Netherlands, in addition to the manufacturing site locations noted above. Products are sold through the Company’s sales organization supplemented by independent distributors and representatives.

The principal raw materials used by the Appearance and Performance Technologies segment include naturally occurring minerals such as kaolin, attapulgite and mica, which are mined from mineral reserves owned or leased by the Company, and a variety of other minerals and chemicals that are readily available.

As of January 1, 2006, the Appearance and Performance Technologies segment had approximately 2,000 employees worldwide. Most hourly employees are covered by collective bargaining agreements. Employee relations have generally been good.

Materials Services

The Materials Services segment serves the Company’s technology segments, their customers and others with precious and base metals and related services. This is a distribution and materials services business that purchases and sells precious metals, base metals and related products and services. It does so under a variety of pricing and delivery arrangements structured to meet the logistical, financial and price-risk management requirements of the Company, its customers and suppliers. Additionally, it offers the related services of precious-metal refining and storage, and produces precious-metal salts and solutions.

The Materials Services segment is responsible for procuring precious and base metals to meet the requirements of the Company’s operations and its customers. Supplies of newly mined platinum group metals are obtained primarily from South Africa and the Russian Federation and, to a lesser extent, from the United States and Canada, the only four regions that are known significant sources. Most of these platinum group metals are obtained pursuant to a number of contractual arrangements with different durations and terms. This segment also refines platinum group metals. Gold, silver and base metals are purchased from various sources. In addition, in the normal course of business, certain customers and suppliers deposit significant quantities of precious metals with the Company under a variety of arrangements. Equivalent quantities of precious metals are returnable as product or in other forms.

Operations are located in the United States, Italy, Japan, the Russian Federation, Switzerland and the United Kingdom. As of January 1, 2006, the Materials Services segment had 84 employees worldwide.

Equity Investments

The Company has equity investments in affiliates that are accounted for under the equity method. These investments are N.E. Chemcat Corporation (NECC), Heesung-Engelhard, H. Drijfhout & Zoon’s Edelmetaalbedrijen (HDZ) and Prodrive-Engelhard. N.E. Chemcat is a 42.1%-owned, publicly traded Japanese corporation and a leading producer of automotive and chemical catalysts, electronic chemicals and other precious-
 
 
metal-based products in Japan. Heesung-Engelhard, a 49%-owned joint venture in South Korea, primarily manufactures and markets catalyst products for automobiles. HDZ is a 45%-owned former subsidiary of Engelhard-CLAL, which manufactured and marketed certain products containing precious metals. Prodrive-Engelhard, a 50%-owned joint venture in the United States, specializes in the design, development and testing of vehicle emission systems.

During the first quarter of 2005, the Company exchanged a 7.5% interest in its Chinese automotive catalyst operations for approximately 2.6% of N.E. Chemcat. This transaction was recorded as an exchange of similar productive assets in accordance with APB29, “Accounting for Nonmonetary Transactions.” The Company also acquired an additional 0.7% of N.E. Chemcat through a public tender offer. These transactions increased the Company’s ownership percentage in N.E. Chemcat from 38.8% to 42.1%.

Major Customers

No customer accounted for more than 10% of the Company’s net sales for the years ended December 31, 2005, 2004 or 2003.

Research and Patents

At December 31, 2005, the Company employed approximately 540 scientists, technicians and auxiliary personnel engaged in research and development in the fields of surface chemistry and materials science. These activities are conducted in the United States and abroad. Research and development expenses were $108.2 million in 2005, $99.9 million in 2004 and $93.1 million in 2003.

Research facilities include fully staffed instrument analysis laboratories that the Company maintains in order to achieve the high level of precision necessary for its technology businesses and to assist customers in understanding how the Company’s products and services add value to their businesses.

The Company owns, or is licensed under, numerous patents secured over a period of years. It is typically the policy of the Company to apply for patents whenever it develops new products or processes considered to be commercially viable and, in appropriate circumstances, to seek licenses when such products or processes are developed by others. While the Company deems its various patents and licenses to be important to certain aspects of its operations, it does not consider any significant portion or its business as a whole to be materially dependent on patent protection.

Environmental Matters

With the oversight of environmental agencies, the Company is currently preparing, has under review, or is implementing environmental investigations and cleanup plans at several currently or formerly owned and/or operated sites, including Plainville, Massachusetts. The Company continues to investigate and remediate contamination at Plainville under a 1993 agreement with the United States Environmental Protection Agency (EPA). The Company continues to address decommissioning issues at Plainville under authority delegated by the Nuclear Regulatory Commission to the Commonwealth of Massachusetts.

In addition, as of December 31, 2005, 14 sites have been identified at which the Company believes liability as a potentially responsible party is probable under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended, or similar state laws (collectively referred to as Superfund) for the cleanup of contamination and natural resource damages resulting from the historic disposal of hazardous substances allegedly generated by the Company, among others. Superfund imposes strict, joint and several liability under certain circumstances. In many cases, the dollar amount of the claim is unspecified and claims have been asserted against a number of other entities for the same relief sought from the Company. Based on existing information, the Company believes that it is a de minimis contributor of hazardous substances at a number of the sites referenced above. Subject to the reopening of existing settlement agreements for extraordinary circumstances, discovery of new information or natural resource damages, the Company has settled a number of other cleanup proceedings. The Company has also responded to information requests from EPA and state regulatory authorities in connection with other Superfund sites.


The accruals for environmental cleanup-related costs reported in the consolidated balance sheets at December 31, 2005 and 2004 were $18.0 million and $19.1 million, respectively, including $0.1 million at December 31, 2005 and 2004 for Superfund sites. These amounts represent those undiscounted costs that the Company believes are probable and reasonably estimable. Based on currently available information and analysis, the Company’s accrual represents approximately 39% of what it believes are the reasonably possible environmental cleanup-related costs of a noncapital nature. The estimate of reasonably possible costs is less certain than the probable estimate upon which the accrual is based.

Cash payments for environmental cleanup-related matters were $1.2 million in 2005, $1.3 million in 2004 and $1.8 million in 2003. In 2003, the Company recognized a $2.0 million liability for a facility in France.

For the past three-year period, environmental-related capital projects have averaged less than 10% of the Company’s total capital expenditure programs, and the expense of environmental compliance (e.g., environmental testing, permits, consultants and in-house staff) was not material.

There can be no assurances that environmental laws and regulations will not change or that the Company will not incur significant costs in the future to comply with such laws and regulations. Based on existing information and current environmental laws and regulations, cash payments for environmental cleanup-related matters are projected to be $2.5 million for 2006, which has already been accrued. Further, the Company anticipates that the amounts of capitalized environmental projects and the expense of environmental compliance will approximate current levels. The Company has an Environmental, Health and Safety (EH&S) department that implements and assesses compliance to policies, procedures and controls around the Company’s environmental exposures and possible liabilities. These policies, procedures and controls are intended to assure that the Corporate EH&S department is aware of all issues that may have a potential impact on the Company. While it is not possible to predict with certainty, management believes environmental cleanup-related reserves at December 31, 2005 are reasonable and adequate, and environmental matters are not expected to have a material adverse effect on financial condition.

ITEM 1A.
RISK FACTORS

There are a number of risk factors faced by the Company. These are primarily addressed in ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS in connection with the presentation of recent results and projections which include forward-looking statements. In particular, readers should review the following:

 
·
“Overview” on page 15 which summarizes specific economic factors.

 
·
“Critical Accounting Policies and Estimates” on pages 30-34 which includes assumptions and estimates that form the basis for certain financial statement amounts.

 
·
“Risk Factors” on pages 35-38 which detail both internal and external risks.

 
·
“Key Assumptions” on pages 38-41 which list the underlying basis for projections made in the various "Outlook" sections.

Additionally, ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK discusses risk with respect to interest rates, foreign currency and commodities.

ITEM 1B.
UNRESOLVED STAFF COMMENTS

Not applicable.


ITEM 2.
PROPERTIES

The Company leases a building on approximately seven acres of land with an area of approximately 271,000 square feet in Iselin, NJ. This building serves as the principal executive and administrative office of the Company and its operating segments. The Company owns approximately eight acres of land and three buildings with a combined area of approximately 160,000 square feet in Iselin, NJ. These buildings serve as the major research and development facilities for the Company’s operations. The Company also owns or leases research facilities in Gordon, GA; Union, NJ; Buchanan, Ossining and Stony Brook, NY; Beachwood, OH; Pasadena, TX; Lyon, France; Hannover, Germany; and De Meern, The Netherlands. The Company is currently constructing a research and development facility on Company-owned property in Shanghai, China.

The Environmental Technologies segment operates company-owned plants in Huntsville, AL; East Windsor, CT; Wilmington, MA; Duncan, SC; East Newark, NJ; Fremont, CA; Nienburg, Germany; Chennai, India; Port Elizabeth, South Africa; Rome, Italy; Indiatuba, Brazil; Shanghai, China; Rayoung, Thailand; Solvesborg, Sweden; and Cinderford in the United Kingdom. The manufacturing operations at the Carteret, NJ facility have been discontinued. See Note 7, “Discontinued Operations,” for more information.

The Process Technologies segment operates company-owned plants in Attapulgus and Savannah, GA; Elyria, OH; Erie, PA; Seneca, SC; Jackson, MS; Pasadena, TX; Nanjing, China; Rome, Italy; De Meern, The Netherlands; and Tarragona, Spain.

The Appearance and Performance Technologies segment operates company-owned attapulgite processing plants in Quincy, FL near the area containing its attapulgite reserves, plus mica mine and processing facilities in Hartwell, GA. In addition, the segment operates three company-owned kaolin mines and three milling facilities in Middle Georgia, which serve a 70-mile network of pipelines to three processing plants. It also operates on company-owned land containing kaolin and leases on a long-term basis kaolin mineral rights to additional acreage. The segment also operates company-owned sales and manufacturing facilities in Kotka and Rauma, Finland and Shanxi, China in addition to owning and operating color, pearlescent pigment, personal care and film manufacturing facilities and sales facilities in Sylmar, CA; Louisville, KY; Eastport, ME; Peekskill and Setauket, NY; New York, NY; Elyria, OH; Charleston, SC; Lyon, France; Paris, France; Tokyo, Japan; Mexico City, Mexico; Haarlem, The Netherlands; and Inchon, South Korea. Management believes the Company’s kaolin, attapulgite and mica reserves will be sufficient to meet its needs for the foreseeable future.

The Materials Services segment’s operations are conducted at leased facilities in Iselin, NJ; Lincoln Park, MI; Tokyo, Japan; Moscow, Russia; Zug, Switzerland; and London, the United Kingdom. In addition, the segment’s operations are conducted at company-owned facilities in Seneca, SC; Carteret, NJ; and Rome, Italy.

The Ventures Group operates company-owned plants in Port Allen and Vidalia, LA; Jackson, MS; and Nienburg, Germany. The Company operates mines in Cheto, AZ.

Management believes that the Company’s processing and refining facilities, plants and mills are suitable and have sufficient capacity to meet its normal operating requirements for the foreseeable future.

ITEM 3.
LEGAL PROCEEDINGS

The Company is one of a number of defendants in numerous proceedings that allege that the plaintiffs were injured from exposure to hazardous substances purportedly supplied by the Company and other defendants or that existed on Company premises. The Company is also subject to a number of environmental contingencies (see Note 22, “Environmental Costs,” for further detail) and is a defendant in a number of lawsuits covering a wide range of other matters. In some of these matters, the remedies sought or damages claimed are substantial. While it is not possible to predict with certainty the ultimate outcome of these lawsuits or the resolution of the environmental contingencies, management believes, after consultation with counsel, that resolution of these matters is not expected to have a material adverse effect on financial condition.

The Company is involved in a value-added tax dispute in Peru. Management believes the Company was targeted by corrupt officials within a former Peruvian government. On December 2, 1999, Engelhard Peru, S.A., (now Engelhard Peru S.A.C. en liquidaciόn or “Engelhard Peru”), a wholly owned subsidiary, was denied refund claims of approximately $28 million. The Peruvian tax authority also determined that Engelhard Peru is liable for
 
 
approximately $63 million in refunds previously paid, fines and interest as of December 31, 1999. Interest and fines continue to accrue at rates established by Peruvian law. The Peruvian Tax Court ruled on February 11, 2003 that Engelhard Peru was liable for these amounts, overruling precedent to apply a “form over substance” theory without any determination of fraudulent participation by Engelhard Peru. Engelhard Peru filed a constitutional action against the Peruvian tax authority and Tax Court. On May 3, 2004, the judge in this action ruled that none of the findings of the Peruvian tax authorities were properly applicable to Engelhard Peru based on several grounds, including improper use of a presumption of guilt with no actual proof of irregularity in the transactions of Engelhard Peru. The government of Peru prevailed on appeal to the Superior Court and prevailed again on appeal to Peru’s Constitutional Court. Although management believes, based on consultation with counsel, that this is an extraordinary decision that is plainly inconsistent with the law and the facts, no further appeal in Peru is likely to be productive. Management believes, based on consultation with counsel, that the maximum economic exposure is limited to the aggregate value of all assets of Engelhard Peru. That amount, which is approximately $30 million, including unpaid refunds, has been fully provided for in the accounts of the Company.

In late October 2000, a criminal proceeding alleging tax fraud and forgery related to this value-added tax dispute was initiated against two Lima-based officials of Engelhard Peru. In September 2005, a Superior prosecutor concluded that there was no basis for the criminal proceedings against several defendants, including both officials of Engelhard Peru. Final dismissal of those criminal charges remains subject to judicial review and determination of the Supreme Prosecutor. Although Engelhard Peru is not a defendant, it may be civilly liable in Peru if its representatives are found responsible for criminal conduct. In its own investigation, and in detailed review of the materials presented in Peru, management has not seen any evidence of tax fraud by these officials. Accordingly, Engelhard Peru is assisting in the vigorous defense of this proceeding. As noted above, management believes the economic exposure is limited to the aggregate of all assets of Engelhard Peru, which has been fully provided for in the accounts of the Company.

On January 4, 2006, Scott Sebastian, who alleges that he is a stockholder of the Company, commenced a purported class action on behalf of the stockholders of the Company against the Company and all of its directors in the Chancery Division of the New Jersey Superior Court for Middlesex County. The complaint alleges that the defendants breached their fiduciary duties in connection with their response to BASF’s proposal to acquire the Company and seeks declaratory and injunctive relief and damages. On January 4, 2006, Hindy Silver, who alleges that she is a stockholder of the Company, commenced a purported class action on behalf of the stockholders of the Company against the Company and all of its directors in the Chancery Division of the New Jersey Superior Court for Mercer County. The complaint alleges that the defendants breached their fiduciary duties in connection with their response to BASF’s proposal to acquire the Company and seeks injunctive relief and an accounting. On January 17, 2006, the plaintiffs in the Sebastian and Silver actions moved to transfer the Sebastian action to the New Jersey Superior Court for Mercer County and to consolidate the two actions in that Court. The defendants cross-moved to stay the New Jersey actions until the Delaware actions, described below, have been resolved or, in the alternative, to dismiss the New Jersey actions for failure to state a claim, and plaintiffs moved for expedited discovery. Plaintiffs opposed defendants’ cross-motions and requested leave to file an amended complaint if the Court was inclined to grant defendants’ motion to dismiss. The proposed amended complaint adds, among other things, allegations that the Schedule 14D-9 filed by the Company with the SEC fails to disclose material information that the proposed amended complaint alleges is needed by Engelhard shareholders to be able to make an informed decision concerning whether to tender their shares to BASF. The proposed amended complaint seeks declaratory and injunctive relief and damages. Defendants opposed plaintiffs’ motion for expedited discovery and motion to amend their complaint. Argument on all motions and cross-motions was held on February 9, 2006 in the New Jersey Superior Court for Mercer County. The Court stated that the motion to consolidate would be granted and took the other matters under advisement.

