UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-K

 

 

Commission file number 1-584

 

FERRO CORPORATION

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code: 216-641-8580

 

Securities Registered Pursuant to section 12(b) of the Act:

 

 

Securities Registered Pursuant to Section 12(g) of the Act:

91/8% Senior Notes due January 1, 2009

Series A ESOP Convertible Preferred Stock, without Par Value

 

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

 

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

 

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 þ     NO o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained here, 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.  þ

 

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

Large accelerated filer þ     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 Act).  YES o     NO þ

 

The aggregate market value of Ferro Corporation Common Stock, par value $1.00, held by non-affiliates and based on the closing sale price as of June 30, 2006, was approximately $658,239,000.

 

On January 31, 2007, there were 43,141,565 shares of Ferro Corporation Common Stock, par value $1.00 outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Proxy Statement for Ferro Corporation’s 2007 Annual Meeting of Shareholders are incorporated into Part III of this Annual Report on Form 10-K.

 

 

TABLE OF CONTENTS

 

PART I

 

History, Organization and Products

 

Ferro Corporation was incorporated in Ohio in 1919 as an enameling company. When we use the terms “Ferro,” “we,” “us” or “the Company,” we are referring to Ferro Corporation and its consolidated subsidiaries unless we indicate otherwise. Today, we are a leading producer of specialty materials and chemicals that are sold to a broad range of manufacturers who, in turn, make products for many end-use markets. In approximately 50 manufacturing sites around the world, we produce the following types of products:

 

 

We refer to our products as performance materials and chemicals because we formulate them to perform specific functions in the manufacturing processes and end products of our customers. The products we develop often are delivered to our customers in combination with customized technical service. The value of our products stems from the value they create in actual use. We develop and deliver innovative products to our customers through our key strengths in:

 

 

We divide our operations into eight business units, which comprise six reportable business segments. We have grouped these segments by their product group below:

 

 

 

 

 

Markets and Customers

 

Ferro’s products are used in a variety of product applications in markets including:

 

 

Many of our products are used as coatings on our customers’ products, such as glazes and decorations on tile, glass and dinnerware. Other products are applied as films in products such as solar cells and other electronic components. Still other products are added to other ingredients during our customers’ manufacturing processes to provide desirable properties to the end product. Often, our products are a small portion of the total cost of our customers’ products, but they can be critical to the appearance or functionality of those products.

 

Our leading customers include manufacturers of tile, major appliances, construction materials, automobiles, glass, multi-layer capacitors, solar cells, batteries, and pharmaceuticals. Many of our customers, including makers of major appliances and automobiles, purchase materials from more than one of our business units. Our customer base is well diversified both geographically and by end market.

 

We generally sell our products directly to our customers. However, a portion of our business uses indirect sales channels, such as distributors, to deliver products to market. In 2006, no single customer or related group of customers represented more than 10% of net sales. In addition, none of our reportable segments is dependent on any single customer or related group of customers.

 

Backlog of Orders and Seasonality

 

Generally, there is no significant lead time between customer orders and delivery in any of our business segments. As a result, we do not consider that the dollar amount of backlogged orders believed to be firm is material information for an understanding of our business. We also do not regard any material part of our business to be seasonal. However, customer demand has historically been higher in the second quarter when building and renovation markets are particularly active, and this quarter is normally the strongest for sales and operating profit.

 

Competition

 

In most of our markets, we have a substantial number of competitors, none of which is dominant. Due to the diverse nature of our product lines, no single competitor directly matches all our product offerings. Our competition varies by product and by region, and is based primarily on price, product quality and performance, customer service and technical support, and our ability to develop custom products to meet specific customer requirements.

 

We are a worldwide leader in the production of glass enamels, porcelain enamels and ceramic glaze coatings. There is strong competition in our markets, ranging from large multinational corporations to local producers. While many of our customers purchase custom products and formulations from us, our customers could generally buy from other sources, if necessary.

Raw Materials and Supplier Relations

 

Raw materials widely used in our operations include:

 

Metal Oxides:(1)

 

 

Polymers:(2)

 

 

Other Inorganic Materials:

 

 

Precious and Non-precious Metals:(3)

 

 

Other Organic Materials:(4)

 

 

 

 

These raw materials make up a large portion of our product costs in certain of our product lines, and fluctuations in the cost of raw materials may have a significant impact on the financial performance of the related businesses. We attempt to pass through to our customers raw material cost fluctuations, including those related to precious metals.

 

We have a broad supplier base and, in many instances, multiple sources of essential raw materials are available worldwide if problems arise with a particular supplier. We maintain many comprehensive supplier agreements for strategic and critical raw materials. In addition, the magnitude of our purchases provides for leverage in negotiating favorable conditions for supplier contracts. We did not encounter raw material shortages in 2006, but we are aware of potential future shortages in the world market for certain commodities. We expect to be affected by the cost increases relating to the shortages, but do not expect any interruptions in our production processes or deliveries to our customers.

 

Environmental Matters

 

As part of the production of some of our products, we handle, process, use and store hazardous materials. As a result of this, we operate manufacturing facilities that are subject to a broad array of environmental laws and regulations in the countries in which they operate, particularly for plant wastes and emissions. The costs to comply with complex environmental laws and regulations are significant and will continue for the industry and us for the foreseeable future. These routine costs are expensed as they are incurred. While these costs may increase in the future, they are not expected to have a material impact on our financial position, liquidity or results of operations. We believe that we are in compliance with the environmental regulations to which our operations are subject and

that, to the extent we may not be in compliance with such regulations, non-compliance will not have a materially adverse effect on our financial position, liquidity or results of operations.

 

Our policy is to operate our plants and facilities in a manner that protects the environment and the health and safety of our employees and the public. We intend to continue to make expenditures for environmental protection and improvements in a timely manner consistent with available technology. Capital expenditures for environmental control were $6.2 million in 2006, $3.3 million in 2005, and $7.1 million in 2004. These amounts pertain primarily to costs associated with environmental protection equipment. Although we cannot precisely predict future environmental capital spending, we do not expect the costs to have a material impact on our financial position, liquidity or results of operations.

 

We also accrue for environmental remediation costs when it is probable that a liability has been incurred and we can reasonably estimate the amount. We determine the timing and amount of any liability based upon assumptions regarding future events, and inherent uncertainties exist in such evaluations primarily due to unknown conditions, changing governmental regulations and legal standards regarding liability, and evolving technologies. We adjust these liabilities periodically as remediation efforts progress, the nature and extent of contamination becomes more certain, or as additional technical or legal information becomes available.

 

Research and Development

 

We are involved worldwide in research and development activities relating to new and existing products, services and technologies required by our customers’ continually changing markets. Our research and development resources are organized into centers of excellence that support our regional and worldwide major business units. We also conduct research and development activities at our Posnick Center for Innovative Technology in Independence, Ohio. These centers are augmented by local laboratories, which provide technical service and support to meet customer and market needs of particular geographic areas.

 

Expenditures for research and development activities for continuing operations were approximately $42.6 million in 2006, $38.4 million in 2005, and $42.4 million in 2004. Expenditures for individual customer requests for research and development were not material. During 2007, we expect to spend approximately $45.9 million on research and development.

 

Patents, Trademarks and Licenses

 

We own a substantial number of patents and patent applications relating to our various products and their uses. While these patents are of importance to us, we do not believe that the invalidity or expiration of any single patent or group of patents would have a material adverse effect on our businesses. Our patents will expire at various dates through the year 2025. We also use a number of trademarks that are important to our businesses as a whole or to a particular segment. We believe that these trademarks are adequately protected.

 

Employees

 

At December 31, 2006, we employed 6,660 full-time employees, including 4,367 employees in our foreign consolidated subsidiaries and 2,293 in the U.S. Total employment decreased from the prior year end due to our various restructuring and cost reduction programs.

 

Collective bargaining agreements cover approximately 21.8% of our U.S. workforce. Approximately 7.3% of the U.S. employees are affected by labor agreements that expire in 2007 and we expect to complete renewals of these agreements with no significant disruption to the related businesses. We consider our relations with our employees, including those covered by collective bargaining agreements, to be good.

 

Our employees in Europe have protections afforded them by local laws and regulations through works councils. Some of these laws and regulations may affect the timing, amount and nature of restructuring and cost reduction programs in that region.

 

Domestic and Foreign Operations

 

Financial information about our domestic and foreign operations by segment is included herein in Note 17 to the consolidated financial statements under Item 8 of this Form 10-K. More than 50% of our net sales are outside of the U.S. Our customers represent more than 30 industries and operate in approximately 100 countries.

 

We began international operations in 1927. Our products are produced and distributed through our subsidiaries in the following countries:

 

Wholly-owned:

 

 

Majority-owned and Controlled:

 

 

Our U.S. parent company receives technical service fees and/or royalties from many of its foreign subsidiaries. As a matter of corporate policy, the foreign subsidiaries have historically been expected to remit a portion of their annual earnings to the U.S. parent company as dividends. To the extent earnings of foreign subsidiaries are not remitted to the U.S. parent company, those earnings are indefinitely re-invested in those subsidiaries.