On January 5, 2006, Laura Benjamin and Sam Cohn, and on January 6, 2006, Stewart Simon, all of whom purport to be stockholders of the Company, each commenced a purported class action on behalf of the stockholders of the Company against the Company and all of its directors in the Delaware Court of Chancery for New Castle County. Each complaint alleged that the defendants breached their fiduciary duties in connection with their response to BASF’s proposal to acquire the Company and sought injunctive relief. The Benjamin and Cohn complaints also sought damages and the Simon complaint sought an accounting. On January 13, 2006 these three actions were consolidated under the caption In re: Engelhard Corporation Shareholders Litigation, Consolidated C.A. No. 1871-N, in the Delaware Court of Chancery for New Castle County, and a Consolidated Amended Complaint was filed and served which names the same defendants and contains allegations similar to those made in the complaints initially filed in the underlying actions, and seeks injunctive relief and damages. On the same day,
 
 
plaintiffs served a request for production of documents. On January 17, 2006, the court entered an order governing the protection and exchange of confidential information. On January 24, 2006, the Court entered a case management order. Defendants have begun to produce documents to plaintiffs. On January 25, 2006, with defendants’ consent, the Court granted plaintiffs leave to file a Second Consolidated Amended Complaint. The Second Consolidated Amended Complaint adds, among other things, allegations that the Schedule 14D-9 filed by the Company with the SEC fails to disclose material information concerning what the Company and its Board of Directors are doing with respect to the exploration of strategic alternatives to BASF’s offer and fails to disclose information that is material to evaluating the opinion Merrill Lynch provided to the Company’s Board of Directors that BASF’s offer is inadequate from a financial point of view.

The Company and the individual defendants believe the claims made in each of the putative class action suits described above are without merit and intend to vigorously defend against these suits.


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

Not applicable.

ITEM 4A.
EXECUTIVE OFFICERS OF THE REGISTRANT

GAVIN A. BELL
Age 44. Vice President, Investor Relations effective July 16, 2004. Director, Investor Relations, American Standard Companies, Inc. (global, diversified manufacturer) from 2002 to 2004. Director, Investor Relations, Becton, Dickinson and Company (global medical technology company) from 2001 to 2002. Director, Investor Relations, Coca-Cola Beverages plc, a London, UK subsidiary of The Coca-Cola Company (global beverage company) from prior to 2001.
   
ARTHUR A. DORNBUSCH, II
Age 62. Vice President, General Counsel and Secretary of the Company from prior to 2001.
   
MARK DRESNER
Age 54. Vice President, Corporate Communications from prior to 2001.
   
JOHN C. HESS
Age 54. Vice President, Human Resources from prior to 2001.
   
MAC C.P. MAK
Age 57. Treasurer, effective April 7, 2003. Senior Vice President, Strategic Planning and Corporate Development, Coty Inc. (global cosmetics company) from December 2001 to April 2003. Vice President, Strategic Planning and Corporate Development, Coty Inc. from prior to 2001.
   
BARRY W. PERRY *
Age 59. Chairman and Chief Executive Officer of the Company since January 2001. Mr. Perry is also a director of Arrow Electronics, Inc. and Cookson Group plc.
   
ALAN J. SHAW
Age 57. Controller of the Company effective January 1, 2003. Vice President-Finance of Materials Services from prior to 2001.
   
MICHAEL A. SPERDUTO
Age 48. Vice President and Chief Financial Officer of the Company effective August 2, 2001. Controller of the Company from prior to 2001.
   
DR. EDWARD T. WOLYNIC
Age 57. Vice President and Chief Technology Officer of the Company effective August 5, 2005. Group Vice President, Strategic Technologies and Chief Technology Officer effective March 1, 2001. Group Vice President, Strategic Technogies from prior to 2000.
 
* Also a director of the Company.

Officers of the Company are elected at the meeting of the Board of Directors held after the annual meeting of shareholders and serve until their successors shall be elected and qualified and shall serve as such at the pleasure of the Board.


PART II

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

(a) As of February 28, 2006, there were 4,125 holders of record of the Company’s common stock, which is traded on the New York Stock Exchange (ticker symbol “EC”), as well as on the Swiss Stock Exchange.

The range of market prices and cash dividends paid for each quarterly period were as follows:
 
   
NYSE
Market Price
  
Cash
dividends paid
  
   
High
  
Low
  
per share
  
2005
              
First quarter
  
$
30.82
     
$
28.64
     
$
0.12
  
Second quarter
    
31.37
    
27.68
    
0.12
  
Third quarter
    
29.96
    
27.35
    
0.12
  
Fourth quarter
    
31.11
    
26.80
    
0.12
  
                     
                     
2004
                    
First quarter
  
$
30.29
  
$
26.66
  
$
0.11
  
Second quarter
    
32.31
    
27.55
    
0.11
  
Third quarter
    
32.72
    
26.63
    
0.11
  
Fourth quarter
    
30.98
    
26.49
    
0.11
  

(c) The Company has Board authorized plans or programs for the repurchase of the Company’s stock. The following table represents repurchases under these plans or programs for each of the three months of the quarter ended December 31, 2005:
 
ISSUER PURCHASES OF EQUITY SECURITIES:
 
Period
  
Total Number of Shares Purchased
  
Average Price Paid per Share
  
Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs
  
Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs (a)
  
10/1/05 - 10/31/05
    
4,000(b)
     
$
26.98
        
4,000
        
5,765,532
  
11/1/05 - 11/30/05
    
24,000     
 
$
28.42
    
24,000
    
5,741,532
  
12/1/05 - 12/31/05
    
—      
    
—
    
—
    
5,741,532
  
     
28,000     
 
$
28.21
    
28,000
        
 
 
(a)
Share repurchase program of 6 million shares authorized in May 2005.

 
(b)
Excludes 286 shares obtained through dividend reinvestment by the Rabbi Trust under the Deferred Compensation Plan for Key Employees of Engelhard Corporation.


ITEM 6.
SELECTED FINANCIAL DATA

Selected Financial Data
($ in millions, except per-share amounts)

   
2005
  
2004
  
2003
  
2002
  
2001
  
Net sales
  
$
4,597.0
  
$
4,136.1
  
$
3,687.8
  
$
3,753.6
  
$
5,096.9
  
Net earnings from continuing operations
    
246.3
    
237.2
    
237.1
    
171.4
    
225.6
  
Earnings per share from continuing operations - basic
    
2.05
    
1.93
    
1.89
    
1.34
    
1.73
  
Earnings per share from continuing operations - diluted
    
2.02
    
1.89
    
1.86
    
1.31
    
1.71
  
Total assets
    
3,879.0
    
3,178.6
    
2,933.0
    
3,020.7
    
2,995.5
  
Long-term debt
    
430.5
    
513.7
    
390.6
    
247.8
    
237.9
  
Shareholders’ equity
    
1,489.2
    
1,414.3
    
1,285.4
    
1,077.2
    
1,003.5
  
Cash dividends paid per share
    
0.48
    
0.44
    
0.41
    
0.40
    
0.40
  
Return on average shareholders’ equity
    
17.0
%   
 
17.6
%   
 
20.0
%   
 
16.5
%   
 
24.0
%

Net earnings from continuing operations in 2005 include a tax provision benefit of $2.7 million resulting from an agreement with the Internal Revenue Service with respect to the Company’s tax returns for 2001.

Net earnings from continuing operations in 2004 include the following: a tax provision benefit of $8.0 million resulting from an agreement reached with the Internal Revenue Service with respect to the Company’s tax returns for 1998 through 2000, a charge of $4.1 million resulting from the consolidation of certain manufacturing operations to improve efficiency and a credit of $0.8 million related to the reversal of prior year special charge accruals (see Note 6, “Special Charges and Credits,” for further detail).

Net earnings from continuing operations in 2003 include the following: a royalty settlement gain of $17.6 million, a charge of $4.8 million for the fair value of the remaining lease costs of certain minerals-storage facilities that the Company ceased to use and restructuring charges of $5.6 million (see Note 6, “Special Charges and Credits,” for further detail). In addition, a transition charge of $2.3 million was recorded on January 1, 2003 as the cumulative effect of an accounting change (see Note 4, “Accounting for Asset Retirement Obligations,” for further detail).

Net earnings from continuing operations in 2002 include the following: an impairment charge of $57.7 million associated with the Engelhard-CLAL joint venture, an impairment charge of $4.1 million associated with an investment in fuel-cell developer Plug Power Inc., a charge of $1.9 million related to a manufacturing consolidation plan and a $6.8 million insurance settlement gain.


The following tables provide information related to the adoption of Statement of Financial Accounting Standards (SFAS) No. 143, “Accounting for Asset Retirement Obligations” (see Note 4, “Accounting for Asset Retirement Obligations,” for further detail):

Selected Financial Data
($ in millions, except per-share amounts)

   
2005
  
2004
  
2003
  
2002
  
2001
  
Net earnings from continuing operations before cumulative effect of a change in accounting principle
  
$
246.3
    
$
237.2
    
$
239.4
    
$
171.4
    
$
225.6
  
Cumulative effect of a change in accounting principle, net of tax of $1,390
   
—
    
—
    
(2.3
)
  
—
    
—
  
Net earnings from continuing operations
  
$
246.3
  
$
237.2
  
$
237.1
  
$
171.4
  
$
225.6
  
                                 
Earnings per share from continuing operations - basic:
                               
Earnings from continuing operations before cumulative effect of a change in accounting principle
  
$
2.05
  
$
1.93
  
$
1.91
  
$
1.34
  
$
1.73
  
Cumulative effect of a change in accounting principle, net of tax
    
—
    
—
    
(0.02
)
  
—
    
—
  
Earnings per share from continuing operations - basic
  
$
2.05
  
$
1.93
  
$
1.89
  
$
1.34
  
$
1.73
  
                                 
Earnings per share from continuing operations - diluted:
                                
Earnings from continuing operations before cumulative effect of a change in accounting principle
  
$
2.02
  
$
1.89
  
$
1.88
  
$
1.31
  
$
1.71
  
Cumulative effect of a change in accounting principle, net of tax
    
—
    
—
    
(0.02
)
  
—
    
—
  
Earnings per share from continuing operations - diluted
  
$
2.02
  
$
1.89
  
$
1.86
  
$
1.31
  
$
1.71
  
                                 
Pro forma amounts assuming the provisions of SFAS No. 143 were applied retroactively:
    
2005
 
 
2004
 
 
2003
 
 
2002
 
 
2001
  
Net earnings from continuing operations
 
$
246.3
  
$
237.2
  
$
239.4
  
$
170.8
  
$
225.0
  
Basic earnings per share from continuing operations
    
2.05
    
1.93
    
1.91
    
1.33
    
1.73
  
Diluted earnings per share from continuing operations
    
2.02
    
1.89
    
1.88
    
1.31
    
1.70
  

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

Unless otherwise indicated, all per-share amounts are presented as diluted earnings per share, as calculated under SFAS No. 128, “Earnings per Share.”

For a discussion of the Company’s critical accounting policies and estimates, see page 30.

Overview

The Company develops, manufactures and markets value-adding technologies based on surface and materials science for a wide spectrum of served markets. The Company also provides its technology segments, their customers and others with precious and base metals and related services. The Company’s businesses are organized into four reportable segments that are discussed individually below. Additional detailed descriptive material is included in “ITEM 1. BUSINESS” and NOTE 20, “BUSINESS SEGMENT AND GEOGRAPHIC AREA DATA” in this Form 10-K.

One of the strengths of the Company is that its segments serve diverse markets, which is important for assessing the variability of future cash flows. The following economic comments also provide a useful context for evaluating the Company’s performance: (1) worldwide auto builds continue to be relatively flat, albeit at fairly high levels - industry growth for auto-emission catalysts will benefit from tougher environmental regulation throughout the world over the next 5-10 years as well as developing economies, especially new Asian production; (2) more stringent diesel-emission regulations are being phased in, affording the Company additional opportunities for catalyst solutions; (3) worldwide petroleum refineries are generally operating close to capacity generating demand for the extra yields provided by the Company’s advanced fluid cracking catalysts and performance additives; (4) markets for effect pigments, colors and active ingredients in cosmetics, auto finishes and coatings have remained positive during the recent economic downturns and tend to be less cyclical; however, the Company is currently experiencing growing competition from Asian producers; (5) the coated, free-sheet paper market has strengthened, but market share loss continues to negatively impact the Company; and (6) inflationary pressures for raw materials and energy, particularly natural gas, are expected to have a negative impact across the Company’s technology segments compared to the recent low inflationary period, which the Company will attempt to mitigate via price increases.

Results of Operations

The information in the discussion of each segment’s results discussed below is derived directly from the internal financial reporting system used for management purposes. Items allocated to each segment’s results include the majority of corporate operating expenses. Unallocated items include interest expense, interest income, certain royalty income, sale of precious metals accounted for under the last-in, first-out (LIFO) method, certain special charges and credits, income taxes, certain information technology development costs and other miscellaneous corporate items.

In 2005, the Company discontinued operations at its Carteret, NJ manufacturing facility. The discussion below excludes the impact of these discontinued operations. Prior period operating earnings of the Environmental Technologies segment reflect the reclassification of the facility as a discontinued operation.

Environmental Technologies

The majority of this segment’s sales is derived from technologies to control harmful emissions from mobile sources, including gasoline- and diesel-powered passenger cars, sport-utility vehicles, trucks, buses and motorcycles. This segment’s customers are driven by increasingly stringent environmental regulations, for which the Company provides sophisticated emission-control technologies. The remainder of this segment’s sales is derived from products sold into a variety of industrial markets, including aerospace, power generation, process industries, temperature sensing and utility engines. The Company supplies these industrial markets with sophisticated emission-control technologies, high-value material products made primarily from platinum group metals and thermal spray and coating technologies.


Results of Operations (in millions)

   
2005
  
2004
  
2003
  
% change 2004 to 2005
  
% change 2003 to 2004
  
Sales
  
$
1,008.7
     
$
883.3
     
$
814.8
       
14.2
%   
 
8.4
%
Operating earnings before special items
    
140.9
    
138.1
    
129.2
    
2.0
%
  
6.9
%
Special charge (credit)
    
—
    
(0.2
)
  
5.2
              
Operating earnings
    
140.9
    
138.3
    
124.0
    
1.9
%
  
11.5
%

Discussion

Results from this segment were as expected, driven primarily by operations serving the overseas mobile-source environmental markets.

Revenues from mobile-source markets increased 15% in 2005 compared with 2004. Approximately 95% of this increase was due to increased pass-through substrate costs. Substrate costs were higher primarily due to increased demand for catalyzed soot filters (CSF) for the European light duty diesel market. This also increased the segment’s working capital requirements by approximately $50 million, which is about half of the overall increase in this segment’s working capital requirements of $100 million compared to last year. This trend of increasing substrate costs, revenues and associated working capital requirements is expected to continue in the near term, as the Company continues to grow its CSF business. The Company serves a wide customer base, and changes in the mix of sales to these markets are common. In 2005 compared with 2004, sales to North American automotive customers decreased significantly, while sales to European and Asian automotive customers increased. In North America, demand for the vehicles for which the Company provides catalytic solutions declined more rapidly than the overall demand for light-duty vehicles in North America. The Company expects this trend to continue near-term. The Company continues to experience improved market penetration from operations located in emerging markets such as China, India, Brazil and Thailand. Sales from these emerging market operations increased over 20% in 2005 compared to 2004. Sales to the motorcycle market more than doubled, but represent less than 2% of the segment’s sales. Sales of catalyst to the heavy-duty diesel original equipment manufacturers (OEMs) were flat compared to last year, as US regulatory requirements will change for 2007 model year vehicles, and overall demand for these vehicles remained relatively flat in 2005. Diesel retrofit sales, which are largely dependent on government funding for projects, declined modestly.