 

Available Information

 

Our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K, including any amendments, will be made available free of charge on our Web site, www.ferro.com, as soon as reasonably practical, following the filing of the reports with the U.S. Securities and Exchange Commission (“SEC”). Our Corporate Governance Principles, Legal and Ethical Policies, Guidelines for Determining Director Independence, and charters for our Audit Committee, Compensation Committee, Finance Committee, and Governance and Nomination Committee are available free of charge on our Web site or to any shareholder who requests them from the Ferro Corporation Investor Relations Department located at 1000 Lakeside Avenue, Cleveland, Ohio, 44114-1147.

 

Forward-looking Statements

 

Certain statements contained here and in future filings with the SEC reflect our expectations with respect to future performance and constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These statements are subject to a variety of uncertainties, unknown risks and other factors concerning our operations and the business environment, which are difficult to predict and are beyond our control.

 

Many factors could cause our actual results to differ materially from those suggested by statements contained in this filing and could adversely affect our future financial performance. Such factors include the following:

 

We depend on reliable sources of raw materials and other supplies at a reasonable cost, but the availability of these materials and supplies could be interrupted and/or their prices could escalate and adversely affect the Company’s sales and profitability.

 

We purchase many raw materials and supplies that we use to manufacture our products. Changes in their availability or price could affect our ability to manufacture enough products to meet customers’ demands or to manufacture products profitably. We try to maintain multiple sources of raw materials and supplies where practical, but this may not prevent unanticipated changes in their availability or cost. Significant disruptions in availability or cost increases could adversely affect our manufacturing volume or costs, which could negatively affect product sales or profitability of our operations.

 

The markets for our products are highly competitive and subject to intense price competition, and that could adversely affect the Company’s sales and earnings performance.

 

Our customers typically have multiple suppliers from which to choose. If we are unwilling or unable to provide products at competitive prices, and if other factors, such as product performance and value-added services do not provide an offsetting competitive advantage, customers may reduce, discontinue, or decide not to purchase our products. If we could not secure alternate customers for lost business, our sales and earnings performance could be adversely affected.

 

We strive to improve operating margins through sales growth, price increases, productivity gains, improved purchasing techniques and restructuring activities, but we may not achieve the desired improvements.

 

We work to improve operating profit margins through activities such as growing sales to achieve increased economies of scale, increasing prices, improving manufacturing processes, adopting purchasing techniques that lower costs or provide increased cost predictability, and restructuring businesses to realize cost savings. However, these activities depend on a combination of improved product design and engineering, effective manufacturing process control initiatives, cost-effective redistribution of production, and other efforts that may not be as successful as anticipated. The success of sales growth and price increases depends not only on our actions but also the strength of customer demand and competitors’ pricing responses, which are not fully predictable. Failure to successfully implement actions to improve operating margins could adversely affect our financial performance.

 

We sell our products into industries where demand has been unpredictable, cyclical or heavily influenced by consumer spending.

 

We sell our products to a wide variety of customers who supply many different market segments. Many of these market segments, such as building and renovation, major appliances and transportation, are cyclical or closely tied to consumer demand, which is difficult to predict. Incorrect forecasts of demand or unforeseen reductions in demand can adversely affect costs and profitability due to factors such as underused manufacturing capacity, excess inventory, or working capital needs. These factors can result in lower profitability.

 

The global scope of our operations exposes us to risks related to currency conversion rates and changing economic, social and political conditions around the world.

 

In order to support global customers, access regional markets and compete effectively, our operations are located around the world. As a result, our operations have additional complexity from changing economic, social and political conditions in multiple locations. While we attempt to anticipate these changes and manage our business appropriately, these changes are often beyond our control and difficult to forecast. The consequences of these risks may have significant adverse effects on our results of operations or financial position.

 

We have a growing presence in the Asia/Pacific region where it can be difficult for a U.S.-based company, such as Ferro, to compete lawfully with local competitors.

 

Many of our most promising growth opportunities are in the Asia/Pacific region, especially the People’s Republic of China. Although we have been able to compete successfully in those markets to date, local laws and customs can make it difficult for a U.S.-based company to compete on a “level playing field” with local competitors without engaging in conduct that would be illegal under U.S. law. Our strict policy of observing the highest standards of legal and ethical conduct may cause us to lose some otherwise attractive business opportunities to local competition in the region.

 

Regulatory authorities in the U.S., European Union and elsewhere are taking a much more aggressive approach to regulating hazardous materials, and those regulations could affect sales of our products.

 

Hazardous material legislation and regulations can restrict the sale of products and/or increase the cost of producing them. Some of our products are subject to restrictions under laws or regulations such as California Proposition 65 or the European Union’s (“EU”) hazardous substances directive. The proposed EU “REACH” registration system, for example, would require us to perform toxicity studies of the components of some of our products and to register the information in a central database, increasing the cost of these products. As a result of these hazardous material regulations, customers may avoid purchasing some products in favor of perceived “greener,” less hazardous or less costly alternatives. This factor could adversely affect our sales and operating profits.

 

Our operations are subject to stringent environmental, health and safety regulations, and compliance with those regulations could require us to make significant investments.

 

We strive to conduct our manufacturing operations in a manner that is safe and in compliance with all applicable environmental, health and safety regulations. Compliance with changing regulations may require us to make significant capital investments, incur training costs, make changes in manufacturing processes or product formulations, or incur costs that could adversely affect the Company’s profitability. These costs may not affect competitors in the same way due to differences in product formulations, manufacturing locations or other factors, and we could be at a competitive disadvantage, which might adversely affect financial performance.

 

We depend on external financial resources, and any interruption in access to capital markets or borrowings could adversely affect our financial condition.

 

As of December 31, 2006, the Company had approximately $592 million of short-term and long-term debt with varying maturities. These borrowings have allowed us to make investments in growth opportunities and fund working capital requirements. Our continued access to capital markets is essential if we are to meet our current obligations as well as fund our strategic initiatives. An interruption in our access to external financing could adversely affect our business prospects and financial condition. See further information regarding the Company’s liquidity in Note 5 to the consolidated financial statements included under Item 8 of this Form 10-K.

 

Interest rates on some of our borrowings are variable, and our borrowing costs could be affected adversely by interest rate increases.

 

Portions of our debt obligations have variable interest rates. Generally, when interest rates rise, as they have over the last year, the Company’s cost of borrowings increases. We estimate, based on the debt obligations outstanding at December 31, 2006, that a one percent increase in interest rates would cause interest expense to increase by approximately $4.8 million annually. Continued interest rate increases could raise the cost of borrowings and adversely affect our financial performance. See further information regarding the Company’s liquidity in Note 5 to the consolidated financial statements included under Item 8 of this Form 10-K.

 

Many of our assets are encumbered by liens that have been granted to lenders, and those liens affect our flexibility to dispose of property and businesses.

 

Our debt obligations are secured by substantially all of the Company’s assets. These liens could reduce our ability and/or extend the time to dispose of property and businesses, as these liens must be cleared or waived by the lenders prior to any disposition. These security interests are described in more detail in Note 5 to the consolidated financial statements under Item 8 of this Form 10-K.

 

We are subject to a number of restrictive covenants under our credit facilities, and those covenants could affect our flexibility to fund strategic initiatives.

 

Our credit facilities contain a number of restrictive covenants as described in more detail in Note 5 to the consolidated financial statements under Item 8 of this Form 10-K. These covenants include customary operating restrictions that limit our ability to engage in certain activities, including additional loans and investments; prepayments, redemptions and repurchases of debt; and mergers, acquisitions and asset sales. We are also subject to customary financial covenants including a leverage ratio and a fixed charge coverage ratio. These covenants restrict the amount of our borrowings, reducing our flexibility to fund strategic initiatives. Breaches of these covenants could become defaults under our credit facilities and cause the acceleration of debt payments beyond our ability to pay.

 

We have significant deferred tax assets, and our ability to utilize these assets will depend on the Company’s future performance.

 

To fully realize the carrying value of our net deferred tax assets, we will have to generate adequate taxable profits in various tax jurisdictions. As of December 31, 2006, the Company had $101.2 million of net deferred tax assets, after a valuation allowance. If the Company does not generate adequate profits within the time periods required by applicable tax statutes, the carrying value of the tax assets will not be realized. If it becomes unlikely that the carrying value of our net deferred tax assets will be realized, the valuation allowance may need to be increased in our financial statements, adversely affecting results of operations. Further information on our deferred tax assets is presented in Note 7 to the consolidated financial statements under Item 8 of this Form 10-K.

 

We are a defendant in several lawsuits that could have an adverse effect on our financial condition and/or financial performance, unless they are successfully resolved.

 

We are routinely involved in litigation brought by suppliers, customers, employees, governmental agencies and others. Litigation is an inherently unpredictable process and unanticipated negative outcomes are possible. The most significant pending litigation is described in Item 3 — Legal Proceedings of this Form 10-K.

 

Our businesses depend on a continuous stream of new products, and failure to introduce new products could affect our sales and profitability.

 

One way that we remain competitive in our markets is by developing and introducing new and improved products on an ongoing basis. Customers continually evaluate our products in comparison to those offered by our competitors. A failure to introduce new products at the right time that are price competitive and that provide the features and performance required by customers could adversely affect our sales, or could require us to compensate by lowering prices. The result could be lower sales and/or lower profitability.

 

Employee benefit costs, especially postretirement costs, constitute a significant element of our annual expenses, and funding these costs could adversely affect our financial condition.

 

Employee benefit costs are a significant element of our cost structure. Certain expenses, particularly postretirement costs under defined benefit pension plans and healthcare costs for employees and retirees, may increase significantly at a rate that is difficult to forecast and may adversely affect our financial results, financial condition or cash flows.

 

We are exposed to risks associated with acts of God, terrorists and others, as well as fires, explosions, wars, riots, accidents, embargos, natural disasters, strikes and other work stoppages, quarantines and other governmental actions, and other events or circumstances that are beyond our control.

 

The Company is exposed to risks from various events that are beyond its control, which may have significant effects on its results of operations. While we attempt to mitigate these risks through appropriate insurance, contingency planning and other means, we may not be able to anticipate all risks or to reasonably or cost-effectively manage those risks that we do anticipate. As a result, our results of operations could be adversely affected by circumstances or events in ways that are significant and/or long lasting.

 

The risks and uncertainties identified above are not the only risks that we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial also may adversely affect the Company. If any known or unknown risks and uncertainties develop into actual events, these developments could have material adverse effects on our financial position, results of operations, and cash flows.

 

None.

 

Our corporate headquarters offices are located at 1000 Lakeside Avenue, Cleveland, Ohio. The Company also owns other corporate facilities, including a centralized research and development facility, which are located in Independence, Ohio. We own principal manufacturing plants that range in size from 17,000 sq. ft. to over 500,000 sq. ft. Plants with more than 250,000 sq. ft. are located in: Germany; Spain; Niagara Falls, New York; Penn Yan, New York; Fort Worth, Texas; and France. The locations of these principal manufacturing plants by reportable business segment are as follows:

 

Performance Coatings — U.S.: Cleveland, Ohio. Outside the U.S.: Argentina, Australia, China, France, Indonesia, Italy, Mexico, the Netherlands, Spain, Thailand and Venezuela.

 

Electronic Materials — U.S.: Penn Yan, New York; South Plainfield, New Jersey; and Niagara Falls, New York. Outside the U.S.: the Netherlands.

 

Color and Glass Performance Materials — U.S.: Toccoa, Georgia; Orrville, Ohio; and Washington, Pennsylvania. Outside the U.S.: Australia, China, France, Germany, Italy, Mexico, United Kingdom and Venezuela.

 

Polymer Additives — U.S.: Bridgeport, New Jersey; Cleveland, Ohio; Walton Hills, Ohio; and Fort Worth, Texas.

 

Specialty Plastics — U.S.: Evansville, Indiana; Plymouth, Indiana; Edison, New Jersey; and Stryker, Ohio. Outside the U.S.: the Netherlands and Spain.

 

Other — U.S.: Waukegan, Illinois; and Baton Rouge, Louisiana. Outside the U.S.: China

 

In October 2005, the Dutch government placed a lien on one of our facilities in the Netherlands as collateral for any future payment relating to an unresolved environmental claim. In March 2006, as a result of a credit rating downgrade, lenders of the Company’s revolving credit facility, senior notes and debentures became entitled to security interest in the Company’s and its domestic material subsidiaries’ real estate. This security interest was substantially completed in April 2006. Ferro’s current revolving credit and term loan facility, which was established in June 2006, also shares in this security interest.

 

In September 2006, we announced we had begun construction of a new manufacturing plant at our existing location in Almazora, Spain. The new plant will include approximately 125,000 sq. ft. of manufacturing space and will produce colors for the European tile coatings market. The new facility is expected to begin commercial production in the fourth quarter of 2007. In November 2006, we announced that we will cease production at our Niagara Falls, New York, manufacturing facility by the end of 2007 and will transfer some of its production to other Ferro production facilities.

 

In addition, we lease manufacturing facilities for the Performance Coatings segment in Brazil and Italy; for the Electronic Materials segment in Vista, California, Germany and Japan; for the Color and Glass Performance Materials segment in Japan and Portugal; for the Polymer Additives segment in Belgium and the United Kingdom; and for the Specialty Plastics segment in Carpentersville, Illinois. In some instances, the manufacturing facilities are used for two or more business segments. Leased facilities range in size from 23,000 sq. ft. to over 300,000 sq. ft. at a plant located in Portugal.

 

In February 2003, we were requested to produce documents in connection with an investigation by the United States Department of Justice into possible antitrust violations in the heat stabilizer industry. In April 2006, we were notified by the Department of Justice that the Government had closed its investigation and that the Company was relieved of any obligation to retain documents that were responsive to the Government’s earlier document request. Before closing its investigation, the Department of Justice took no action against the Company or any of its current or former employees. The Company was previously named as a defendant in several lawsuits alleging civil damages and requesting injunctive relief relating to the conduct the Government was investigating. We are vigorously defending the Company in those actions and believe we would have a claim for indemnification by the former owner of our heat stabilizer business if the Company were found liable. Because these actions are in their preliminary stages, we cannot determine the outcomes of these lawsuits at this time.

 

In a July 2004 press release, we announced that our Polymer Additives business performance in the second quarter of 2004 fell short of expectations and that our Audit Committee would investigate possible inappropriate accounting entries in the Polymer Additives business. We were later sued in a series of putative securities class action lawsuits related to this July 2004 announcement. Those lawsuits were consolidated into a single case, and the consolidated case is currently pending in the United States District Court for the Northern District of Ohio against the Company, our deceased former Chief Executive Officer, our former Chief Financial Officer, and a former operating Vice President of the Company. This claim is based on alleged violations of Federal securities laws. We consider these allegations to be unfounded and are defending this action vigorously. We have notified Ferro’s directors and officers liability insurer of the claim. Because this action is in its preliminary stage, we cannot determine the outcome of this litigation at this time.

 

Also following this July 2004 press release, four derivative lawsuits were filed and subsequently consolidated in the United States District Court for the Northern District of Ohio. These lawsuits alleged breach of fiduciary duties and mismanagement-related claims. In March 2006, the Court dismissed the consolidated derivative action without prejudice. In April 2006, the plaintiffs filed a motion seeking relief from the judgment that dismissed the derivative lawsuit and seeking to amend their complaint further following discovery. The plaintiffs’ motion was denied. Later in April 2006, plaintiffs filed a Notice of Appeal to the Sixth Circuit Court of Appeals. The Directors and named executives consider the allegations contained in the derivative actions to be unfounded, have vigorously defended this action and will defend against the new filing. We have notified Ferro’s directors and officers liability insurer of the claim. Because this appeal is in the preliminary stage, we cannot determine the outcome of this litigation at this time.

 

Finally, in June 2005, a putative class action lawsuit was filed against the Company and certain former and current employees alleging breach of fiduciary duty with respect to ERISA plans in connection with the matters announced in the July 2004 press release. In October 2006, the parties reached a settlement in principle that would result in the dismissal of the lawsuit with prejudice in exchange for a settlement amount of $4.0 million, which would be paid by the Company’s liability insurer subject to our satisfaction of the remaining retention amount under the insurance policy. The Company and the individual defendants have expressly denied any and all liability. The United States District Court granted preliminary approval of the settlement in November 2006. Several conditions must be met before the settlement becomes final. We do not expect the ultimate outcome of the lawsuit to have a material effect on the financial position, results of operations or cash flows of the Company.

 

In October 2004, the Belgian Ministry of Economic Affairs’ Commercial Policy Division (the “Ministry”) served on our Belgian subsidiary a mandate requiring the production of certain documents related to an alleged cartel among producers of butyl benzyl phthalate (“BBP”) from 1983 to 2002. Subsequently, German and

Hungarian authorities initiated their own national investigations related to the same allegations. Our Belgian subsidiary acquired its BBP business from Solutia Europe S.A./N.V. (“SOLBR”) in August 2000. Ferro promptly notified SOLBR of the Ministry’s actions and requested SOLBR to indemnify and defend Ferro and its Belgian subsidiary with respect to these investigations. In response to our notice, SOLBR exercised its right under the 2000 acquisition agreement to take over the defense and settlement of these matters. In December 2005, the Hungarian authorities imposed a de minimus fine on our Belgian subsidiary, and we expect the German and Belgian authorities also to assess fines for the alleged conduct. We cannot predict the amount of fines that will ultimately be assessed and cannot predict the degree to which SOLBR will indemnify Ferro’s Belgian subsidiary for such fines.