Operating earnings from mobile-source markets decreased 1% in 2005 compared with 2004. Operating earnings from light-duty markets were consistent with the above mentioned sales mix, as increased earnings from European and emerging markets were offset by decreased earnings from US light duty markets. Modest productivity improvements were offset by higher selling, general and administrative expenses driven by higher heavy-duty diesel research and development expenses of $2 million and higher bad debt expense of $1 million due to the bankruptcy of Delphi. The Company continues to assess counterparty risk on sales to the North American automotive market and establish credit limits and assess collectibility accordingly. Heavy-duty diesel earnings were down due to the aforementioned diesel research and development expense of $2.0 million and absence of warranty reversals of $1.5 million, which occurred in 2004. Sales to the motorcycle market now contribute to earnings, with operating margin percentages similar to those experienced in other mobile source markets. The Company serves the large Asian markets of Japan and Korea through joint ventures accounted for under the equity method. Accordingly, the results of those operations, reflecting continued strength in the Asian markets, are included on the equity earnings line.

Sales to industrial markets increased 7% in 2005 compared with 2004. Approximately half of this increase was to the temperature-sensing market. The Company continues to invest in the operations serving the temperature-sensing market, and anticipates significant growth from this small market. Sales to the aerospace market increased, while sales of catalyst to the small engine market declined due to the loss of a customer. Results from the Company’s Carteret, NJ manufacturing facility are no longer included in this discussion, as these results are now included in discontinued operations.

Operating earnings from industrial markets increased in 2005 compared with 2004. Earnings from sales to most served markets were higher. Notably, earnings from sales of ozone converting catalyst to the aerospace industry, increased on higher volumes sold. The temperature-sensing market represents a niche growth area for the Company, and experienced higher earnings, although volumes need to increase substantially to meet the Company’s
 
 
long term growth projections. While sales and earnings from the Company’s thermal spray and coating operations serving the aerospace and power generation markets improved modestly in 2005, more work needs to be done, and the Company augmented operational management in 2005. The Company expects continued near-term improvement in overall earnings from industrial markets.

Outlook

Please see the section labeled “Key Assumptions” on page 38 for a detailed discussion of the Company’s basis for the discussion below.

Demand for the Company’s products sold to mobile-source markets is expected to remain at 2005 levels for the first half of 2006, with a stronger second half relative to 2005, as customers ramp up for the 2007 model year. Worldwide automobile builds for 2006 are forecast to grow at 4%, and at 2% CAGR through 2010. The Company expects a 6% CAGR in light-duty automotive catalyst sales through 2010, driven by the aforementioned growth in automobile builds, penetration in the light-duty diesel market, and stricter worldwide environmental regulations. Demand for diesel-emission technologies is expected to increase, as stricter regulations for light-duty and heavy-duty vehicles come into effect, and more light-duty vehicles are sold. Additionally, the Company expects an increase in market share from the light-duty diesel markets. Diesel retrofit markets are expected to remain at current levels driven by local political pressure to reduce emissions from existing vehicles in urban areas. Demand for the Company’s technology to mobile-source markets is subject to changes in mix, the level of worldwide auto builds and competitive pressures. The Company maintains a strong technology position in these markets and continues to invest significantly in research and development.

In businesses serving stationary-source markets, demand is expected to remain soft for technologies related to peak-power generation due to the current lack of funding for these projects. The overall power-generation industry has experienced difficulty in recent years due to deregulation and cyclicality. The Company maintains the technical ability and capacity to serve the power-generation market when demand returns. These businesses also serve the food service market. Sales to the food service market are expected to grow from approximately $3 million in 2005 to $10 million in 2010, representing about half the growth expected from this business.

The Company’s thermal spray operation, which serves the power-generation and aerospace markets, has seen a modest improvement in demand. The Company expects this trend to continue, but does not expect these markets to return to pre-2001 levels. In response, this operation will focus on cost reduction efforts and will continue to develop applications of its technology for previously unserved markets.

Other industrial markets served include temperature-sensing. The Company has positioned itself via acquisition in 2004 and internal development to participate in the projected 6% worldwide growth of the temperature-sensing market through 2010. The Company also expects an increase in market share from the temperature-sensing markets.

2004 compared with 2003

Sales to mobile-source markets increased 10% in 2004 compared with 2003. Approximately half this increase related to higher substrate costs. Substrate costs rose in 2004 due to an increase in demand for emission-control systems for diesel engines. Foreign currency translation of sales of the Company’s foreign operations accounted for 40% of the sales increase to mobile-source markets in 2004 compared with 2003. In 2004 compared with 2003, increased sales to diesel engine OEMs were largely offset by decreased sales to the diesel retrofit market, which, in 2003, included low-margin sales from a canning facility the Company closed in 2003.

Operating earnings from mobile-source markets increased 9% in 2004 compared with 2003. The largest reason for this increase was absence of a $4.6 million restructuring charge recorded in 2003. Favorable impacts from foreign currency translation of $4.7 million and reversal of warranty reserves of $1.5 million were mostly offset by higher information technology expenses of $4.0 million and higher diesel research and development expense of $1.4 million. In 2004, profits from mobile-source diesel markets increased while profits from other mobile-source markets decreased compared with 2003. These improvements were partially offset by a decline in earnings from diesel retrofit markets. In 2003, the Company experienced strong profitability from a diesel retrofit project in Hong Kong, which was completed early in 2004. Operating earnings from traditional light-duty vehicle markets declined in 2004. Although light-duty automobile builds in North America and Europe were flat in 2004
 
 
compared with 2003, operating earnings declined due to the mix of vehicle platforms for which the Company provided catalyst.

Sales to industrial product markets decreased 4% as a decline in sales to power-generation customers more than offset improved sales to the aerospace, temperature-sensing and refining markets. The decline in demand from the power-generation market was expected, and costs were reduced accordingly. Earnings from industrial product markets improved significantly in 2004 compared with 2003 primarily due to productivity initiatives. Earnings from the aerospace market improved versus the prior year, but have not returned to levels experienced prior to 2001. Profits from temperature sensing markets were flat in 2004 versus 2003.

Process Technologies

The Process Technologies segment enables customers to make their processes more productive, efficient, environmentally sound and safer through the supply of advanced chemical-process catalysts, additives and sorbents.

Results of Operations (in millions)

   
2005
  
2004
  
2003
  
% change 2004 to 2005
  
% change 2003 to 2004
  
Sales
  
$
687.1
     
$
615.2
     
$
569.2
       
11.7
%   
 
8.1
%
Operating earnings before special items
    
98.0
    
87.3
    
98.5
    
12.3
%
  
-11.4
%
Special charge
    
—
    
—
    
2.6
              
Operating earnings
    
98.0
    
87.3
    
95.9
    
12.3
%
  
-9.0
%
 
Discussion

This segment experienced strong results in 2005 as productivity improvements coupled with continuing demand in operations serving the petroleum-refining business yielded strong results, and catalyst sales to the major chemical markets increased.

Sales to the petroleum-refining market increased 10% in 2005 compared with 2004. Higher volumes and prices of petroleum-refining catalysts drove the improvement, as demand remained strong for catalyst based on the Company’s Distributed Matrix Structure (DMS) technology platform. DMS technology allows refiners to increase yields, and accordingly, these products sell at premium prices. In 2005, the Company completed a productivity initiative that reduced the cost, and increased the capacity of the Company’s DMS products. The Company operates at or near capacity in these operations. Approximately 80% of the Company’s product mix to this market is now DMS-based. In 2005, the Company implemented price increases and energy surcharges to this market, which accounted for approximately $3 million of increased revenues. The Company experienced decreased demand in the year for certain older product offerings. Demand for these older product offerings is expected to remain at current levels for the near-term, and decrease over the long-term. Sales of additives, which have been a source of growth over the past two years, increased significantly, due to increased fourth quarter volumes of product sold to potential new customers who are assessing the effectiveness of these additives in their processes.

Operating earnings from products sold to petroleum-refining markets increased in 2005 compared with 2004 primarily due to the aforementioned increase in additive volumes and improved pricing and volumes of catalysts sold. These improvements were partially offset by higher natural gas costs of approximately $5 million, net of the aforementioned energy surcharges, other Hurricane Katrina impacts (see the section on Hurricane and Natural Gas Impacts), higher selling, general and administrative expense of approximately $3 million and higher raw material costs. During 2004, strong demand for DMS technology began to exceed existing capacity at the operating facilities that produce these products. In the second quarter of 2005, the Company completed and implemented a project to reduce costs and increase capacity at these facilities, resulting in lower per-unit manufacturing costs compared to 2004. The Company plans to maintain an asset utilization rate of approximately 90% for DMS offerings for the foreseeable future.

Sales of catalysts to the chemical-process markets increased 13% in 2005 compared with 2004. The increase in revenues came from the oleochemical, petrochemical and fine chemical markets, and was partially offset by decreased sales to the polyolefins markets. Sales of precious metal included in products sold accounted for
 
 
approximately $7 million of the increase in revenues. The second-quarter acquisition of the catalyst business of Nanjing Chemical Industry Corporation accounted for $9 million of increased revenues. Demand in 2006 is expected to increase compared to 2005, as customers continue to drive more volume through their reactors with capacity utilization rates near 90%. Volumes of polypropylene catalysts were flat in 2005 compared with 2004. Tightness in the Asian supply of monomer in the first half of 2005 and some decreased domestic demand negatively impacted the Company’s revenues from products sold to the polyolefins market. Price increases initiated in 2004 and 2005 accounted for $5 million of higher revenues from the chemical-process markets.

Operating earnings from products sold to chemical-process markets were higher in 2005 compared with 2004, as all served markets experienced improved results. The aforementioned price increases and the positive results of productivity initiatives were somewhat offset by higher selling, general and administrative expense spending of approximately $5 million and higher raw material costs. Margins as a percent of sales were somewhat lower due to higher sales of lower margin products, and the impact of higher precious metal costs which are passed through to customers, but are included in revenue and cost of sales.

Outlook

Please see the section labeled “Key Assumptions”on page 38 for a detailed discussion of the Company’s basis for the discussion below.

The outlook for operations serving the petroleum-refining markets is strong for 2006 and beyond. Demand for premium-priced catalysts and additives is expected to remain high due to external factors, including high crude-oil prices, absence of additional worldwide refining capacity, increased demand for gasoline and environmental-fuel compliance. The Company operates at utilization rates of approximately 90%, and therefore near-term growth is dependent upon maximizing the profitability of the Company’s product mix. The Company continues to invest in research and development to maintain the competitive advantage derived from its unique DMS technology platform, as demonstrated by the recent introduction of the next generation fluid cracking catalyst, Napthamax II. Over the long term, sales of refining catalyst are expected to grow modestly at approximately 2% CAGR through 2010. Additives sold to these markets remain a growth area, and the Company expects significant growth through 2010, driven predominantly by new product offerings, as existing additives are not expected to increase at growth rates experienced in recent years. Additionally, the Company expects to leverage existing technologies and market presence to serve the diesel, distillate and petrochemical feedstock markets. These newly served markets are expected to contribute approximately $38 million in revenues in 2010.

The outlook for operations serving chemical-process markets is good for 2006, as sales levels experienced in the second half of 2005 to the Company’s existing customer base are expected to continue. Long-term growth to existing markets will be relatively modest, while growth to previously unserved petrochemical markets, the emerging gas economy catalyst market, and continued expansion into the polyethylene catalyst market will drive overall revenue growth of 8% CAGR. Growth in the polypropylene market will be driven by increased commercial relationships and licensing arrangements.

2004 compared with 2003

Sales of catalyst and additives to the petroleum-refining market increased in 2004 compared with 2003. The increase was driven by strong demand for products derived from the Company’s DMS technology platform. Higher volumes of petroleum-refining additives also positively impacted sales. These improvements were modestly offset by decreased demand for older product offerings displaced by DMS technology.

Operating earnings from products sold to petroleum-refining markets increased in 2004 compared with 2003. Profits from increased demand for DMS technologies and other additives were partially offset by higher information technology costs of approximately $2 million, higher raw material costs of approximately $3 million and the impact of a particularly severe hurricane season. During 2004, strong demand for DMS technology began to exceed existing capacity at the operating facility that produces these products. As a result, other assets were utilized to meet the additional demand, resulting in higher transportation, production-scheduling and asset-utilization costs. Operating earnings for 2004 also were negatively impacted by $1.1 million compared with 2003 due to the timing of customer orders for certain older technologies.


Sales of catalysts to the chemical-process markets increased modestly in 2004 compared with 2003. The increase resulted from a currency-exchange impact of approximately $8 million and a change in product mix, which was partially offset by $7.5 million of price reductions in older custom catalyst technologies. Volumes of Lynx polypropylene catalysts increased in 2004 compared with 2003 as market acceptance continued and expanded capacity at the Company’s facility in Tarragona, Spain came on-line.

Operating earnings from products sold to chemical-process markets decreased significantly, driven primarily by the above-mentioned price reduction of $7.5 million, higher raw material costs of approximately $6 million, a change in product mix and higher information technology costs of approximately $3 million. These factors were partially offset by a favorable impact from currency exchange of approximately $3 million and absence of restructuring expenses included in the special charge referenced in the table above.

Appearance and Performance Technologies

The Appearance and Performance Technologies segment provides coatings and pigment extenders, effect materials, personal care active ingredients and performance additives that enable its customers to market enhanced image and functionality in their products. This segment serves a broad array of end markets, including cosmetics and personal care, coatings, plastics, automotive, packaging, construction and paper. The segment’s products help customers improve the look, functionality, performance and overall cost of their products. In addition, the segment is the internal supply source of precursors for most of the Company’s advanced petroleum-refining catalysts.

Results of Operations (in millions)

   
2005
  
2004
  
2003
  
% change 2004 to 2005
  
% change 2003 to 2004
  
Sales
  
$
726.1
     
$
690.2
     
$
653.8
       
5.2
%   
 
5.6
%
Operating earnings before special items
    
65.6
    
75.1
    
77.3
    
-12.6
%
  
-2.8
%
Special charge
    
—
    
6.6
    
7.8
              
Operating earnings
    
65.6
    
68.5
    
69.5
    
-4.2
%
  
-1.4
%

Discussion

Results from this segment were down, as higher costs in operations serving the paper and effect materials markets more than offset the impact of higher revenues from the personal care actives and specialty minerals markets.

Sales from the Company’s mineral-based operations increased 1% in 2005 compared with 2004. This modest increase is due to improved sales of kaolin-based products to non-paper specialty markets and higher attapulgite volumes mostly offset by lower volumes of kaolin-based products to the paper market. Lower sales to the paper market were partially attributable to customer strikes in Finland and Canada. The Company has implemented price increases and energy surcharges for mineral-based products late in 2005, and has seen some positive results, but expects 2006 pricing to be substantially better than 2005. Overall, volumes to the paper market were off approximately 8% versus last year. The Company continues to focus on non-paper kaolin markets to maximize cash flows from these assets. These markets include plastics, construction, automotive, agriculture, coatings and refining catalysts.

Operating earnings from mineral-based products decreased significantly in 2005 compared with 2004 in spite of absence of restructuring charges totaling $6.6 million in 2004. Earnings from kaolin-based products to the paper market decreased as a result of higher natural gas prices, exacerbated by Hurricanes Katrina and Rita, of approximately $12 million in 2005 compared to 2004. The Company has initiated price increases and energy surcharges to these markets, and expects significant improvement in 2006. Increased sales of kaolin-based products to specialty markets yielded improved results. Cash flows from kaolin-based operations remain substantial, and these assets continue to be monitored with respect to SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”

Sales of effect materials, colors and personal care actives collectively increased 10% in 2005 compared with 2004. Earlier in the year, the Company strengthened its position in the personal care market by acquiring
 
 
Coletica, S.A., a French company that develops performance-based, skin-care compounds and related technologies. In 2004, the Company acquired The Collaborative Group, a domestic company serving similar markets. These operations, along with certain previously existing operations, serve the personal care markets. The recent acquisitions accounted for $44 million of sales increases in 2005 compared to 2004. Effect materials sales were lower due to lower sales of cosmetic-grade borosilicate products compared to strong volumes in 2004, lower cosmetic mica sales, and lower iridescent film sales due to competitive pressure in Asia. Colorant sales were down modestly in 2005 compared to 2004, as a significant customer built inventory late in 2004, resulting in lower volumes for 2005.

Operating earnings from personal care actives increased in 2005, while earnings from effect materials and colorant markets decreased compared to 2004. Increased earnings from the above mentioned personal care acquisitions of $7.7 million were partially offset by lower volumes of colorants, lower effect materials sales, discussed above, and increased operating costs.

Outlook

Please see the section labeled “Key Assumptions” on page 38 for a detailed discussion of the Company’s basis for the discussion below.

Earnings from the sale of minerals-based products are expected to improve in 2006 as the Company expects significantly improved pricing from paper customers, and continued diversification away from traditional paper markets. In addition to price increases, the Company has also implemented energy surcharges to paper and other kaolin customers. These operations are currently profitable, and generate significant cash flows. The Company expects these operations to remain profitable, but changes in volumes, pricing or energy costs could cause this situation to change. These businesses experience significant competition from Brazilian and other kaolin producers and not-in-kind competition from calcium carbonate. The Company expects modest long-term growth from these operations as a result of diversification efforts, specifically penetration into crop protectants and other high-margin kaolin applications.

The Company is in the process of implementing EITF 04-6, “Accounting for Stripping Costs Incurred during Production in the Mining Industry.” As a result of EITF 04-6, the Company expects an equity charge of approximately $29 million in the first quarter of 2006. The Company does not expect this standard to have an impact on the Company’s future cash flows.

Recent investments in assets serving the personal care market are expected to improve earnings, as the Company continues to further develop its position in this market. The Company’s two recent acquisitions serving these markets are substantially integrated and are positioned to increase revenues due to their combined global presence. In 2010, the Company expects revenues from these operations to be double their current levels.

The Company expects long-term growth from operations serving the effect materials and colorants markets to grow at approximately 6% CAGR through 2010. The Company will continue to manage competitive risks, including increasing pressures from producers in Asia, through cost management, innovation and continued expansion of its market presence in China.

2004 compared with 2003

Sales of minerals-based products decreased 1% in 2004 compared with 2003 as decreased volumes to the paper market were mostly offset by significant sales growth of non-paper kaolin applications. In late 2003, the Company attempted to maintain pricing and implement an energy surcharge. Certain paper customers responded by contracting with other kaolin providers, and the Company’s market share decreased in 2004. During 2004, the Company rationalized certain products for the paper market and aggressively pursued other specialty, kaolin-based applications. Sales of kaolin-based products to markets other than paper increased significantly in 2004 compared with 2003.

Operating earnings from minerals-based products decreased 26% in 2004 compared with 2003. Included in the 2004 results is a restructuring charge of $6.6 million related to consolidation of certain manufacturing facilities that included asset impairment charges of $5.3 million and severance charges of $1.3 million. Results for 2003 include a charge of $7.8 million for the fair value of remaining lease costs of certain minerals-storage facilities the
 
 
 Company ceased to use. These businesses incurred higher information technology costs of approximately $3 million in 2004 compared with 2003. Decreased earnings from mineral-based products to the paper market were partially offset by earnings from mineral-based products to other markets as discussed above.

Sales of effect materials, colors and personal care actives increased 13% in 2004 compared with 2003. In July of 2004, the Company strengthened its position in the personal care market by acquiring The Collaborative Group, Ltd., including its wholly owned subsidiary Collaborative Laboratories, Inc. This accounted for approximately 25% of the increase in sales of effect materials, colors and personal care actives. Sales of effect materials and colors were strong to other served markets including cosmetics, automotive, coatings, plastics and construction.

Operating earnings from effect materials, colors and personal care actives increased approximately 4% in 2004 compared with 2003, due primarily to the above-mentioned acquisition. The impact of higher volumes mentioned above was offset by increased information technology costs of approximately $3 million and higher costs associated with product development and commercialization.

Materials Services

The Materials Services segment serves the Company’s technology segments, their customers and others with precious and base metals and related services. This is a distribution and materials services business that purchases and sells precious metals, base metals, other commodities and related products and services. It does so under a variety of pricing and delivery arrangements structured to meet the logistical, financial and price-risk management requirements of the Company, its customers and suppliers. Additionally, it offers the related services of precious-metal refining and storage, and produces precious-metal salts and solutions.

Results of Operations (in millions)

   
2005
  
2004
  
2003
  
% change 2004 to 2005
  
% change 2003 to 2004
  
Sales
  
$
2,096.3
     
$
1,895.0
     
$
1,598.2
       
10.6
%   
 
18.6
%
Operating earnings
    
28.4
    
16.8
    
10.1
    
69.0
%
  
66.3
%
 
Discussion

Sales for this segment include substantially all the Company’s sales of metals to industrial customers of all segments. Sales also include fees invoiced for services rendered (e.g. refining charges). Because of the logistical and hedging nature of much of this business and the significant precious metal values included in both sales and cost of sales, gross margins tend to be low in relation to the Company’s technology segments, as does capital employed. This effect also dampens the gross margin percentages of the Company as a whole, but improves the return on investment.

While many customers of the Company’s platinum-group-metal catalysts purchase the metal from Materials Services, some choose to deliver metal from other sources prior to manufacture. In such cases, precious metal values are not included in sales. The mix of such arrangements and extent of market price fluctuations can significantly affect the reported level of sales and cost of sales. Consequently, there is no necessary direct correlation between year-to-year changes in reported sales and operating earnings. The revenue increase in 2005 was due to higher prices and volumes of platinum group metals.

Operating earnings in 2004 include $3.6 million of legal provisions related to litigation, while 2005 included recovery of $0.7 million of legal fees resulting from settlement of litigation. Earnings from metal sourcing operations increased 19% in 2005 compared with 2004 due to increased platinum group metal prices and volumes partially driven by demand related to pending diesel regulations. These earnings and volumes are at levels higher than the Company anticipates going forward. Refining and related service operations were improved compared with the same period last year. Increased volumes and improved operating efficiencies at the Company’s refinery drove the improvement. The Company’s operations within the Process Technologies segment serving the
 
 
petrochemical industry are an indicator of refining volume, as customers requiring new catalyst generally refine their spent catalyst upon change out.

Outlook

Operating earnings from this segment are expected to approach $20 million in 2006 as strong demand for platinum group metals is expected to continue. Sourcing and recycling opportunities are difficult to predict, but the Company maintains industry knowledge to seek out and capitalize on opportunities.

2004 compared with 2003

Operating earnings in 2004 include $3.6 million of legal provisions related to litigation. Operating earnings in 2003 benefited from a contract settlement of $9.3 million and reversal of a $2.8 million accrual that is no longer necessary. Earnings from metal sourcing operations improved in 2004 compared with 2003. Refining and related service operations also improved in 2004 compared with 2003 as the Company’s U.S. refinery resolved certain performance difficulties. These refining operations, which are strategically important to the operations of the Company’s Environmental Technologies and Process Technologies segments, returned to profitability.

Ventures

Please see the section labeled “Key Assumptions” on page 38 for a detailed discussion of the Company’s basis for the discussion below.

The Ventures group, which is not a reportable segment as defined in SFAS 131, “Disclosures about Segment of an Enterprise and Related Information,” develops opportunities that leverage attractive markets, new technologies and the Company’s core competencies in surface and materials science. Through its existing Separation Systems business, this group also serves a broad array of end markets with adsorbents, agents and desiccants which purify liquids and gases. In September 2005, the Company acquired U.S.-based Almatis AC, Inc., a major developer and producer of alumina-based adsorbents and purification catalysts for approximately $65 million. In addition, this group is currently developing market positions that will serve the oil and gas field services, fuel cell and battery materials markets in the future. Current expectations for the oil and gas field services market include opening a plant in the second half of 2006, while fuel cell and battery material remain in development stages. In 2005, this group earned $6.1 million of operating earnings on $76.0 million of revenues.

Hurricane and Natural Gas Impacts

In the current year, the Company experienced a negative economic impact from Hurricanes Katrina and Rita. The Company operates a number of facilities in Georgia, and some facilities in Louisiana, Mississippi and Texas that were affected by these hurricanes. Additionally, many of the Company’s suppliers, customers and logistics network providers were directly impacted by these hurricanes. Direct impacts from these hurricanes, such as customer and supplier force majeure declarations, lost production time and facility damage, are readily quantifiable and were approximately $1 million. Indirect impacts, such as higher natural gas and other energy costs, higher raw material costs as a result of supplier difficulties, higher logistics costs due to fuel and disrupted distribution networks and short-term productivity costs, exist but are not readily quantifiable. Already high natural gas prices further increased because of Gulf Coast hurricanes. Natural gas prices negatively impacted the Company by approximately $20 million in 2005 compared with 2004.


Acquisitions

Counter party
      
Business arrangement
      
Transaction date
      
Business opportunity
             
Almatis AC, Inc.
  
Acquired alumina-based adsorbents and catalyst business for $65 million
  
September 2005
  
Expand adsorbent and purification portfolio to include aluminas
             
Nanjing Chemical Industry Corporation
  
Acquired syngas catalyst business for $20 million
  
June 2005
  
Expand syngas growth strategy
             
Coletica S.A.
  
Acquired manufacturing, research and development and distribution facilities for $73 million, net of cash acquired
  
March 2005
  
Expand personal care actives business to include major European presence
             
The Collaborative Group, Ltd.
  
Acquired manufacturing and research and development facilities for $62 million
  
July 2004
  
Expand personal care business to include active ingredients
             
Platinum Sensors, SrL
  
Acquired manufacturing and distribution facilities for $6.6 million
 
April 2004
  
Expand temperature-sensing business globally


Consolidated Gross Profit

Gross profit as a percentage of sales was 15.6% in 2005, compared with 16.2% in 2004 and 17.2% in 2003. The following table represents gross margin percentages of the Materials Services segment and the Company’s technology segments (Environmental, Process and Appearance and Performance Technologies) and the “All Other” category for the years ended December 31, 2005, 2004 and 2003.

   
2005
  
2004
  
2003
  
Materials Services
    
2.9
%    
 
2.5
%    
 
2.3
%
Technology segments and the “All Other” category
    
26.3
%
  
27.8
%
  
28.7
%
Total Company
    
15.6
%
  
16.2
%
  
17.2
%

The overall decrease in 2005 compared to 2004 was primarily due to lower margins in all technology segments (see Management’s Discussion and Analysis sections on Environmental Technologies, Process Technologies, and Appearance and Performance Technologies for further discussion), partially offset by higher margins in the Materials Services segment (see Management’s Discussion and Analysis section on Materials Services for a further discussion on the lack of correlation between sales and earnings in Materials Services). As described earlier, the lower margins on Materials Services sales are driven by the inclusion of the value of precious metals in both sales and cost of sales. The trend of lower margins in the Environmental Technologies segment from 2003 through 2005 is primarily a result of catalyzed soot filter (CSF) substrate costs, which are passed through to customers (see Management’s Discussion and Analysis section on Environmental Technologies). Gross profit as a percentage of sales is expected to improve in 2006, as improved pricing on kaolin-based products sold to the paper market will impact the Appearance and Performance Technologies segment.

Selling, Administrative and Other Expenses

Selling, administrative and other expenses were $419.4 million in 2005 compared with $389.1 million in 2004 and $361.8 million in 2003. The increase in 2005 was primarily due to incremental operating expenses from acquisitions of $18.0 million, higher compensation and employee benefit costs of $10.6 million, increased research and development expense of $8.3 million, increased information technology expenses of $4.1 million, partially offset by decreased rent expense of $3.0 million and decreased legal fees of $3.2 million.


The increase in 2004 was primarily due to increased benefit and pension expenses of $8.7 million, increased research and development expenses of $6.8 million, incremental Sarbanes-Oxley compliance related expenses of approximately $5 million, $3 million in incremental operating expenses from the Collaborative acquisition, increased freight, shipping, and railcar related expenses of $2.9 million, increased legal fees of $2.5 million and the impact of foreign currency translation on selling, administrative and other expenses of approximately $2 million partially offset by higher royalty income of $4.8 million and lower bad debt expense of $3.6 million.

The Company expects selling, administrative and other expenses to increase in 2006 compared to 2005. Key drivers will be the new SFAS No. 123(R), “Share-Based Payment,” requirements regarding stock option expense, information technology expenses, full-year operating expenses from the acquisitions, the inflationary impact on other expenses and expenses associated with the BASF hostile tender offer.

Equity Earnings

Equity in earnings of affiliates was $32.6 million in 2005 compared to $37.6 million in 2004 and $39.4 million in 2003.

The Company recognized earnings from its Asian joint ventures (N.E. Chemcat Corporation and Heesung-Engelhard) of $30.9 million in 2005, $27.8 million in 2004 and $18.2 million in 2003. The Company participates in these joint ventures primarily to serve the Japanese and Korean mobile-source environmental markets. The strong improvements from 2003 through 2005 are primarily due to improved sales to these mobile-source markets. The Company maintains active alliances with these joint ventures to improve its overall position in these markets. During the first quarter of 2005, the Company exchanged a 7.5% interest in its Chinese automotive catalyst operations for approximately 2.6% of N.E. Chemcat Corporation (NECC), a publicly-traded joint venture. This transaction was recorded as an exchange of similar productive assets in accordance with APB 29, “Accounting for Nonmonetary Transactions.” The Company also acquired an additional 0.7% of NECC through a public tender offer. These transactions increase the Company’s ownership percentage in NECC from 38.8% to 42.1%. The Company expects earnings from these operations to remain at current levels, as the Japanese and Korean automotive markets are not anticipated to grow substantially.

The Company currently owns 45% of HDZ, a former subsidiary of Engelhard-CLAL. The Company recognized earnings from this joint venture and related holdings of $0.1 million in 2005, $7.9 million in 2004 and $19.6 million in 2003. Prior years’ earnings resulted primarily from the sale of platinum inventories at favorable prices, realized gains on the sale of an inactive facility, and the strengthening of the Euro versus the U.S. dollar. The Company has substantially liquidated this joint venture and related holdings.

Interest Income and Expense

Interest expense increased to $33.7 million in 2005 compared with $23.7 million in 2004 due to both higher short-term borrowing rates and higher average debt levels, partially offset by the issuance of yen-denominated notes at low interest rates. Interest income increased to $8.2 million in 2005 compared with $5.2 million in 2004. Higher debt levels were driven by acquisitions and working capital requirements.

Income Taxes

The worldwide income tax expense was $59.1 million in 2005 compared with $57.4 million in 2004 and $65.9 million in 2003.

The effective tax rate was 19.3% in 2005, 19.5% in 2004 and 21.6% in 2003.

The Company believes that its effective tax rate on future recurring business operations will be approximately 24%.

The Company’s effective tax rate is dependent upon many factors including (1) the impact of enacted tax laws in jurisdictions in which the Company operates, (2) the amount of earnings by jurisdiction due to varying tax rates by country, (3) the amount of depletion deductions related to the Company's mining activities, (4) the ability to utilize minimum tax credits, foreign tax credits and research and development tax credits , (5) the ability to utilize
 
 
state tax net operating losses and various state tax credits and (6) the amount of extraterritorial income and domestic production related benefits.