 

In October 2005, we disclosed to the New Jersey Department of Environmental Protection (“NJDEP”) that we had identified potential violations of the New Jersey Water Pollution Control Act, and that we had started an investigation of the possible violations. We also committed to report any violations and to undertake any necessary remedial actions. In September 2006, we entered into an agreement with the NJDEP under which we paid the State of New Jersey a civil administrative penalty of approximately $0.2 million in full settlement of the violations. In December 2006, a former employee pled guilty to a charge of negligently submitting false information and was fined accordingly.

 

In late February 2007, we discovered that some of the values shown on certificates of analysis provided to customers by its Specialties Plastics business were inaccurate. While we are uncertain as to when these inaccuracies began or their source, we believe the material currently being shipped by our Specialty Plastics business is consistent with the overall quality of past shipments. We are in the process of compiling historical physical properties data on products supplied to customers in the past and will work with the customers to show how the historical data can be utilized as the basis for establishing shipping specifications consistent with what those customers have been receiving. While it is possible some customers may not accept products with the new shipping specifications or otherwise may assert claims relating to this issue, we cannot predict at this time the financial effects of any resulting lost business or claims.

 

There are various other lawsuits and claims pending against the Company and its consolidated subsidiaries. In our opinion, the ultimate liabilities, if any, and expenses resulting from such lawsuits and claims will not materially affect the consolidated financial position, results of operations, or cash flows of the Company.

 

At Ferro Corporation’s 2006 Annual Meeting of Shareholders held on November 3, 2006, there were a total of 40,171,441 shares represented either in person or by proxy.

 

The shareholders elected three Directors to the Ferro Corporation Board of Directors, Jennie S. Hwang, Ph.D., James F. Kirsch, and William J. Sharp, to serve on the Board until the meeting in the year 2009. The results of the voting for Directors were as follows.

 

 

The terms of office for Michael H. Bulkin, Sandra Austin Crayton, William B. Lawrence, Michael F. Mee, Dennis W. Sullivan, and Alberto Weisser continued after the meeting.

 

Shareholders approved the 2006 Long-Term Incentive Plan. The vote was 24,691,739 for; 11,927,139 against; and 843,804 abstaining.

 

Shareholders approved an amendment of Ferro’s Code of Regulations to permit notice of shareholder meetings via electronic communication. The vote was 39,653,898 for; 402,780 against; and 114,763 abstaining.

 

Executive Officers of the Registrant

 

The executive officers of the Company as of February 28, 2007, are listed below, along with their ages and positions held during the past five years. The year indicates when the individual was named to the indicated position. No family relationship exists between any of Ferro’s executive officers.

 

James F. Kirsch — 49

Chairman, President and Chief Executive Officer, 2006

President and Chief Executive Officer, 2005

President and Chief Operating Officer, 2004

President, Premix Inc., and President, Quantum Composites Inc., manufacturers of thermoset molding compounds, parts and sub-assemblies for the automotive, aerospace, electrical and HVAC industries, 2002

 

Sallie B. Bailey — 47

Vice President and Chief Financial Officer, 2007

Senior Vice President-Finance and Controller, The Timken Company, an international manufacturer of highly engineered bearings and alloy steels and provider of related products and services, 2003

Corporate Controller, The Timken Company, 2001

 

James C. Bays — 57

Vice President, General Counsel and Secretary, 2006

Vice President and General Counsel, 2001

 

Ann E. Killian — 52

Vice President, Human Resources, 2005

Vice President, Human Resources, W. W. Holdings, LLC, a manufacturer and distributor of doors, frames and hardware products for the commercial construction industry, 2003

Vice President, Compensation & Benefits, TRW Inc., a provider of advanced technology products and services for the global automotive, aerospace and information systems markets, 1999

 

Celeste Beeks Mastin — 38

Vice President, Growth and Development, 2006

Vice President, Color and Glass Performance Materials, 2004

World Wide Business Director, Performance Pigments and Colors, 2003

Vice President and General Manager, Bostik Findley, Inc., Nonwovens Division, a global producer of adhesives, 2001

 

Michael J. Murry — 55

Vice President, Inorganic Specialties, 2006

Vice President, Performance Coatings, 2005

President, Chief Executive Officer, and Director, Catalytica Energy Systems, Inc., a provider of products that reduce nitrogen oxides (NOx) emissions for the transportation and power generation industries, 2003

Vice President and General Manager, Ballard Power Systems Inc., a producer of hydrogen proton exchange membrane (PEM) fuel cells and component systems, 2001

 

Barry D. Russell — 42

Vice President, Electronic Material Systems, 2006

Group Vice President and General Manager, Electronic Materials, Honeywell International, a provider of aerospace products and services; control technologies for buildings, homes, and industry; turbo chargers; automotive products; and specialty materials, 2004

Business Director and General Manager, Specialty Additives, Honeywell International, 2002

 

Peter T. Thomas — 51

Vice President, Organic Specialties, 2006

Vice President, Pharmaceuticals and Fine Chemicals and Polymer Additives, 2004

Vice President, Pharmaceuticals and Fine Chemicals, 2003

Worldwide Business Director, Pharmaceuticals and Fine Chemicals, 2002

 

PART II

 

The following table presents selected financial data for the last five years ended December 31:

 

 

On September 30, 2002, we sold our Powder Coatings business unit. On June 30, 2003, the Company sold its Petroleum Additives business and its Specialty Ceramics business. For all periods presented, we report those businesses as discontinued operations. The divestiture of the Powder Coatings, Petroleum Additives and Specialty Ceramics businesses are further discussed in Note 15 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K.

 

Overview

 

Market conditions in 2006 were generally favorable and sales increased in a number of product lines and regions. Sales increased most significantly in our Electronic Materials, Performance Coatings and Color and Glass Performance Materials segments. Sales grew at a slower pace in our Polymer Additives segment, and declined in Specialty Plastics. Both the Polymer Additives and Specialty Plastics segments were affected by weaker demand during the second half of the year from North American customers serving residential construction and automotive markets. For the year, sales increased by approximately 3% in North America, 15% in Europe, 17% in Asia and 17% in Latin America. Total company sales increased by 8.5%.

 

Beyond fundamental product demand, the factors that most affected 2006 results included the following:

 

 

Prices for a number of raw materials increased significantly during the year. Natural gas prices were high in the beginning of the year, but moderated somewhat as the year progressed. We were able to adjust product prices higher, in aggregate, to cover increases in raw material costs. We also reformulated certain products to provide customers with alternatives that used less costly raw materials. In some cases we also employed hedging strategies to reduce the volatility of our raw material costs and provide more time to change prices in anticipation of future raw material cost increases.

 

During 2006, our debt levels increased, largely as a result of increased deposit requirements for precious metal consignment arrangements and for increased working capital to support higher sales. In addition, we entered into new revolving credit and term loan agreements during the year that included higher interest rates than the

agreements they replaced. As a result, our interest expense increased. Also during 2006, we initiated multiple restructuring programs that are expected to reduce our operating costs in future years. As part of these programs, we recorded asset impairments, accelerated depreciation, severance and other costs that reduced our overall profitability.

 

In 2006, we recorded costs associated with the accounting investigation and restatements of our 2003 and first quarter 2004 consolidated financial statements. We completed the restatements of those financial statements in 2006 and became current in our financial filings with the SEC.

 

Total segment income increased in 2006 to $151.8 million from $118.0 million in 2005. This improvement was driven by increases in the Electronic Materials, Performance Coatings, Color and Glass Performance Materials and Specialty Plastics segments, primarily as the result of improved prices. Segment income in Polymer Additives declined for the year, primarily as a result of higher manufacturing costs throughout the year and weaker sales volume in the fourth quarter.

 

Income from continuing operations for the year increased to $20.6 million from $17.1 million in 2005. The primary reasons for the increase were higher sales, improving gross profit, lower selling, general and administrative expenses, increased interest earned and lower taxes. These improvements were partially offset by higher restructuring-related costs and increased interest expense.

 

During 2006, working capital increased as a result of higher receivables and inventory levels required to support increased sales. As a result of the higher working capital requirements, including cash deposit requirements for precious metal consignments, total short-term and long-term debt increased by $38.7 million. Also, at the end of 2006, our note receivable from Ferro Finance Corporation (“FFC”), a wholly-owned unconsolidated qualified special purpose entity, was $16.1 million, down from $111.9 million at the end of 2005. This change reflects proceeds from FFC in excess of trade accounts receivable sold to FFC during 2006 in our primary receivable sales program. An additional $25.0 million investment by Ferro Corporation in FCC was the primary driver of an increase in other non-current assets at the end of 2006, compared with the end of 2005. Post retirement and pension liabilities declined in 2006, primarily as the result of $37.3 million in curtailments resulting from changes to our U.S. pension and post retirement benefit programs, as announced in February 2006, and settlements paid, primarily to the beneficiaries of our deceased former Chief Executive Officer, from a non-qualified defined benefit retirement plan.