In respect of certain provisions of the American Jobs Creation Act of 2004 (the "Act"), the Company decided not to repatriate certain offshore earnings from its foreign subsidiaries at a reduced tax rate due to its intention to increase its investments outside of the United States.

In the first quarter of 2005, the Company recorded a $2.7 million reduction of tax expense resulting from an agreement with the IRS relating to the audit of the Company’s tax return for 2001. The Company is currently under examination for the 2002 and 2003 tax periods with the IRS, and the Company also seeks resolution with tax authorities in foreign jurisdictions in which the Company operates.

In the second quarter, the Company recorded a benefit of $5.7 million related to prior tax periods in the Netherlands and a tax expense of $3.3 million related to prior tax periods in Germany, due to changes in estimates based upon information obtained during the audit process.

In the third quarter, as a result of the Company filing its 2004 federal income tax return, the Company recorded a tax benefit of approximately $6 million associated with the American Jobs Creation Act in respect of foreign tax credits relating to its minority investments in certain foreign corporations which had previously been subject to a valuation allowance. In addition, due to the expiration of a tax closing agreement covering the tax years 1998-2004 with the state of New Jersey, which the state has not agreed to extend to 2005 and beyond, the Company recorded an additional state income tax expense of approximately $2 million (after federal income tax effect).
 
In the fourth quarter, the Company recorded a net tax benefit of approximately $5.2 million. Of this amount, $4.1 million relates to the reversal of a FTC valuation allowance based upon earnings and profit analyses and foreign source income analyses for 2005, both of which were completed in the fourth quarter.

Liquidity and Capital Resources

Liquidity

Working capital was $513.8 million at December 31, 2005, compared with $659.8 million at December 31, 2004. The current ratio was 1.3 and 1.7 at December 31, 2005 and December 31, 2004, respectively. This reflects the Company’s utilization of existing cash balances to fund three acquisitions (see Note 5, “Acquisitions”). Also impacting the current ratio are corresponding increases in the Company’s committed metal positions and hedged metal obligations, and an increase in the working capital requirements of the Company’s Environmental Technologies segment. The overall working capital of the Company’s technology segments (Environmental Technologies, Process Technologies and Appearance and Performance Technologies) has not been subject to significant fluctuations from period to period; however, in the current year, Environmental Technologies has experienced a fundamental increase in working capital employed of approximately $100 million. This increase is primarily due to Environmental Technologies' recent market penetration into catalyzed soot filter (CSF) technology for light-duty diesel applications to the mobile-source environmental markets (see Environmental Technologies section for further discussion). This trend is expected to continue, and will negatively impact net cash provided by operating activities through 2006. The working capital of the Materials Services segment may vary due to the timing of metal contracts, but is monitored closely by senior management. In the recent period, committed metal positions and hedged metal obligations have increased due to the effects of higher prices and usage, a shift in the mix of metals and inclusion of significant advances made for the purchase of precious metals that have been received but for which the final price has yet to be determined. While long-term working capital requirements cannot be readily predicted, it is expected that they will grow proportionally with the revenues of the technology segments.

On March 7, 2005, the Company replaced existing committed credit facilities with a new $800 million, five-year committed credit facility. This facility is available for general corporate purposes, including, without limitation, to provide liquidity support for the issuance of commercial paper and acquisition financing. As of December 31, 2005, the Company had $28.0 million of commercial paper outstanding, all of which matured on January 3, 2006.

 
In May 2005, the Company entered into a five-year committed credit facility for approximately $33 million (270 million Chinese Renminbi) with three major foreign banks. The facility is available for general corporate purposes for various subsidiaries within China. In addition, in March 2006 the Company replaced an existing $12 million credit facility with a new $17 million, five-year committed, dual currency revolving credit facility for its Environmental Technologies business within China.

On August 12, 2005, the Company issued a third tranche of Japanese yen 5.5 billion notes (approximately $50 million) bearing a coupon of 0.75% in the private placement market. In addition to the low coupon rate, these notes serve as an effective net investment hedge of a portion of the Company’s yen-denominated investments.

In the fourth quarter of 2005, the Company entered into a cross-currency swap with a notional amount of $150 million. This transaction effectively swaps the Company’s US dollar floating rate exposure for a Euro floating rate exposure. The notional Euro amount has been designated as a net investment hedge of a portion of the Company’s Euro-denominated investments.

The Company’s total debt increased to $600.1 million at December 31, 2005 from $525.7 million at December 31, 2004 due to acquisitions, higher working capital requirements and a voluntary pension contribution of $50 million. The percentage of total debt to total capitalization was 29% at December 31, 2005 compared with 27% at December 31, 2004.

The Company maintains a shelf registration of $450 million to facilitate the Company’s ability to raise cash for general corporate purposes. The Company maintains investment-grade credit ratings that it considers important for cost-effective and ready access to the capital markets. Should the Company’s rating drop below investment grade, the Company would experience higher capital costs and may incur difficulty in procuring metals.

In January of 2006, BASF announced a tender offer for all of the outstanding shares of the Company’s stock, for $37.00 per share. Since then, the Company’s stock has traded above $40.00 per share. As a result, many employees and former employees exercised vested stock options resulting in proceeds of $59.7 million and an increase in the shares outstanding of 2.8 million as of February 21, 2006. As a result of the BASF Offer, the Company was required to fund a trust account for certain previously unfunded retirement programs for current and former senior executives and directors, resulting in a cash payment to this trust of approximately $111 million in January 2006. Should a change in control of the Company occur at a price of $37.00 per share, additional cash payments of approximately $85 million will be due to certain employees.

The Company’s available cash and unused committed credit lines represent a measure of the Company’s short-term liquidity position. The Company’s Materials Services segment provides sufficient cash to fund the Company’s committed metal positions, as discussed in the Capital Resources section. The Company believes that its short-term liquidity position is sufficient to meet the cash requirements of the Company. The Company’s investment grade rating, $450 million shelf registration and access to debt and equity markets are sufficient to meet the long-term liquidity requirements of the Company.

Capital Resources

The Company’s technology segments represent the most significant internal capital resource of the Company. The Company’s technology segments contain businesses that generate significant cash flow. Cash flows from the Materials Services segment tend to fluctuate from period to period due to the timing of metal contracts. The “All Other” category includes the Ventures group, the Strategic Technologies group and other corporate functions, which collectively use cash. The Strategic Technologies group develops technologies to commercial levels to generate future sources of cash.

Net cash provided by operating activities was $258.1 million in 2005 compared with $323.4 million in 2004. The Company voluntarily contributed $50 million to its domestic defined benefit pension plans in response to economic factors in 2005. The Environmental Technologies segment experienced reduced cash flows from operations of approximately $100 million primarily due to an increase in working capital requirements associated with the segment’s diesel catalyzed soot filter business. Other variances in cash flows from operating activities occurred in the Materials Services segment and reflect changes in metal positions used to facilitate requirements of the Company, its metal customers and suppliers (see Note 25 “Supplemental Information,” for Material Services variations). Materials Services routinely enters into a variety of arrangements for the sourcing of metals. Generally,
 
 
transactions are hedged on a daily basis. Hedging is accomplished primarily through forward, future and option contracts. However, in closely monitored situations for which exposure levels have been set by senior management, the Company, from time to time, holds large unhedged industrial commodity positions that are subject to future market price fluctuations. These positions are included in committed metal positions, along with hedged metal holdings. The bulk of hedged metal obligations represent spot short positions. Other than in closely monitored situations, these positions are hedged through forward purchases. Unless a forward counterparty fails to perform, there is no price risk for these transactions. In addition, the aggregate fair value of derivatives in a loss position is reported in hedged metal obligations (derivatives in a gain position are included in committed metal positions). Materials Services works to ensure that the Company and its customers have an uninterrupted source of metals, primarily platinum group metals, utilizing supply contracts and commodities markets around the world. Committed metal positions may include significant advances made for the purchase of precious metals that have been delivered to the Company but for which the final purchase price has not yet been determined. As of December 31, 2005, the fair value of precious metal received but not priced exceeded provisional payments by $138.9 million.

The Company’s joint ventures operate independently of additional Company financing. These joint ventures returned $15.4 million of cash to the Company in 2005. The Company anticipates cash proceeds from its joint ventures to remain at this level in 2006.

The Company also depends upon access to debt and equity markets, as discussed in the liquidity section, as a source of cash.

The Company continues to invest currently to develop future sources of cash through self-investment, alliances, licensing agreements and acquisitions. Notably, during 2005, the Company invested $108.2 million in research and development, $141.6 million in capital projects and $166.0 million in acquisitions and other investments. Capital expenditures for 2006 are expected to approximate $150 million. Acquisitions during 2005 included approximately $73 million, net of cash acquired, for the acquisition of Coletica, S.A. and related holdings (see Note 5 “Acquisitions”). In the second quarter of 2005, the Company acquired the catalyst business of Nanjing Chemical Industry Corporation (NCIC) for approximately $20 million (see Note 5 “Acquisitions”). The Company has paid $14 million of this to date, and expects to pay the remaining $6 million due to the former owners of NCIC in 2006. In the third quarter of 2005, the Company acquired Almatis AC, Inc. for a total purchase price of $65 million (see Note 5 “Acquisitions”). The Company actively pursues investment opportunities that meet risk and return criteria set by senior management. The Company expects to find opportunities in the future and will act upon these opportunities accordingly.

In addition to investment opportunities, the Company will return value to the shareholders through effective capital structure management. This is done through share buy-back programs and dividends. In 2005, the Company purchased approximately 2.1 million outstanding shares of common stock, net of stock options exercised. In May 2005, the Company’s Board of Directors authorized a share repurchase program of 6 million shares. In addition, the Company’s Board of Directors approved an increase in the quarterly dividend from $0.11 per share to $0.12 per share in the first quarter of 2005. The Company expects to find future investment opportunities, and will be able to reduce the future amount of shares purchased when this occurs.


The following table is a representation of the Company’s contractual obligations as of December 31, 2005 (the notes below provide further detail with regard to the Company’s contractual obligations):

PAYMENTS DUE BY PERIOD

CONTRACTUAL OBLIGATIONS
  
Total
  
Less than
1 year
  
2-3 years
  
4-5 years
  
More than
5 years
  
(in millions)
                      
Short-term borrowings
  
$
48.8
  
$
48.8
  
$
—
  
$
—
  
$
—
  
Accounts payable
    
562.0
    
562.0
    
—
    
—
    
—
  
Other current liabilities
    
265.4
    
265.4
    
—
    
—
    
—
  
Hedged metal obligations
    
640.8
    
640.8
    
—
    
—
    
—
  
Long-term debt, including interest payments (a)
    
764.4
    
140.1
    
33.1
    
170.5
    
420.7
  
Other long-term liabilities reflected on the balance sheet under GAAP (b)
   
319.1
    
1.0
    
45.2
    
39.1
    
233.8
  
Purchase obligations - metal supply contracts (c)
    
5,355.4
    
874.8
    
1,823.4
    
1,328.6
    
1,328.6
  
Pool accounts (d)
    
455.2
    
455.2
    
—
    
—
    
—
  
Operating leases
    
180.1
    
24.9
    
48.7
    
44.9
    
61.6
  
PGM leases (e)
   
108.3
    
108.3
    
—
    
—
    
—
  
Other purchase obligations (f)
    
100.3
    
82.4
   
17.9
    
—
    
—
  
Total contractual obligations
  
$
8,799.8
  
$
3,203.7
  
$
1,968.3
  
$
1,583.1
  
$
2,044.7
  
 
(a) Future interest payments calculated using the December 31, 2005 LIBOR rate and foreign exchange rates as of December 31, 2005.

(b) Amounts relate to postretirement/postemployment obligations (see Note 17, “Benefits,” for further detail), with the remainder consisting of executive deferred compensation, SFAS No. 143 asset retirement obligations (see Note 4, “Accounting for Asset Retirement Obligations,” for further detail) and the long-term portion of the environmental reserve (see Note 22, “Environmental Costs,” for further detail). The ‘More than 5 years’ category includes $81.7 million related to the Company’s minimum pension liability (see Note 17, “Benefits”), as well as $58.1 million of other noncurrent liabilities for which the timing of payment is not readily determinable.

(c) These amounts reflect minimum purchase obligations for the purchase of platinum group metals (PGM) assuming the December 31, 2005 prices for the various metals continue into the specified future periods. However, these are not fixed price arrangements; the prices are based on future market prices. As a result, the Company will be able to hedge the purchases with sales at those future prices.

(d) Represents the December 31, 2005 value of precious metals deposited with the Company, principally for the manufacture of catalysts utilizing those metals

(e) Represents the December 31, 2005 value of PGM which the Company has leased from third parties and then onward leased to industrial customers.

(f) Amounts primarily relate to purchase orders for raw material purchases and warehousing- and transportation-related costs.

In the normal course of business, the Company incurs obligations with regard to contract completion, regulatory compliance and product performance. Under certain circumstances, these obligations are supported through the issuance of letters of credit. At December 31, 2005, the aggregate outstanding amount of letters of credit supporting such obligations amounted to $121.4 million, of which $114.7 million will expire in less than one year, $1.0 million will expire in two to three years, $0.2 million will expire in four to five years and $5.5 million will expire after five years.

The Company has not engaged in any transaction within the past 12 months, and has no agreement or other contractual arrangement, to which an entity unconsolidated with the Company is a party that would constitute an off-balance sheet arrangement, as such term is defined in Item 303(a)(4)(ii) of Regulation S-K.


Credit Risk

The Company believes that its financial instruments do not represent a concentration of credit risk because the Company deals with a variety of major banks worldwide and its accounts receivable are spread among a number of major industries, customers and geographic areas. A centralized credit committee reviews significant credit transactions and risk-management issues before granting credit, and an appropriate level of reserves is maintained. In addition, the Company, through its credit committee and credit department, monitors the status of worldwide accounts receivable and the financial condition of its customers to help ensure collections and to minimize losses.

The Company may enter into transactions in which it advances funds after receipt of metal as provisional payment for the metal which is to be finally priced under market-based pricing formulae that will result in a determination of that price. If the final price is less than the provisional price paid, the supplier will be obligated to return the difference to the Company. Therefore, if the market price (and the anticipated final price) falls below the provisional price, the Company is exposed to the potential credit risk associated with the possibility of non-payment by the supplier, although no payment is due until after the final price is determined. As of December 31, 2005, the aggregate market value of metals purchased under a contract for which a provisional price had been paid was in excess of the amounts advanced by a total of $138.9 million. As a result, this amount was recorded in committed metal positions and accounts payable at December 31, 2005, and no credit risk existed.

Commitments and Contingencies

For information about commitments and contingencies, see Note 22, “Environmental Costs” and Note 23, “Litigation and Contingencies.”

Dividends and Capital Stock

Common stock dividends paid were $0.48 per share in 2005, $0.44 per share in 2004 and $0.41 per share in 2003.

Peru Update

See Note 23, “Litigation and Contingencies,” for a discussion of Peru.

Special Charges and Credits

See Note 6, “Special Charges and Credits,” for a discussion of the Company’s special charges and credits.

Other Matters

See Note 1, “Summary of Significant Accounting Policies,” for a discussion of new accounting pronouncements.

Related Party Transactions

See Note 16, “Related Party Transactions,” for a discussion of related party transactions.

Critical Accounting Policies and Estimates

Certain key policies and estimates are explained below to assist in understanding the Company’s consolidated financial statements. More detailed explanations may be found elsewhere in Management’s Discussion and Analysis of Financial Condition and Results of Operations section and in the Notes to Consolidated Financial Statements.

Sales

A significant portion of consolidated net sales represent the sale of platinum group metals to industrial customers who buy the metals from Materials Services in connection with products manufactured by the Environmental and Process Technologies segments. Accordingly, almost all of these sales are reported in the
 
 
Materials Services segment, with a limited amount included in Environmental and Process Technologies’ reported sales. Because metal price levels may vary widely, there is no consistent relationship between consolidated sales and gross profit.

Because the timing of the purchase of spot metals often does not coincide with the timing of the subsequent sales to industrial users, Materials Services needs to hedge price risk, usually by selling forward (i.e., for future delivery) to investment-grade trading entities, industrial companies or on futures exchanges. If a surplus of physical metal develops, Materials Services may also sell spot and buy forward to balance the risk position. Other than hedges entered into with industrial customers, sales related to these hedging transactions are not included in reported sales, as they are not meaningful in an industrial context.

Customers of the Environmental and Process Technologies segments who purchase products that improve efficiency and yields are often unable to precisely predict the dates that catalysts will be required. Accordingly, they may request that product that has already been ordered, manufactured and prepared for shipment at the agreed upon date be temporarily held by the Company until that customer’s manufacturing facility is prepared to accept the new charge of catalyst. In cases where the customer requests the Company to hold the goods, agrees to be invoiced and to pay the invoices on normal terms, as well as to accept title to the goods, the Company will recognize the sale prior to shipment. Stringent procedures and controls are in place to ensure that these sales are only recognized in accordance with the applicable revenue recognition guidance.

Mark-to-market

Materials Services procures physical metal from third parties for resale and enters into forward contracts and other relatively straight-forward hedging derivatives that are recorded as either assets or liabilities at their fair value. By acting in its capacity as a distributor and materials service provider to the Company’s technology businesses and their customers and by taking closely monitored unhedged positions as described below, Materials Services takes on the attributes of a dealer in commodities. Both spot metal and derivative instruments used in hedging (i.e., forwards, futures, swaps and options) are stated at fair value. The Company values platinum, palladium, gold and silver based on the daily closing New York Mercantile Exchange settlement prices. There are no so-called “terminal” markets for rhodium. The Company values rhodium based upon prices published in “Metals Week,” an independent trade journal. Values for base metals come from the closing prices of the London Metals Exchange.

In closely monitored situations, for which exposure levels and transaction size limits have been set by senior management, the Company holds unhedged metal positions that are subject to future market fluctuations. Such positions may include varying levels of derivative instruments. At times, these positions can be significant. All unhedged metal transactions are monitored and marked-to-market daily. This metal that has not been hedged is therefore subject to price risk and is disclosed in Note 12, “Committed Metal Positions and Hedged Metal Obligations.”

The fair values of Materials Services’ various spot and derivative positions are included in committed metal positions on the asset side of the consolidated balance sheet and hedged metal obligations on the liability side. The credit (performance) risk associated with the fair value of derivatives in a gain position is greatly mitigated through the selection of investment-grade counterparties.

Precious metals

Most of the platinum group metals used by Environmental and Process Technologies to manufacture products are provided in advance by the customers. The customers often purchase these metals from Materials Services, but they may also be shipped in from other sources.

Certain quantities of precious metals are carried at historical cost using the LIFO method. Because most of the metal was acquired some time ago, the market value of this metal, while fluctuating from year to year, has generally been substantially above cost. While this excess of market over cost is useful in evaluating the consolidated balance sheet from a credit perspective, the annual changes are not reflected in the income statement except to the extent that periodic liquidations of LIFO layers produce book profits. LIFO liquidation profits are separately disclosed and not included in the operating earnings of the technology or Materials Services segments but are included in the “All Other” category.


Provision for environmental remediation

With the oversight of environmental agencies, the Company is currently preparing, has under review, or is implementing environmental investigations and cleanup plans at several currently or formerly owned and/or operated sites, including Plainville, Massachusetts. The Company continues to investigate and remediate contamination at Plainville under a 1993 agreement with the United States Environmental Protection Agency (EPA). The Company continues to address decommissioning issues at Plainville under authority delegated by the Nuclear Regulatory Commission to the Commonwealth of Massachusetts.

In addition, as of December 31, 2005, 14 sites have been identified at which the Company believes liability as a potentially responsible party is probable under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended, or similar state laws (collectively referred to as Superfund) for the cleanup of contamination and natural resource damages resulting from the historic disposal of hazardous substances allegedly generated by the Company, among others. Superfund imposes strict, joint and several liability under certain circumstances. In many cases, the dollar amount of the claim is unspecified and claims have been asserted against a number of other entities for the same relief sought from the Company. Based on existing information, the Company believes that it is a de minimis contributor of hazardous substances at a number of the sites referenced above. Subject to the reopening of existing settlement agreements for extraordinary circumstances, discovery of new information or natural resource damages, the Company has settled a number of other cleanup proceedings. The Company has also responded to information requests from EPA and state regulatory authorities in connection with other Superfund sites.

The accruals for environmental cleanup-related costs reported in the consolidated balance sheets at December 31, 2005 and 2004 were $18.0 million and $19.1 million, respectively, including $0.1 million at December 31, 2005 and 2004 for Superfund sites. These amounts represent those undiscounted costs that the Company believes are probable and reasonably estimable. Based on currently available information and analysis, the Company’s accrual represents approximately 39% of what it believes are the reasonably possible environmental cleanup-related costs of a noncapital nature. The estimate of reasonably possible costs is less certain than the probable estimate upon which the accrual is based.

Cash payments for environmental cleanup-related matters were $1.2 million in 2005, $1.3 million in 2004 and $1.8 million in 2003. In 2003, the Company recognized a $2.0 million liability for a facility in France.

For the past three-year period, environmental-related capital projects have averaged less than 10% of the Company’s total capital expenditure programs, and the expense of environmental compliance (e.g., environmental testing, permits, consultants and in-house staff) was not material.

There can be no assurances that environmental laws and regulations will not change or that the Company will not incur significant costs in the future to comply with such laws and regulations. Based on existing information and current environmental laws and regulations, cash payments for environmental cleanup-related matters are projected to be $2.5 million for 2006, which has already been accrued. Further, the Company anticipates that the amounts of capitalized environmental projects and the expense of environmental compliance will approximate current levels. The Company has an Environmental, Health and Safety (EH&S) department that implements and assesses compliance to policies, procedures and controls around the Company’s environmental exposures and possible liabilities. These policies, procedures and controls are intended to assure that the Corporate EH&S department is aware of all issues that may have a potential impact on the Company. While it is not possible to predict with certainty, management believes environmental cleanup-related reserves at December 31, 2005 are reasonable and adequate, and environmental matters are not expected to have a material adverse effect on financial condition. However, if these matters are resolved in a manner different from the estimates, they could have a material adverse effect on the Company’s operating results or cash flows.

Goodwill

As of December 31, 2005, the Company had $400.7 million of goodwill that, based on impairment testing in 2005, is not impaired. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” the Company completes an impairment test of goodwill annually, or more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of its reporting units below their carrying value. The impairment test requires the Company to estimate the fair values of its reporting units, which is done by using a
 
 
discounted cash flow model. Significant estimates used in the Company’s discounted cash flow model include future cash flows and long-term rates of growth of its reporting units and a discount rate based on the Company’s weighted-average cost of capital. Assumptions used in determining future cash flows include current and expected market conditions and future sales forecasts.

Approximately 95% of the Company’s goodwill is attributable to reporting units with fair values that exceed the carrying values of the reporting units by a substantial margin. The use of different estimates and assumptions, within the range of predictable possibilities, employed in the discounted cash flow model that measures the fair value of these reporting units, would not be expected to result in an impairment of goodwill. The remaining 5% of the goodwill resides in reporting units with fair values that modestly exceed the carrying values of the reporting units. The use of different estimates and assumptions employed in the discounted cash flow model that measures the fair value of these reporting units could result in an impairment of goodwill. However, the maximum value exposed to changes in estimates and assumptions, based upon the current range of predictable possibilities, is $19.9 million. Included in this amount is $15.9 million of goodwill acquired with the industrial products business within the Environmental Technologies segment and $4.0 million of goodwill related to two acquisitions that provide minerals-based products within the Appearance and Performance Technologies segment.

Certain long-lived assets

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company reviews its property, plant and equipment for impairment whenever events or circumstances indicate that their carrying amount may not be recoverable. Impairment reviews require a comparison of the estimated future undiscounted cash flows to the carrying value of the asset. If the total of the undiscounted cash flows is less than the carrying value, an impairment charge is recorded for the difference between the estimated fair value and the carrying value of the asset. Significant assumptions used in the Company’s undiscounted cash flow model include future cash flows attributed to the group of assets, the group of assets subject to the impairment and the time period for which the assets will be held and used. Assumptions used in determining future cash flows include current and expected market conditions and future sales forecasts. The use of different estimates or assumptions within the Company’s undiscounted cash flow model could result in undiscounted cash flows lower than the current value of the Company’s assets, thereby requiring the need to compare the carrying values to their fair values. The use of different estimates or assumptions when determining the fair value of the Company’s property, plant and equipment may result in different values for our property, plant and equipment, and any related impairment charges.

Income taxes

As of December 31, 2005, net deferred tax assets are approximately $100.1 million. The Company determines its current and deferred taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” The tax effect of the reversal of tax differences is recorded at rates currently enacted for each jurisdiction in which it operates. To the extent that temporary differences will result in future tax benefit, the Company must estimate the timing of their reversal, and whether taxable operating income in future periods will be sufficient to fully recognize any deferred tax assets of the Company. The future impact on income taxes from earnings that may result from using different assumptions and/or estimates cannot be reasonably quantified due to the number of scenarios and variables that are present.
 
As of December 31, 2005, the Company had approximately $400.0 million of state net operating loss carryforwards that expire at various intervals between 2006 and 2025. The probability of not being able to utilize these net operating loss carryforwards is low under a wide range of scenarios. Due to shortened available carryover periods in certain state jurisdictions, the Company has recorded a valuation allowance of approximately $52 million of the state net operating loss carryforwards.

It is the Company’s policy to establish reserves for taxes that may become payable in future years as a result of tax examinations. The Company establishes reserves for taxes based upon management’s assessment of tax exposures under applicable accounting principles and pronouncements. The tax reserves are analyzed on a quarterly basis and adjustments are recorded as events occur that warrant changes to individual exposure items and to the overall tax reserve balance. As of December 31, 2005, the Company has recorded appropriate reserves for tax exposures it has determined are probable.


The Company is regularly audited by the Internal Revenue Service (IRS) and the various foreign and state tax authorities in the jurisdictions in which the Company does business. The IRS has examined the Company’s tax returns through 2001 and it is currently examining the Company’s tax returns for 2002 and 2003.

Pensions and other postretirement/postemployment costs

The Company’s employee pension and other postretirement/postemployment benefit costs and obligations are dependent on its assumptions used by actuaries in calculating such amounts. These assumptions include discount rates, salary growth, expected returns on plan assets, retirement rates, mortality rates and other factors. The discount rate assumption reflects the rate that the liabilities could be settled on the measurement date of September 30th. The Company based this discount rate on investment yields available on AA-rated corporate long-term bond yields. The duration of the AA bonds closely matches the duration of the Company’s pension liability. The salary growth assumptions reflect the Company’s long-term actual experience, the near-term outlook and assumed inflation. The health care cost trend assumptions are developed based on historical cost data, the near-term outlook and an assessment of likely long-term trends. Retirement rates are based primarily on actual plan experience. Mortality rates are based on published data. Actual results that differ from the Company’s assumptions are accumulated and amortized over future periods and, therefore, generally affect recognized expense and recorded obligations in such future periods. While the Company believes that the assumptions used are appropriate, significant differences in actual experience or significant changes in assumptions would affect pension and other postretirement/postemployment benefit costs and obligations.

The Company has determined that its net pension cost is projected to be approximately $41 million in 2006, compared with $33 million in 2005 and $26 million in 2004. Based on a review of the current environment, the Company used a long-term rate of return assumption of 8.9% (domestic) and 7% (foreign) to value its net periodic pension expense in 2005 and expects to maintain these assumptions in 2006. A 1% change in the long-term rate of return assumption would increase or decrease net periodic pension expense by approximately $6 million in 2006. The Company lowered its domestic discount rate for determining net periodic pension expense from 6.25% in 2004 to 6.0% in 2005. Further adjustments are being made in 2006 to lower the domestic rate to 5.5%. This adjustment reflects industry trends and the current interest rate environment. A 25 basis-point increase in the discount rate would decrease pension expense by approximately $3 million in 2006 and decrease the 2005 projected benefit obligation (PBO) by approximately $25 million. A 25 basis-point decrease in the discount rate would increase pension expense by approximately $3 million in 2006 and increase the 2005 PBO by approximately $27 million. The Company used September 30, 2005 as the measurement date for its assets and liabilities. Assets on this date were $640 million. The value of the assets increased to $651 million at December 31, 2005. The Company expects its postretirement/postemployment benefit costs to be $12 million in 2006.

Forward-Looking Statements

This document contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to analyses and other information that are based on forecasts of future results and estimates of amounts not yet determinable. These statements also relate to future prospects, developments and business strategies. These forward-looking statements are identified by their use of terms and phrases such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “predict,” “project,” “will” and similar terms and phrases, including references to assumptions. A summary of key assumptions used to develop these forward looking statements is included below under the caption “Key Assumptions”. These forward-looking statements involve risks and uncertainties, internal and external, that may cause the Company’s actual future activities and results of operations to be materially different from those suggested or described in this document. A discussion of these risk factors is included below under the caption “Risk Factors”. Investors are cautioned not to place undue reliance upon these forward-looking statements, which speak only as of their dates.
 
 
Risk Factors

Internal risks and uncertainties that could cause actual results to differ materially and negatively impact the Company include:

 
·
The Company’s ability to achieve and execute internal business plans. The Company is engaged in growth and productivity initiatives in all technology segments. Specifically, the Company has major growth initiatives in businesses serving the personal care, energy materials, polyethylene, diesel emissions and gas-to-liquids markets. These initiatives represent forays into relatively new markets for the Company, and therefore are subject to greater risk than the Company’s traditional markets. Additionally, failure to commercialize proprietary and other technologies or to acquire businesses or licensing agreements to serve targeted markets would negatively impact the Company.

 
·
Future divestitures and restructurings. The Company may experience changes in market conditions that cause the Company to consider divesting or restructuring operations, which could impact future earnings.

 
·
The success of research and development activities and the speed with which regulatory authorizations and product launches may be achieved. The Company’s future cash flows depend upon the creation, acquisition and commercialization of new technologies to replace obsolete technologies.

 
·
Manufacturing difficulties, property loss, or casualty loss. Although the Company maintains business interruption insurance, the Company is dependent upon the operating success of its manufacturing facilities, and does not maintain redundant capacity. Failure of these manufacturing facilities would cause short-term profitability losses and could damage customer relations in the long-term.

 
·
Capacity constraints. Some of the Company’s businesses operate near current capacity levels, notably operations serving the petroleum refining operations. Should demand for certain products increase, the Company would experience short-term difficulty meeting the increased demand, hindering growth opportunities.

 
·
Product quality deficiencies. The Company’s products are generally sold based upon specifications agreed upon with our customers. Failure to meet these specifications could negatively impact the Company.

 
·
The impact of physical inventory losses, particularly with regard to precious and base metals. Although the Company maintains property and casualty insurance, the Company holds large physical quantities of precious and base metals, often for the account of third parties. These quantities are subject to loss by theft and manufacturing inefficiency.

 
·
Litigation and legal claims. The Company is currently engaged in various legal disputes, including litigation related to the BASF Offer. Unfavorable resolution of these disputes would negatively impact the Company. Still unidentified future legal claims could also negatively impact the Company.

 
·
Contingencies related to actual or alleged environmental contamination to which the Company may be a party (see Note 22, “Environmental Costs”).