 

Our financial condition and the refinancing of our former credit facility significantly affected the nature of our 2006 cash flows. This resulted in a decrease in net borrowing cash flows for 2006 as compared with 2005 of $11.5 million and the payment of debt issue costs in 2006 of $16.2 million. Also as a result of our financial condition in 2006, we were required to invest $25.0 million in Ferro Finance Corporation and to place $51.1 million more on deposit for precious metals. In 2005, we were required to place $11.0 million more on deposit for precious metals. Increased working capital requirements for accounts receivable and inventories aggregating $47.0 million negatively impacted operating cash flows for 2006. These were offset by increased net income of $3.8 million, increased non-cash restructuring charges of $19.5 million, increased depreciation expense of $4.7 million due to accelerated depreciation, other changes in working capital aggregating $6.9 million, and increased proceeds from our asset securitization program of $101.9 million, which positively impacted operating cash flows for 2006.

 

Outlook

 

Economic conditions continue to be generally favorable, although we expect differences between geographic regions. We expect to continue overall sales growth, although weaker demand in the United States, particularly from customers serving markets related to residential construction and automotive production, is expected to continue for several quarters. We expect to continue to record charges associated with current and future restructuring programs, particularly related to our rationalization of the manufacturing assets in our European operations. Interest expense is expected to decline somewhat from the levels experienced during the final quarter of 2006 as a result of lower deposit requirements on precious metals and slightly lower interest rates realized by becoming current on our financial reporting.

 

Results of Operations

 

Comparison of the years ended December 31, 2006 and 2005

 

 

Sales from continuing operations grew by 8.5% in 2006, driven primarily by improved pricing and product mix throughout the world. Improved volumes in Europe and Latin America were offset by volume declines in North America and Asia. On a consolidated basis, favorable changes in foreign exchange rates increased sales by less than one percent.

 

Gross profit increased during 2006, compared with 2005. The increase in gross profit was the result of higher sales, and prices that increased more than the aggregate increase in raw material costs. Gross margin percentage, defined as gross profit as a percentage of sales, declined in 2006, compared with 2005, as a result of accelerated depreciation costs and higher precious metal prices. Gross profit was reduced by $4.6 million in 2006 as a result of costs associated with our manufacturing rationalization programs. Higher precious metal costs also contributed to the decline in gross margin percentage because changes in precious metal prices are generally passed through to customers without gross margin contribution.

 

Selling, general and administrative (SG&A) costs decreased by $4.8 million during 2006, while SG&A expenses as a percent of revenues declined from 16.5% to 15.0% during the year. Charges of $8.2 million, primarily related to the accounting investigation and restatement, were recorded as part of SG&A expense during 2006. These charges were $2.3 million less than the amount recorded in 2005. This reduction in 2006 SG&A expense was partially offset by other expense increases required to support the growth in sales, particularly in our Electronic Materials business. During the first quarter of 2006, we announced changes to some of our postretirement benefit programs. Certain employees who had been participating in our largest defined benefit program stopped accruing benefit service after March 31, 2006. In addition, we limited eligibility for retiree medical and life insurance coverage to those employees who were 55 years of age or older with 10 or more years of service as of December 31, 2006. Benefits under these programs will be available only to those employees who retire by December 31, 2007, after having advised us of their retirement plans by March 31, 2007. These changes resulted in a one-time benefit of $5.0 million in the second quarter of 2006. Offsetting this benefit was a $4.9 million settlement loss from a

nonqualified benefit retirement plan, related primarily to a lump sum payment to the beneficiary of Ferro’s deceased former Chief Executive Officer.

 

Restructuring charges of $23.1 million were recorded in 2006, primarily associated with the consolidation and closing of some of our manufacturing assets in our Performance Coatings and Color and Glass Performance Materials segments in Europe and our Electronic Materials segment in the United States.

 

Interest expense was higher in 2006 as a result of increased debt levels and higher interest rates. Our total borrowings were increased, in part, as a result of higher cash deposit requirements on precious metal consignment arrangements. These deposits increased from $19.0 million at the end of 2005 to $70.1 million at the end of 2006. We expect that these deposit requirements will be less in 2007, as a result of our regaining current status on financial reporting and our efforts to negotiate more favorable terms from participants in our consignment programs. Borrowings also increased as a result of other increased working capital requirements used to support higher sales levels. During 2006, inventories increased to $254.5 million from $215.3 million in 2005. Net receivables increased to $220.9 million from $182.4 million in the prior year. Also included in the 2006 interest expense are charges of $2.5 million associated with previously unamortized fees and discounts related to certain of our debentures that were repaid in July and August 2006 and previously unamortized fees related to our former revolving credit facility.

 

Interest earned during 2006 increased to $4.5 million from $0.5 million in 2005 primarily as a result of interest earned on cash deposits associated with our precious metal consignments.

 

Net foreign currency losses were largely unchanged from 2005 to 2006. We use certain foreign currency financial instruments to offset, or hedge, short-term transactions that are denominated in non-dollar currencies. The carrying values of these contracts are adjusted to market value and the resulting gains or losses are charged to income or expense in the period.

 

In 2006, we recognized a $0.4 million gain on the sale of our interest in Chilches Materials SA, an unconsolidated affiliate, and a $0.3 million loss from the liquidation of Ferro Toyo Company Limited, a consolidated subsidiary.

 

Net miscellaneous income from continuing operations was $0.1 million in 2006, compared with income of $1.6 million in 2005. Within net miscellaneous income during 2006, we recorded a gain of $2.4 million for a legal settlement in a class action lawsuit for price fixing in the rubber chemicals industry. In addition, we recorded a loss of $2.5 million associated with mark-to-market supply contracts, mainly for natural gas. During 2005, we recorded a gain of $3.1 million associated with supply contracts.

 

For the year, taxes on continuing income were $5.0 million, or 19.6% of income, compared to $6.9 million or 28.8% of income in 2005. The primary reason for the decrease in 2006 was a net decrease in our valuation allowance due to our determination that it is more likely than not certain deferred assets would be realized, and a tax rate change in the Netherlands affecting our deferred income taxes. The decrease was partially offset by an allowance for unremitted earnings from foreign subsidiaries no longer considered indefinitely reinvested.

 

There were no new businesses included in discontinued operations in 2006. We recorded a loss of $0.5 million, net of taxes, in 2006 related to post-closing matters associated with businesses we sold in previous years.

 

 

Performance Coatings Segment Results.  Sales grew in Performance Coatings as a result of improved pricing across the business and improved volumes in the tile coatings portion of the business. Sales growth was strong in North America, Europe and Latin America, while overall sales in Asia declined modestly. Growth in Asia was negatively impacted by natural gas supply issues in Indonesia, which affected both our own and our customers’ manufacturing operations. Favorable currency exchange rates also contributed to the sales increase for the year. Operating income increased during 2006 primarily because pricing was increased in excess of raw material cost increases. In addition, the mix of products was more favorable, particularly in our porcelain enamel business.

 

Electronic Materials Segment Results.  Sales in Electronic Materials were sharply higher for the year due to strong customer demand for metal pastes for solar cells and materials for multilayer capacitors, compared with 2005 when customers’ demand was weak for capacitor materials in the first half of the year. In addition, higher precious metals prices, which are passed through to customers, contributed to the sales increase. Sales increased in North America, Asia and Europe. Operating income increased as a result of the combination of improved volume, product mix, pricing and lower manufacturing costs. These improvements more than offset increases in raw material costs and increased product development expense.

 

Color and Glass Performance Materials Segment Results.  Sales in Color and Glass Performance Materials increased primarily as a result of improved pricing. Sales growth was the strongest in Europe, and sales also grew in Latin America and Asia. Sales were relatively flat in North America. Operating income increased as improved pricing more than offset increased raw material costs.

 

Polymer Additives Segment Results.  Sales in Polymer Additives increased for the year, although the growth rate was negatively impacted by weak demand in North America during the fourth quarter. This weakness was mainly due to reduced customer demand for products used in residential construction. For the year, improved pricing and product mix more than offset declines in volume. Sales increases in Europe were partially offset by declines in North America. Segment income declined for the year. Although price increases exceeded raw material cost increases for the year, these increases were not enough to offset lower volumes and increased manufacturing costs, resulting in a decline in segment income.

 

Specialty Plastics Segment Results.  Sales declined in Specialty Plastics primarily as a result of weakness in the North American market during the second half of the year. During that period, customer demand related to U.S. residential construction and automotive production declined, leading to lower sales volume. Although prices increased, they did not increase enough to offset the lower volume. Despite the lower volume, operating income increased due to price increases, lower manufacturing costs and lower SG&A expenses, which together more than offset raw material cost increases.

 

 

Sales increased in the United States, driven by increases in Electronic Materials and Performance Coatings. These increases were partially offset by U.S. sales declines in Polymer Additives and Specialty Plastics. International sales increases occurred in Europe, Asia and Latin America and were primarily within the Performance Coatings, Color and Glass Performance Materials and Performance Coatings segments.