 
·
Uncertainty regarding the outcome of the BASF Offer may affect the Company’s stock price and future business. The uncertainty as to the outcome of the BASF Offer may have an adverse effect on employee retention and recruitment, and may negatively impact supplier and customer relationships.
 
 
 
·
Exposure to product liability lawsuits. As a manufacturer, the Company is subject to end-user product liability litigation associated with the Company’s products.

External risks, uncertainties and changes in market conditions that could cause actual results to differ materially and negatively impact the Company include:

 
·
Competitive pricing or product development activities affecting demand for our products. The Company operates in a number of markets where overcapacity, low-priced foreign competitors, and other factors create a situation where competitors compete for business by reducing their prices, notably the kaolin to paper market, some effect pigments markets, the colorant market, certain chemical process markets and certain components of the mobile-source environmental markets.

 
·
Overall demand for the Company’s products, which is dependent on the demand for our customers’ products. As a supplier of materials to other manufacturers, the Company is dependent upon the markets for its customers’ products. Notably, some North American automobile producers have recently experienced financial difficulties and decreased product demand. Additionally, technological advances by direct and not-in-kind competitors could render the Company’s current products obsolete.

 
·
Changes in the solvency and liquidity of our customers. Although the Company believes it has adequate credit policies, the creditworthiness of customers could change. Certain customers of the Company, who supply parts to the North American automobile producers, have recently experienced financial difficulties, including bankruptcy. Bankruptcy of other customers remains a threat. These customers represent a substantial portion of the Environmental Technologies segment’s business. The Company actively establishes and monitors credit limits to all customers.

 
·
Fluctuations in the supply and prices of precious and base metals and fluctuations in the relationships between forward prices to spot prices. The Company depends upon a reliable source of precious metals, used in the manufacture of its products, for itself and its customers. These precious metals are sourced from a limited number of suppliers. A decrease in the availability of these precious metals could impact the profitability of the Company. In closely monitored situations, for which exposure levels and transaction size limits have been set by senior management, the Company holds unhedged metal positions that are subject to future market fluctuations. Such positions may include varying levels of derivative instruments. At times, these positions can be significant. Significant changes in market prices could negatively impact the Company.

 
·
A decrease in the availability or an increase in the cost of energy, notably natural gas. The Company consumes more than 11 million MMBTUs of natural gas annually. Compared with other sources of energy, natural gas is subject to volatility in availability and price, due to transportation, processing and storage requirements. Recent hurricanes impacting the Gulf Coast have driven up natural gas prices and have limited availability. A prolonged continuation of these higher prices, absent the ability to recover these costs via price increases or energy surcharges, will negatively impact the Company. Changes could include customer and product rationalization, plant closures and asset impairments, particularly in certain minerals operations serving the paper market.

 
·
The availability and price of rare earth compounds. The Company uses certain rare earth compounds, produced in limited locations worldwide.

 
·
The availability of substrates. In the Environmental Technologies segment, the Company purchases large quantities of catalyst substrates from a limited number of suppliers. These substrates are specifically designed and manufactured to requirements established by the Company’s customers. An inability to obtain substrates in sufficient volumes to meet customer demand would negatively impact the Company.
 
 
 
·
The availability and price of other raw materials. The Company’s products contain a broad array of raw materials for which increases in price or decreases in availability could negatively impact the Company.

 
·
The impact of increased employee benefit costs and/or the resultant impact on employee relations and human resources. The Company employs approximately 7,100 employees worldwide and is subject to recent adverse trends in benefit costs, notably pension and medical benefits.

 
·
Higher interest rates. A portion of the Company’s debt is exposed to short-term interest rate fluctuations. An increase in long-term debt rates would impact the Company when the current long-term debt instruments mature, or if the Company requires additional long-term debt.

 
·
Changes in foreign currency exchange rates. The Company regularly enters into transactions denominated in foreign currencies, and accordingly is exposed to changes in foreign currency exchange rates. The Company’s policy is to hedge the risks associated with monetary assets and liabilities resulting from these transactions. Additionally, the Company has significant foreign currency investments and earnings, which are subject to changes in foreign currency exchange rates upon translation into U.S. dollars.

 
·
Geographic expansions not developing as anticipated. The Company expects markets in Asia to fuel growth for many served markets. China’s expected growth exceeds that of most developed countries, and failure of that growth to materialize would negatively impact the Company.

 
·
Economic downturns and inflation. The diversity of the Company’s markets has substantially insulated the Company’s profitability from economic downturns in recent years. The Company is exposed to overall economic conditions. Recent inflationary pressures have resulted in higher material costs. The inability of the Company to pass these higher costs to customers via price increases and surcharges would have a negative impact on the Company.

 
·
Increased levels of worldwide political instability, as the Company operates primarily in the United States, the European community, Asia, the Russian Federation, South Africa and Brazil. Much of the Company’s identified growth prospects are foreign markets. As such, the Company expects continued foreign investment and, therefore, increased exposure to foreign political instability. Additionally, the worldwide threat of terrorism can directly and indirectly impact the Company’s foreign and domestic profitability.

 
·
The impact of the repeal of the U.S. export sales tax incentive and the enactment of the American Jobs Creation Act of 2004. The Company has decided not to repatriate any amounts from its foreign subsidiaries at a reduced tax rate under the Act due to its intention to increase its investments outside of the United States.

 
·
Government legislation and/or regulation particularly on environmental and taxation matters. The Company maintains manufacturing facilities and, as a result, is subject to environmental laws and regulations. The Company will be impacted by changes in these laws and regulations. The Company operates in tax jurisdictions throughout the world, and, as a result, is subject to changes in tax laws, notably in the United States, the United Kingdom, Germany, the Netherlands, Italy, Switzerland, France, Spain, South Africa, Brazil, Mexico, China, Korea, Japan, India and Thailand.
 
 
 
·
A slowdown in the expected rate of environmental regulations. The Company’s Environmental Technologies segment’s customers, and to a lesser extent, the Process Technologies segment’s customers, are generally driven by increasingly stringent environmental regulations. A slowdown or repeal of regulations could negatively impact the Company.

 
·
The impact of natural disasters. Natural disasters causing damage to the Company and our customers and suppliers would negatively impact the Company.

Key Assumptions

The Company does not as a matter of course make detailed public projections as to future performance or earnings. After BASF commenced its $37 per share tender offer, the Board of Directors, on January 20, 2006, unanimously determined that the BASF Offer was inadequate and not in the best interest of the Company’s stockholders (other than BASF and its affiliates). This determination was in part based on the Board’s belief that the offer did not fully reflect the value of the Company’s businesses, particularly its future growth prospects. As a result, the Company decided to publicly release information regarding its annual management operation plans that was developed in August 2005, prior to the BASF Offer. The key assumptions used in developing these plans, arranged by businesses within the Company’s segments, are set forth below.
 
The Company's internal financial forecasts are prepared solely for internal use and capital budgeting and other management decisions and are subjective in many respects and thus susceptible to interpretations and periodic revisions based on actual experience and business developments. The projections were not prepared with a view to public disclosure or compliance with the published guidelines of the SEC or the guidelines established by the American Institute of Certified Public Accountants regarding projections or forecasts. The Company's independent accountants have not examined, compiled or otherwise applied procedures to the projections and, accordingly, do not express an opinion or any other form of assurance with respect to the projections.

The projections also reflect numerous assumptions made by management of the Company with respect to industry performance, general business, economic, market and financial conditions and other matters, all of which are difficult to predict and many of which are beyond the Company's control. Accordingly, there can be no assurance that the assumptions made in preparing the projections will prove accurate. It is expected that there will be differences between actual and projected results, and actual results may be materially greater or less than those contained in the projections. The inclusion of the projections herein should not be regarded as an indication that the Company or its affiliates or representatives considered or considers the projections herein should be relied upon as such.
 
Neither the Company nor any of its affiliates or representatives have made or makes any representations to any person regarding the ultimate performance of the Company compared to the information contained in the projections.
 
Environmental Technologies

Light Duty Vehicles
 
·
Light duty vehicle builds will grow globally at 2% over the plan period, from 62 million vehicles in 2005 to 68 million by 2010, driven primarily by increasing living standards in emerging markets.
 
·
N. America with strictest regulation and largest engines averages almost three catalysts per vehicle. Europe, with increasing penetration rates of catalyzed soot filters (CSF) will increase to slightly over two catalysts per vehicle. Tightening regulatory standards in developing countries will bring the average in these regions up to one catalyst per vehicle.
 
·
Increasingly strict regulatory standards and fluctuating precious metal pricing will require more advanced technology with related value pricing.
 
·
Net effect of the above is that the global market for light duty emission control catalysts will grow at a 5% CAGR, from $1.5 billion in 2005 to $1.9 billion by 2010. Of the $1.9 billion in 2010, $1.4 billion relates to gasoline with the remaining $0.5 billion relating to light-duty diesel, primarily in Europe.
 
·
Gasoline:
 
o
Global segment will grow from 103 million catalysts in 2005 to 115 million by 2010, a 2.2% CAGR, with an average catalyst manufacturing charge of $12/catalyst.
 
o
N. America and Europe will show minimal growth with Japan and Korea flat. Most of the growth
 
 
    will come from emerging markets, led by China.
 
o
Stricter regulations will be adopted in the emerging markets over the plan period. China and India will begin Euro 3 this year and Euro 4 by 2008-10. Brazil will adopt a US Tier 2 program in 2009. Russia will begin to implement Euro 2 this year and Euro 3 by 2008.
 
·
Light-duty Diesel:
 
o
Europe, which accounts for 75% of the market, will grow from 9.4 million vehicles in 2005 to almost 12 million by 2010, a 5% CAGR. A large percentage of the remaining 25% is produced in Japan and Korea for export into Europe.
 
o
The biggest driver for this growth is the diesel penetration rate growing from 46% this year to 50% by 2010.
 
o
The catalyst market for light-duty diesels in Europe is currently forecasted to be almost $400 million by the end of 2010. The largest growth opportunity is the accelerated adoption rate of CSF’s.
 
o
Euro 4, which began phasing in during 2004 (2005 new platforms) has not been filter (CSF) forcing. However, several European countries became aware that ambient air quality standards were being exceeded in urban areas, primarily due to particulate matter. Driving restrictions on unfiltered vehicles were discussed as a possible solution which prompted OEMs to “voluntarily” install filters.
 
o
Awareness of particulate matter has forced the EU to accelerate the adoption of Euro 5 for light-duty diesel (now projected for 2009). Euro 5 reduces particulate emissions by 80% vs. Euro 4 and will be filter forcing for a majority of diesel vehicles.
 
o
Grow EC’s market share in Europe from 24% to 35% by 2008.

Heavy-Duty Diesel
 
·
Heavy-duty diesel engine demand will increase only 1% per year, from 1.6 million engines in 2005 to 1.7 million engines in 2010 in the U.S., Europe and Japan.
 
·
However, tightening regulations will increase the catalyst market from 1.4 million units in 2005 to 5 million units in 2010.
 
·
Revenues (ex-PGM/ex-substrate) are projected to grow from $100 million in 2005 to $330 million in 2010.
 
·
For On-Road, US 2007 & 2010, Euro 4 & 5 and Japan 2005 & 2009 are “On Track” for implementation.
 
·
Successful fleet testing of US07 emission systems in 2006.
 
·
Non-vanadium SCR will be required in US, Europe and Japan.
 
·
European tax incentive programs will drive early adoption of CSF’s.
 
·
New off-road regulations begin in 2008 and are not included in revenues or earnings estimates.

Stationary Source
 
·
The Food Service market will grow from $3 million in 2005 to $10 million in 2010 driven by pending charbroiler regulations (2007). Addresses fine particulate control and health and safety benefits for ventless ovens.
 
·
Successful development of differentiated mercury sorbent technology for coal-fired power plants assumed for 2008-2010.

Temperature Sensing
 
·
Market will grow from $225 million in 2005 to $300 million in 2010, a CAGR of 6%.
 
·
EC will improve on its 8% market share through three growth strategies:
 
·
Accelerate optical thermometry commercialization by penetrating new markets.
 
·
Continue Asia geographic expansion.
 
·
Add wafer thermocouple technology to complete EC temperature measurement portfolio.

Process Technologies

Chemicals
 
·
Gas economy catalyst market forecast to approximate $350 million in 2006 with a CAGR of 15%.
 
·
Additional Gas economy catalyst growth from:
 
o
Planned expansion from current “gas-to-liquids” (GTL) customer.
 
o
Leveraging Fischer-Tropsch catalyst technology to other major GTL players.
 
 
 
o
Leverage our syngas position from Nanjing acquisition.
 
·
Successful entry into unserved petrochemical markets, including ethane-based styrene, ethane-based acetic acid, propane-based acrylic acid and propane-based propylene oxide, based on current commercial agreements.
 
·
Growth rates for catalyst markets for oleochemicals, petrochemicals and fine chemicals range from 2% to 10% over the plan period.

Petroleum Refining
 
·
FCC additives growth approximating 22% over the plan period.
 
·
Underlying market growth of 10% over the plan period.
 
·
Additional growth from the expansion into environmental and gasoline conversion additive technologies to meet increasing global demands of propylene and petrochemical feedstocks and regulatory compliance.
 
·
Entry into new refining market areas by leveraging EC technology through prospective licensing agreements, including hydrocracking, deep catalytic cracking and reforming.
 
·
FCC market growth only projected at 2% over the plan period with additional income from productivity gains.
 
·
Natural gas price used was $7.25 per MMBTU. Adverse variances are expected to be substantially covered by surcharges and other pricing actions.

Polyolefins
 
·
Polypropylene growth approximating 26% over the plan period.
 
·
Assumed growth of 7% over the plan period in proprietary catalyst representing underlying market growth of 5-6% and remaining growth through differentiation and acceleration of our technology development into the packaging and film markets.
 
·
Growth in volume from new licenses.
 
·
Continuation of entry into polyethylene market.

Appearance and Performance Technologies

Personal Care Materials
 
·
7% growth per year in delivery systems for personal care through 2009. In the case of commodity vitamins (30% of market) where we don’t participate, the rate is 5%. For more specialized actives, such as unique extracts from plants, the growth rate is closer to 10%.
 
·
Additional revenues/earnings from expanding the product offerings globally from the acquisitions made in the U.S. and France in 2004 and 2005.

Additional earnings from optimizing synergies in technology, manufacturing and sales as we continue to integrate the two acquisitions.

Effects
 
·
Market for effects pigments in cosmetics and personal care will grow at 7% per year. The market growth rate for industrial applications will be 4-5%. Growth in the automotive market will be lower.
 
·
Expanding our innovation track into new programs beyond mica and borosilicate glass, bismuth and film by focusing research and development on technology platforms and away from line extensions will add $15 million to revenues by 2010.
 
·
Cost reductions will add $10 million to earnings by 2010.
 
·
Faster innovation and an applications lab in China will work to counter Chinese competition, and cost management.

Kaolin
 
·
Recover $10 million in revenue and $4 million in earnings from customer strikes in Finland and Canada.
 
·
$24 million in revenue in 2010 from Décor Growth Program (decorative laminate paper market with substitution for TiO2).
 
·
Crop protectants (Surround) will add $28 million of revenues and $10 millions of earnings by 2010.
 
·
Cost reduction initiatives will add $12 million in earnings by 2010.
 
·
Natural gas price used was $7.25 per MMBTU. Adverse variances are expected to be substantially covered by surcharges and other pricing actions.
 
 
Ventures
 
·
Alumina business acquired in 2005 accounts for $12 million of 2010 operating earnings with modest growth rates.
 
·
Proppants accounts for $9 million of 2010 operating earnings and depends mostly on continued demand from the energy sector.
 
·
Aseptrol/water treatment are slated to generate $7 million of operating earnings by 2010 related to health requirements.
 
·
Nothing included in revenues and earnings for ceramic proppants and battery materials programs.

Corporate
 
·
Share buy-back programs, enabled by operating cash flows, will offset the dilutive impact of employee benefit plans. Diluted shares outstanding for Operating Plan period are 122 million.
 
·
The average effective tax rate for the Operating Plan period is 23%, with the 2010 period at 24%.
 
·
Equity earnings from the Company’s equity method joint ventures, which primarily serve the Japanese and Korean automotive catalyst markets, have conservatively been held constant throughout the plan period, despite a 25% CAGR over the past three years.

 
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market Risk Sensitive Transactions

The Company is exposed to market risks arising from adverse changes in interest rates, foreign currency exchange rates and commodity prices. In the normal course of business, the Company uses a variety of techniques and instruments, including derivatives, as part of its overall risk-management strategy. The Company enters into derivative agreements with a diverse group of major financial and other institutions with individually determined credit limits to reduce exposure to the risk of nonperformance by counterparties.

Interest rate risk

The Company uses a sensitivity analysis to assess the market risk of its debt-related financial instruments and derivatives. Market risk is defined here as the potential change in the fair value of debt resulting from an adverse movement in interest rates. The fair value of the Company’s total debt was $564.2 million and $520.8 million at December 31, 2005 and 2004, respectively, based on prevailing interest rates at those dates. A 100 basis-point increase in interest rates could result in a reduction in the fair value of total debt of $8.1 million at December 31, 2005, compared with $13.6 million at December 31, 2004.

The Company also uses interest rate derivatives that are designated as fair value hedges to help achieve its fixed and floating rate debt objectives. The Company currently has three interest rate swap agreements with a total notional value of $150 million maturing in May 2013. These agreements effectively change fixed rate debt obligations into floating rate debt obligations. The total notional values and maturity dates of these agreements are equal to the face values and the maturity dates of the related debt instruments. For these fair value hedges, there was no gain or loss recognized from hedged firm commitments no longer qualifying as fair value hedges for the years ending December 31, 2005, 2004 and 2003.

In December 2005, the Company entered into an interest rate derivative contract, referred to as a Forward Rate Agreement (FRA) contract. This derivative economically hedged the Company’s interest rate exposure for the May 15, 2006 Euribor rate reset under two US dollar to Euro cross-currency interest rate derivative swap agreements.

In September 2005, the Company terminated two interest rate swap agreements, with a total notional value of $100 million maturing in August 2006, that were designated as fair value hedges. The accumulated gain of $0.4 million resulting from the termination of these two interest rate swap agreements will be amortized to earnings over the remaining term of the underlying debt instrument.

In June 2005, the Company terminated two interest rate swap agreements, with a total notional value of $120 million maturing in June 2028, that were designated as fair value hedges. The termination of these two interest rate swap agreements resulted in an accumulated gain of $20.1 million that will be amortized to earnings over the remaining term of the underlying debt instrument.

In January 2005, the Company entered into two additional FRA contracts, which economically hedged the Company’s interest rate exposure for the May 16, 2005 and the June 1, 2005 LIBOR rate reset under two pre-existing interest rate swap agreements. The FRA contracts were terminated in March 2005 due to favorable market conditions and the gain was reflected in earnings.

In January 2005, the Company entered into a derivative agreement with a total notional value of $74.7 million maturing in January 2012. This agreement effectively changes a rental obligation that varies directly with short-term commercial paper rates to a fixed payment obligation. The total notional value and other terms of this agreement are equal to the rental payments and other terms of an operating lease for machinery and equipment used in the Process Technologies segment that was renewed in January 2005. This derivative is designated as a cash flow hedge, and as such, it is marked-to-market with the gain/loss reflected in other comprehensive income. As of December 31, 2005, the Company reported an after tax gain of $1.2 million in accumulated other comprehensive income. There was no gain or loss reclassified from accumulated comprehensive income into earnings as a result of the discontinuance of cash flow hedges due to the probability of the original forecasted transactions not occurring or hedge ineffectiveness.


In June 2004, the Company entered into two additional FRA contracts, which economically hedged the Company’s interest rate exposure for the December 1, 2004 LIBOR rate reset under a pre-existing interest rate swap agreement. This FRA is marked-to-market with the gain/loss being reflected in earnings.

In March 2004, the Company entered into a FRA contract, which hedged the Company’s interest rate exposure for the May 15, 2004 LIBOR rate reset under a pre-existing interest rate swap agreement. In June 2004, the Company entered into two additional FRA contracts, which economically hedged the Company’s interest rate exposure for the December 1, 2004 LIBOR rate reset under a pre-existing interest rate swap agreement. These FRAs have been marked-to-market with the gain/loss being reflected in earnings.

Approximately 33% and 76% of the Company’s borrowings had variable interest rates as of December 31, 2005 and 2004, net of related interest rate swaps, respectively.

Foreign currency exchange rate risk

The Company uses a variety of strategies, including foreign currency derivative contracts, to minimize or eliminate foreign currency exchange rate risk associated with its foreign currency transactions, including metal-related transactions denominated in other than U.S. dollars.

The Company uses a sensitivity analysis to assess the market risk associated with its foreign currency derivative contracts. Market risk is defined here as the potential change in fair value resulting from an adverse movement in foreign currency exchange rates. A 10% adverse movement in foreign currency rates could result in a net loss of $19.2 million at December 31, 2005, compared with $19.5 million at December 31, 2004, on the Company’s foreign currency derivative contracts. However, since the Company limits the use of foreign currency derivative contracts to the hedging of contractual and anticipated foreign currency payables and receivables, this loss in fair value for those contracts generally would be offset by a gain in the value of the underlying payable or receivable.

A 10% adverse movement in foreign currency rates could result in an unrealized loss of $42.9 million at December 31, 2005, compared with $59.1 million at December 31, 2004, on the Company’s net investment in foreign subsidiaries and affiliates. However, since the Company views these investments as long term, the Company would not expect such a gain or loss to be realized in the near term.

Commodity price risk

In closely monitored situations, for which exposure levels and transaction size limits have been set by senior management, the Company, from time to time, holds large, unhedged industrial commodity positions that are subject to market price fluctuations. Such positions may include varying levels of derivative commodity instruments. All unhedged industrial commodity transactions are monitored and marked-to-market daily. All other industrial commodity transactions are hedged on a daily basis, using forward, future, option or swap contracts to substantially eliminate the exposure to price risk. These positions are also marked-to-market daily.

The Company performed a “value-at-risk” analysis on all of its metal-related commodity assets and liabilities. The “value-at-risk” calculation is a statistical model that uses historical price and volatility data to predict market risk on a one-day interval with a 95% confidence level. While the “value-at-risk” models are relatively sophisticated, the quantitative information generated is limited by the historical information used in the calculation. For example, the volatility in the platinum and palladium markets in 2001 and 2000 was much greater than historical norms. Therefore, the Company uses this model only as a supplement to other risk management tools and not as a substitute for the experience and judgment of senior management and dealers who have extensive knowledge of the markets and adjust positions and revise strategies as the markets change. Based on the “value-at-risk” analysis in the context of a 95% confidence level, the maximum potential one-day loss in fair value was approximately $4.8 million at December 31, 2005, compared with $2.3 million as of December 31, 2004. The actual one-day changes in fair value of the Company’s metal-related commodity assets and liabilities never exceeded the average of the “value-at-risk” amounts as of the yearly open and close for each of the Company’s 2005 and 2004 fiscal years.
 
The Company is also exposed to commodity price risk on the unhedged portion of its natural gas purchases related to its purchase of natural gas that is used in the manufacture of its products. As of December 31, 2005, the Company has hedged approximately 30% of its expected natural gas purchases for 2006. At December 31, 2005, a uniform one-dollar increase in the price of natural gas would result in a decrease in operating earnings of approximately $8.2 million for the year ending December 31, 2006 based upon the Company’s unhedged portion of its expected natural gas purchases for 2006.
 
 
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

ENGELHARD CORPORATION
CONSOLIDATED STATEMENTS OF EARNINGS

Year ended December 31 (in thousands, except per-share amounts)
  
2005
  
2004
  
2003
  
Net sales
  
$
4,597,016
    
$
4,136,109
    
$
3,687,821
  
Cost of sales
    
3,879,014
    
3,465,509
    
3,051,778
  
Gross profit
    
718,002
    
670,600
    
636,043
  
Selling, administrative and other expenses
    
419,397
    
389,095
    
361,765
  
Special charge (credit), net
    
—
    
5,304
    
(11,978
)
Operating earnings
    
298,605
    
276,201
    
286,256
  
Equity in earnings of affiliates
    
32,564
    
37,582
    
39,368
  
Loss on investment
    
(239
)
  
(663
)
  
—
  
Interest income
    
8,205
   
5,205
    
4,035
  
Interest expense
    
(33,709
)
  
(23,704
)
  
(24,330
)
Earnings before income taxes
    
305,426
    
294,621
    
305,329
  
Income tax expense
    
59,078
    
57,405
    
65,934
  
Net earnings from continuing operations before cumulative effect of a change in accounting principle
    
246,348
    
237,216
    
239,395
  
Cumulative effect of a change in accounting principle, net of tax of $1,390
    
—
    
—
    
(2,269
)
Net earnings from continuing operations
    
246,348
    
237,216
    
237,126
  
Loss from discontinued operations, net of tax
    
(8,106
)
  
(1,688
)
  
(2,903
)
Net Earnings
  
$
238,242
  
$
235,528
  
$
234,223
  
Earnings per share - basic:
                    
Earnings from continuing operations before cumulative effect of a change in accounting principle 
  
$
2.05
  
$
1.93
  
$
1.91
  
Cumulative effect of a change in accounting principle, net of tax
    
—
    
—
    
(0.02
)
Earnings from continuing operations
    
2.05
    
1.93
    
1.89
  
Loss from discontinued operations, net of tax
    
(0.07
)
  
(0.01
)
  
(0.02
)
Earnings per share - basic
  
$
1.98
  
$
1.91
  
$
1.87
  
Earnings per share - diluted:
                    
Earnings from continuing operations before cumulative effect of a change in accounting principle 
  
$
2.02
  
$
1.89
  
$
1.88
  
Cumulative effect of a change in accounting principle, net of tax
    
—
    
—
    
(0.02
)
Earnings from continuing operations
    
2.02
    
1.89
    
1.86
  
Loss from discontinued operations, net of tax
    
(0.07
)
  
(0.01
)
  
(0.02
)
Earnings per share - diluted
  
$
1.95
  
$
1.88
  
$
1.84
  
Average number of shares outstanding - basic
    
120,291
    
123,155
    
125,359
  
Average number of shares outstanding - diluted
    
122,215
    
125,350
    
127,267
  

See accompanying Notes to Consolidated Financial Statements.


ENGELHARD CORPORATION
CONSOLIDATED BALANCE SHEETS

December 31 (in thousands)
  
2005
  
2004
  
           
Assets
          
Cash and cash equivalents
  
$
41,619
     
$
126,229
  
Receivables, net of allowances of $14,466 and $12,411, respectively
    
526,962
    
406,962
  
Committed metal positions
    
904,953
    
457,498
  
Inventories
    
532,638
    
458,020
  
Other current assets
    
145,392
    
140,740
  
Total current assets
    
2,151,564
    
1,589,449
  
Investments
    
204,495
    
179,160
  
Property, plant and equipment, net
    
936,193
    
902,751
  
Goodwill
    
400,719
    
330,798
  
Other intangible assets, net and other noncurrent assets
    
186,007
    
176,434
  
Total assets
  
$
3,878,978
  
$
3,178,592
  
 
Liabilities and shareholders’ equity
              
Short-term borrowings
  
$
48,784
  
$
11,952
  
Current maturities of long-term debt
    
120,852
    
73
  
Accounts payable
    
561,955
    
375,343
  
Hedged metal obligations
    
640,812
    
292,880
  
Other current liabilities
    
265,359
    
249,419
  
Total current liabilities
    
1,637,762
    
929,667
  
Long-term debt
    
430,500
    
513,680
  
Other noncurrent liabilities
    
321,554
    
320,933
  
Total liabilities
    
2,389,816
    
1,764,280
  
 
Shareholders’ equity
              
Preferred stock, no par value, 5,000 shares authorized but unissued
    
—
    
—
  
Common stock, $1 par value, 350,000 shares authorized and 147,295 shares issued
    
147,295
    
147,295
  
Additional paid-in capital
    
39,782
    
34,334
  
Retained earnings
    
1,980,893
    
1,800,531
  
Treasury stock, at cost, 27,172 and 25,393 shares, respectively
    
(634,116
)
  
(572,815
)
Accumulated other comprehensive (loss) income
   
(44,692
)
  
4,967
  
Total shareholders’ equity
    
1,489,162
    
1,414,312
  
Total liabilities and shareholders’ equity
  
$
3,878,978
  
$
3,178,592
  

See accompanying Notes to Consolidated Financial Statements.


ENGELHARD CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS

Year ended December 31 (in thousands)
  
2005
  
2004
  
2003
  
               
Cash flows from operating activities
              
Net earnings
  
$
238,242
    
$
235,528
    
$
234,223
  
Adjustments to reconcile net earnings to net cash provided by operating activities:
                    
Depreciation and depletion
    
126,933
    
124,951
    
124,315
  
Amortization of intangible assets
    
5,463
    
3,736
    
3,357
  
Loss on investment
    
239
    
663
    
—
  
Equity results, net of dividends
    
(17,167
)
  
(16,038
)
  
(14,805
)
Net change in assets and liabilities:
                    
Materials Services related
    
6,152
    
(31,566
)
  
107,590
  
All other
    
(101,768
)
  
6,107
    
(48,696
)
Net cash provided by operating activities
    
258,094
    
323,381
    
405,984
  
                     
Cash flows from investing activities
                    
Capital expenditures
    
(141,616
)
  
(123,168
)
  
(113,557
)
Proceeds from sale of investments
    
—
    
1,988
    
6,651
  
Acquisitions and other investments, net of cash acquired
    
(165,970
)
  
(68,640
)
  
(1,000
)
Net cash used in investing activities
    
(307,586
)
  
(189,820
)
  
(107,906
)
                     
Cash flows from financing activities
                    
Proceeds from short-term borrowings
    
31,163
    
—
    
—
  
Repayment of short-term borrowings
    
—
    
(56,250
)
  
(284,283
)
Repayment of long-term debt
    
(73
)
  
(73
)
  
(184
)
Proceeds from issuance of long-term debt
    
48,945
    
108,669
    
150,224
  
Purchase of treasury stock
    
(92,156
)
  
(113,027
)
  
(119,568
)
Cash from exercise of stock options
    
23,395
    
24,420
    
32,880
  
Dividends paid
    
(57,880
)
  
(54,281
)
  
(51,576
)
Net cash used in financing activities
    
(46,606
)
  
(90,542
)
  
(272,507
)
                     
Effect of exchange rate changes on cash
    
11,488
    
(4,679
)
  
14,072
  
Net (decrease)increase in cash
    
(84,610
)
  
38,340
    
39,643
  
Cash and cash equivalents at beginning of year
    
126,229
    
87,889
    
48,246
  
Cash and cash equivalents at end of year
  
$
41,619
  
$
126,229
  
$
87,889
  

See accompanying Notes to Consolidated Financial Statements.


ENGELHARD CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(in thousands, except per-share amounts)
  
Common stock
  
Additional paid-in capital
  
Retained earnings
  
Treasury stock
  
Comprehensive income(loss)
  
Accumulated other comprehensive income(loss)
  
Total shareholders’ equity
  
                               
Balance at December 31, 2002
  
$
147,295
    
$
20,876
    
$
1,436,637
    
$
(412,451
)  
       
$
(115,190
)  
$
1,077,167
  
Comprehensive income(loss):