 

Comparison of the years ended December 31, 2005 and 2004

 

 

Revenue gains in 2005 over 2004 were driven by improved pricing and more favorable product mix in North America, Asia-Pacific and Latin America. Weakness in the market for multilayer capacitors depressed unit demand and revenues, particularly in the first half of 2005. On a consolidated basis, the impact of strengthening foreign currencies versus the U.S. dollar had only a minimal positive impact on revenues.

 

The reduced gross margin percentage was mainly due to a combination of higher raw materials costs and lower customer unit demand, partially offset by a more favorable price and mix of products sold.

 

As a percent of sales, selling, general and administrative (SG&A) expenses were 16.5% in 2005, compared with 16.8% in the prior-year period. The lower SG&A expense primarily was driven by ongoing cost reduction measures which resulted in a decline in spending for sales, technical service, research and development, partially offset by an increase in fees related to the accounting investigation and restatement. During 2005, we recorded as part of SG&A expenses $10.5 million relating to the accounting investigation and restatements of our 2003 and first quarter 2004 consolidated financial statements.

 

The increase in interest expense was due to the combined effect of higher interest rates on our variable-rate borrowings and increased borrowing levels. Long-term debt increased to $547.9 million on December 31, 2005, compared with $498.8 million on December 31, 2004. The increase was partially due to increased deposit requirements on precious metal consignment agreements in the fourth quarter of 2005. In addition, increased borrowings were made to support higher working capital requirements, primarily driven by a decline in accounts payable.

 

We use certain foreign currency instruments to offset the effect of changing exchange rates on foreign subsidiary earnings and short-term transaction exposures. The carrying values of such contracts are adjusted to market value and resulting gains or losses are charged to income or expense in the period.

 

In 2004, we recognized $5.2 million as gain on sale of business and related to the sale of our interest in Tokan Material Technology Co. Limited, which was an unconsolidated affiliate. There were no divestitures made in 2005.

 

During 2005, we recorded gains of $3.1 million associated with marked-to-market forward supply contracts, primarily for natural gas. During 2004, we recorded a loss of $1.7 million from marked-to-market supply contracts. Partially offsetting this 2005 increase were higher minority interest expenses, lower realized gains on investments designated to fund payments for a nonqualified benefit plan, and lower gains on sales of fixed assets in 2005.

 

Income tax as a percentage of pre-tax income from continuing operations for the year ended December 31, 2005, was 28.8% compared with 10.7% for the year ended December 31, 2004. The primary reason for the increase in 2005 was our 2004 reversal of valuation allowances due to utilization of net operating losses and our determination that, more likely than not, certain deferred tax assets would be realized. Also contributing to the higher effective tax rate in 2005 was a higher proportion of earnings in jurisdictions having higher effective tax rates.

 

Discontinued operations relate to the Powder Coatings, Petroleum Additives and Specialty Ceramics business that were sold in 2002 and 2003. However, we recorded costs in both 2005 and 2004 related to certain post-closing matters associated with these businesses.

 

 

Performance Coatings Segment Results.  The higher revenue in the Performance Coatings segment was due to price increases and a favorable mix of products, as well as improved volumes. Growth was mainly within our tile coatings business, and was distributed across the Asia-Pacific, European and North American markets. The increase in segment gross profit was driven primarily by increased volume and higher average selling prices, which more than offset higher raw materials costs.

 

Electronic Materials Segment Results.  The decline in revenue for our Electronic Materials segment was largely due to weakness in the demand for multilayer capacitors due to inventory corrections by our customers. These inventory corrections resulted in sharply lower volumes. Sales increased in Asia-Pacific, but not enough to offset declines in North America and Europe. The decline in segment gross profit reflected the lower volume of products sold, and the resulting negative impact of fixed manufacturing costs coupled with lower prices for the Company’s products.

 

Color and Glass Performance Materials Segment Results.  The volume increase for the year in our Color and Glass Performance Materials segment was slightly larger than the decline due to the combination of price and a less favorable product mix. The higher segment gross profit was due primarily to improvements in the average selling price of products sold. This improvement was partially offset by higher raw materials costs.

 

Polymer Additives Segment Results.  The year-over-year increase in sales for our Polymer Additives segment was primarily due to improved performance in North American end markets, including vinyl processing and construction. Increased pricing, particularly in the markets for polymer modifiers, more than offset a reduction in volumes across the Polymer Additives product lines. The increased segment gross profit was due to these pricing increases and to lower SG&A expenses result from previous cost cutting programs.

 

Specialty Plastics Segment Results.  The year-over-year increase in sales for our Specialty Plastics segment was primarily due to improved demand for North American durable goods, including automobiles and appliances. These sales gains were partially offset by weakness in Europe, where sales declined by approximately 8%. Segment operating income increased to $13.4 million from $9.6 million in 2004. The higher segment gross profit was due primarily to improved average selling prices, partially offset by higher raw material costs and lower volumes.

 

 

Increased sales in the United States were primarily due to sales growth in our Polymer Additives, Performance Coatings and Specialty Plastics businesses, partially offset by lower sales in Electronic Materials. The increase in international sales was driven by sales growth in Asia, largely within the Color and Glass Performance Materials and Electronic Materials segments. This growth was partially offset by a volume decline in Europe that was not fully offset by pricing and product mix improvements.

 

Summary of Cash Flows

 

 

Operating activities.  The increase in net cash provided by operating activities of continuing operations was driven by the increase in net income of $3.8 million in 2006, supplemented by increased proceeds from the asset securitization program of $101.9 million, an increase in non-cash restructuring charges of $19.5 million and changes in other working capital items of $6.9 million. The other reconciling items primarily had positive impacts to operating cash flows and related to deferred income taxes, retirement benefits and increased depreciation expense of $4.7 million primarily due to accelerated depreciation. Offsetting these positive cash flow items were increased changes in deposit requirements under the Company’s precious metals consignment program of $40.0 million, increased changes in inventories of $28.4 million, and increased changes in accounts receivable of $18.6 million. The increase in inventory levels was primarily due to a discrete build in inventory levels and increases to raw material prices from suppliers. Accounts receivable increased due to higher net sales.

 

In 2005, cash flows from operating activities of continuing operations decreased $40.3 million as compared to 2004. We increased our use of cash for retirement benefits by $36.5 million during the year. We also increased payments of accounts payable by $38.1 million in order to manage vendor relationships. We used operating cash through lower net income of $8.6 million, increased accounts receivable balance of $12.7 million due to increased sales, and other operating cash outflows of $14.0 million. Partially offsetting these decreases in operating cash flows were slower growth in inventories of $36.9 million and a reduction in the balance of the note receivable from Ferro Finance Corporation and the asset securitization program of $8.4 million. Additionally, the cash flow impact from accrued expenses and other current liabilities of $25.4 million favorably impacted operating cash flows, primarily due to the payment of such liabilities in 2004 without comparable payment levels in 2005.

 

Investing activities.  In June 2006, the Company invested an additional $25.0 million in Ferro Finance Corporation, a wholly-owned unconsolidated subsidiary, in connection with the June 2006 amendment of the asset

securitization agreement. Capital expenditures during 2006 increased $7.8 million as compared with 2005. The primary reasons for the increased capital spending included the start of construction of a freestanding, state-of-the-art plant in Spain that will produce colors for the European tile market and increased investment in the Company’s manufacturing facilities in the Asia Pacific region.

 

In 2005, cash flows from investing activities decreased $16.4 million as compared to 2004. The decreased in cash flows from investing activities reflected the absence of a discrete adjustment to the purchase price of a prior acquisition of $8.5 million, decreased proceeds from the sales of assets and businesses of $2.6 and increased capital expenditures for property, plant and equipment of $3.8 million. Expenditures for property, plant and equipment increased due in our investments in production equipment in the Asia Pacific region.

 

Financing activities.  In March 2006, we accepted a commitment from a group of lenders for a $700 million credit facility (the “New Credit Facility”) and, in June 2006, finalized the agreement. The New Credit Facility consists of a five-year, $250 million multi-currency senior revolving credit facility and a six-year, $450 million senior term loan facility. The New Credit Facility replaced the former revolving credit facility that would have expired in September 2006. In June 2006, Ferro borrowed $95 million of the term loan facility to partially repay the former revolving credit facility. In addition, in July and August of 2006, we borrowed another $155 million of the term loan facility to repay $155 million of outstanding debentures, as bondholders accelerated payment of these obligations due to defaults caused by our delayed financial filings with the SEC for 2005. In 2006, our net borrowings on long-term debt decreased to $36.9 million as compared with 2005 borrowings of $48.4 million, for a net decrease in our rate of borrowing of $11.5 million. We paid $16.2 million in debt issue costs to establish and use the New Credit Facility in 2006, whereas in 2005 we did not pay any debt issue costs. Increased 2006 short-term borrowings of $3.5 million and other financing activities of $3.1 million as compared to 2005 offset the negative financing cash flows described above. We also continued to pay dividends on our common stock at our historical quarterly rate of $0.145 per share, totaling $25.9 million in 2006.

 

In 2005, cash flows from financing activities increased $70.0 million as compared to 2004. This increase reflected our borrowing on the former revolving credit facility of $75.4 million in order to finance operations, offset by other changes in financing cash flows and short-term borrowings of $5.6 million.

 

Capital Resources and Liquidity

 

New Credit Facility

 

At December 31, 2006, we had borrowed $128.0 million of the revolving credit facility and had $109.3 million available, after reductions for standby letters of credit secured by this facility. In addition, we can request an increase of $50 million in the revolving credit facility. At the same time, we had borrowed $250.0 million of the term loan facility and had $55 million available, which we drew down in January 2007 and used to partially repay the revolving credit facility. At December 31, 2006, we were in compliance with the covenants of the New Credit Facility.

 

Senior Notes

 

At December 31, 2006, we had $200.0 million principal amount outstanding under senior notes. In March 2006, Standard & Poor’s Rating Group (“S&P”) downgraded the Company’s senior credit rating from BB to B+, and Moody’s Investor Service, Inc. (“Moody’s”) downgraded its rating from Ba1 to B1 and then withdrew its rating. Moody’s cited the absence of audited financial statements for a sustained period of time and the concern that there may be additional delays in receiving audited financials for 2005. Moody’s also noted that the Company’s business profile is consistent with a rating in the Ba category, according to Moody’s rating methodology for the chemical industry. Moody’s indicated it could reassign ratings to the Company after we filed audited financial statements for 2004 and 2005 with the SEC. We have filed these statements with the SEC and have had initial discussions with Moody’s about reinstatement of its ratings.

 

In April 2006, we received from the Trustee of the senior notes a notice of default caused by our delayed financial filings with the SEC for 2005. In December 2006, we became current with all of our financial reporting

requirements under the senior notes, and the related default was no longer continuing. At December 31, 2006, we were in compliance with the covenants under the indentures for the senior notes.

 

Off Balance Sheet Arrangements

 

Receivable Sales Programs.  We sell, on an ongoing basis, substantially all of Ferro’s U.S. trade accounts receivable under an asset securitization program. This program accelerates cash collections at favorable financing costs and helps us manage the Company’s liquidity requirements. We sell these trade accounts receivable to Ferro Finance Corporation (“FFC”), a wholly-owned unconsolidated qualified special purpose entity (“QSPE”). FFC finances its acquisition of trade receivable assets by issuing beneficial interests in (securitizing) the receivables to multi-seller receivables securitization companies (“conduits”) for proceeds of up to $100.0 million. FFC and the conduits have no recourse to Ferro’s other assets for failure of debtors to pay when due as the assets transferred are legally isolated in accordance with the U.S. bankruptcy laws. Ferro’s consolidated balance sheet does not include the trade receivables sold, but does include a note receivable from FFC to the extent that cash proceeds from the sales of accounts receivable to FFC have not yet been received by Ferro. In June 2006, we amended the program to cure a default that resulted from a credit rating downgrade, to modify the reporting requirements to more closely match those in the New Credit Facility, and to extend the program to June 2009. The program requires FFC to maintain a minimum tangible net worth. To meet this requirement, we invested an additional $25 million in FFC in June 2006. At December 31, 2006, FFC had received net proceeds of $60.6 million for outstanding receivables, and the balance of Ferro’s note receivable from FFC was $16.1 million.

 

In addition, we maintain several international programs to sell trade accounts receivable, primarily without recourse. The commitments supporting this program can be withdrawn at any time and totaled $49.2 million at December 31, 2006. The amount of outstanding receivables sold under the international programs was $33.7 million at December 31, 2006.

 

Consignment and Customer Arrangements for Precious Metals.  In the production of some of our products, we use precious metals, primarily silver for Electronic Materials products and gold for Color and Glass Performance Materials products. We obtain most precious metals from financial institutions under consignment agreements with terms of one year or less. The financial institutions retain ownership of the precious metals and charge us fees based on the amounts we consign. These fees were $3.1 million for 2006. In November 2005, the financial institutions renewed their requirement for cash deposits from us to provide additional collateral beyond the value of the underlying precious metals. Outstanding collateral deposits grew from $19.0 million at December 31, 2005, to $109.4 million during 2006, but declined to $70.1 million by December 31, 2006. We also process precious metals owned by our customers. At December 31, 2006, we had on hand $120.9 million of precious metals owned by financial institutions, measured at fair value.

 

Bank Guarantees and Standby Letters of Credit.  At December 31, 2006, the Company had bank guarantees and standby letters of credit issued by financial institutions, which totaled $21.0 million. These agreements primarily relate to Ferro’s insurance programs, natural gas contracts, potential environmental remediation liabilities, and foreign tax payments.

 

Other Financing Arrangement

 

We maintain other lines of credit to provide global flexibility for Ferro’s short-term liquidity requirements. These facilities are uncommitted lines for our international operations and totaled $21.0 million at December 31, 2006. The unused portions of these lines provided $18.7 million of additional liquidity at December 31, 2006.

 

Liquidity Requirement

 

Our liquidity requirements primarily include debt service, purchase commitments, working capital requirements, capital investments, postretirement obligations and dividend payments. Ferro’s level of debt and debt service requirements could have important consequences to its business operations and uses of cash flows.

 

The Company’s aggregate amount of obligations for the next five years and thereafter is set forth below:

 

 

Cash required for interest costs in 2006 was $63.0 million. We expect that the amount for 2007 will not be substantially different, but the actual amount depends on interest rates on our variable-rate debt and our overall debt levels.

 

We pay taxes as part of our normal operations as a profitable company. The amount of taxes we pay depends on a variety of factors described in more detail in Critical Accounting Policies below. However, the principal factors are the level of our profitability and the countries in which we earn our taxable income. We have paid and expect to continue to pay taxes for the foreseeable future. Based on the historical relationship between pretax income and the amount of income taxes we have paid, we expect to pay a substantially higher amount of taxes in 2007.

 

We expect to contribute approximately $41.3 million to our post employment benefit plans in 2007. Over the four-year period from 2008 through 2011, we may be required to contribute an additional $107.7 million to these plans. We determined these funding amounts based on the minimum contributions required under various applicable regulations in each respective country. Actual contributions also depend on the future funded status of the plans and on the amount of employee contributions.

 

Critical Accounting Policies and Their Application

 

When we prepare our financial statements we are required to make estimates and assumptions that affect the amounts we report in the financial statements and footnotes. We consider the policies discussed below to be more critical than other policies because their application requires our most subjective or complex judgments. These estimates and judgments arise because of the inherent uncertainty in predicting future events. Management has discussed the development, selection and disclosure of these policies with the Audit Committee of the Board of Directors.

 

Inventories

 

We value inventory at the lower of cost or market, with cost determined utilizing the first-in, first-out (FIFO) method, except for selected inventories where the last-in, first-out (LIFO) method is used. As of December 31, 2006, we are considering changing our accounting method for those inventories valued on the LIFO method to the FIFO method. This potential change in accounting method could result in an increase in inventory values of $15.5 million upon the date of adoption. If we make such a change, our financial statements would be retroactively adjusted to reflect the new method in each period presented.

 

We periodically evaluate the net realizable value of inventories based primarily upon their age, but also upon assumptions of future demand and market conditions. As a result of the evaluation, the inventory may be written down to the lower of cost or realizable value. Historically, write-downs for the net realizable value of inventories have not been significant, and we do not expect them to have a material impact on our financial position, liquidity or results of operations in the future. However, if actual demand and market conditions turn out to be less favorable

than those we projected in our evaluations of the net realizable value of inventories, additional write-downs may be required.

 

Environmental Liabilities

 

Our manufacturing facilities are subject to a broad array of environmental laws and regulations in the countries in which they operate. The costs to comply with complex environmental laws and regulations are significant and will continue for the foreseeable future. We expense these recurring costs as they are incurred. While these costs may increase in the future, they are not expected to have a material impact on our financial position, liquidity or results of operations.

 

We also accrue for environmental remediation costs when it is probable that a liability has been incurred and we can reasonably estimate the amount. We determine the timing and amount of any liability based upon assumptions regarding future events. Inherent uncertainties exist in such evaluations primarily due to unknown conditions, changing governmental regulations and legal standards regarding liability, and evolving technologies. We adjust these liabilities periodically as remediation efforts progress or as additional technical or legal information becomes available. Because of these inherent uncertainties with respect to environmental remediation costs, potential liabilities could increase significantly from the $5.1 million recorded as of December 31, 2006, due to adverse changes in circumstances.

 

At December 31, 2006, our consolidated balance sheet included an accrued liability for environmental remediation costs of $5.5 million compared with $6.6 million at December 31, 2005. Of the $5.5 million accrued liability at December 31, 2006, approximately 24.0% was reserved for facilities outside of the U.S. Of the amounts accrued, $1.1 million at December 31, 2006, and $1.2 million at December 31, 2005, related to 6 Superfund sites.

 

Income Taxes

 

The breadth of our operations and complexity of income tax regulations require us to assess uncertainties and make judgments in estimating the ultimate amount of income taxes we will pay. The final income taxes we pay are based upon many factors, including existing income tax laws and regulations, negotiations with taxing authorities in various jurisdictions, outcomes of tax litigation and resolution of disputes arising from federal, state, and international income tax audits. The resolution of these uncertainties may result in adjustments to our income tax assets and liabilities in the future.

 

Deferred income taxes result from differences between the financial and tax basis of our assets and liabilities and we adjust our deferred income tax assets and liabilities for changes in income tax rates and income tax laws when changes are enacted. We record valuation allowances to reduce deferred income tax assets when it is more likely than not that a tax benefit will not be realized. Significant judgment is required in evaluating the need for and the magnitude of appropriate valuation allowances against deferred income tax assets. The realization of these assets is dependent on generating future taxable income, our ability to carry back or carry forward net operating losses and credits to offset taxable income in a prior year, as well as successful implementation of various tax strategies to generate taxable income where net operating losses or credit carryforwards exist. In evaluating our ability to realize the deferred income tax assets, we rely principally on forecasted taxable income using historical and projected future operating results, the reversal of existing temporary differences and the availability of tax planning strategies.

 

We earn a significant portion of our pre-tax income outside the U.S. Many of these non-U.S. tax jurisdictions have statutory income tax rates that are lower than that in the U.S. Because we carry a majority of our debt in the U.S., we also have significant cash needs in the U.S. to service this debt. As a result, it is necessary for us to perform significant tax and treasury planning and analysis to determine the best actions to achieve the goals of meeting our U.S. cash needs, while also reducing our worldwide taxable income. In this tax and treasury planning, we consider future taxable income in the U.S. and non-U.S. jurisdictions, future cash needs in the U.S., and the timing and amount of dividend repatriations. Our ability to balance future taxable income and cash flows between the U.S. and foreign locations depends on various strategies, such as the charging of management fees for intercompany services, transfer pricing, intercompany royalties, intercompany sales of technologies and intellectual property, and choosing between allowable tax methods.

 

Pension and Other Postretirement Benefits

 

We sponsor defined benefit plans in the U.S. and many countries outside the U.S., and we also sponsor retiree medical benefits for a segment of our salaried and hourly work force within the U.S. The U.S. pension plans represent approximately 64% of pension plan assets, 63% of benefit obligations and 53% of net periodic pension cost. The measurement dates used to determine pension and other postretirement benefit measurements are September 30th for the U.S. plans and December 31st for the plans outside the U.S.

 

The assumptions we use in actuarial calculations for these plans have a significant impact on benefit obligations and annual net periodic benefit costs. We meet with our actuaries annually to discuss key economic assumptions used to develop these benefit obligations and net periodic costs. In accordance with U.S. GAAP, actual results that differ from the assumptions are accumulated and amortized over future periods and, therefore, affect expense recognized and obligations recorded in future periods.

 

We determine the discount rate for the U.S. pension and retiree medical plans based on a bond model. Using the pension plans’ projected cash flows, the bond model considers all possible bond portfolios that produce matching cash flows and selects the portfolio with the highest possible yield. These portfolios are based on bonds with a quality rating of AA or better under either Moody’s or S&P. The discount rates for the non-U.S. plans are based on a yield curve method, using AA-rated bonds applicable in respective capital markets. The duration of each plan’s liabilities is used to select the rate from the yield curve corresponding to the same duration. We then round the resulting yields to the nearest 25 basis points.

 

We calculate the expected return on assets at the beginning of the year for defined benefit plans as the weighted-average of the expected return for the target allocation of the principal asset classes held by each of the plans. Our target asset allocation percentages are 31% bonds and 69% equity securities for U.S. plans and 60% bonds, 35% equity securities, and 5% other investments for non-U.S. plans. In determining the expected returns, we consider both historical performance and an estimate of future long-term rates of return. The resulting expected returns are then rounded to the nearest 25 basis points. The actual rate of return in 2006 was 8.4% for U.S. plans and 5.0% for non-U.S. plans. Future actual pension expense will depend on future investment allocation and performance, changes in future discount rates and various other factors related to the population of participants in the Company’s pension plans.

 

All other assumptions are reviewed periodically by our actuaries and us and may be adjusted based on current trends and expectations as well as past experience in the plans.

 

The following table provides the sensitivity of net annual periodic benefit costs for our pension plans, including a U.S. nonqualified retirement plan, and the retiree medical plan to a 25-basis-point decrease in both the discount rate and asset return assumption:

 

The following table provides the rates used in the assumptions and the changes between 2006 and 2005:

 

 

Changes in the rates used in these assumptions reflect changes in the underlying bond and equity yields.

 

The amortization of net actuarial unrecognized gains or losses is a component of net periodic cost. These gains or losses result from the difference between actual and assumed results and from changes in actuarial assumptions. At December 31, 2006, our U.S. and non-U.S. pension plans, including the nonqualified retirement plan, and our U.S. retiree medical plan had unrecognized net losses of $104.3 million. We will recognize these unrecognized net losses in net periodic cost in future years, with an estimated $6.5 million being recognized in 2007.

 

As of December 31, 2006 we adopted the recognition and disclosure provisions of FASB Statement No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, (“FAS No. 158”). As a result of our adoption of FAS No. 158, we recorded a decrease in other non-current assets of $1.2 million, an increase in accrued expenses and other current liabilities of $6.5 million, a decrease in postretirement and pension liabilities of $5.2 million, an increase in non-current deferred tax assets of $3.5 million, and a decrease in accumulated other comprehensive loss of $1.0 million.

 

During 2006, we entered into an agreement to contingently make an additional contribution above the requirements of local statutory law to one international defined benefit plan if we terminate the participants in the plan prior to December 31, 2012. We may avoid the additional contribution if we transfer the participants and their accrued benefits to a third party. We would be required to make an additional contribution of $4.7 million should we terminate these participants in 2007, declining to $1.1 million should we terminate them in 2012.

 

Our overall net periodic benefit cost for all defined benefit plans decreased approximately $3.3 million from 2005 to 2006, primarily due to $11.4 million in expense reductions relating to the changes in our defined benefit pension and retiree medical plans as described below. This reduction in expense for 2006 was offset by a $4.9 million charge related primarily to a lump sum settlement payment to the beneficiary of our deceased former Chief Executive Officer from our nonqualified defined benefit retirement plan. Also as a result of these actions we reduced our additional minimum pension liability by $7.7 million, net of tax, as a credit to Other Comprehensive Income in shareholders’ equity.

 

In April 2006, we froze the retirement benefits for our largest U.S. defined benefit pension plan that covers certain salaried and hourly employees. This change in benefits does not affect current retirees or former employees. We now provide the affected employees with retirement benefits through our defined contribution plan that provides us with more predictable benefit costs. This change should reduce annual pension costs by $5.7 million for the next several years.

 

Additionally, we limited eligibility for the retiree medical and life insurance coverage for all nonunion employees. Only employees age 55 or older with 10 or more years of service as of December 31, 2006, are now eligible for post-retirement medical and life insurance benefits. Moreover, these benefits will be available only to those employees who retire by December 31, 2007, after having advised the Company of their retirement plans by March 31, 2007. This change does not affect current retirees’ benefits. This change should reduce annual costs by $0.7 million for the next several years.

 

In November 2006, we announced that we will be closing our manufacturing facility in Niagara Falls, New York by the end of 2007. In the first quarter of 2007, we will record a net curtailment loss of $0.3 million for pension benefits related to this closing. We will also record a net curtailment gain of approximately $1.9 million for other benefits for the closing, but the timing and eventual amount depend on when employees are terminated. As a result of this action, our annual net periodic benefit cost will be reduced by approximately $0.4 million.

 

Restructuring and Cost Reduction Programs

 

During 2006, we developed and initiated several restructuring programs across a number of our business segments with the objectives of leveraging our global scale, realigning and lowering our cost structure and optimizing capacity utilization. The programs are primarily associated with North America and Europe. Management continues to evaluate our business, and therefore, there may be supplemental provisions for new plan initiatives as well as changes in estimates to amounts previously recorded, as payments are made or actions are completed. Significant restructuring programs are described below. The majority of initiatives begun in 2005 and prior are substantially completed.

 

In total, we recorded $23.1 million of pre-tax restructuring charges in 2006 as compared with $3.7 million of pre-tax charges during 2005. All of the 2005 charges related to severance benefits for employees affected by plant closings or capacity reduction, as well as various personnel in administrative or shared service functions. The 2006 charges included both termination benefits and asset writedowns. We estimated accruals for termination benefits based on various factors including length of service, contract provisions, local legal requirements, projected final service dates, and salary levels. We also analyzed the carrying value of long-lived assets and recorded estimated accelerated depreciation through for the assets affected by the restructuring. In all likelihood, this accelerated depreciation will result in reducing the net book value of those assets to zero at the date operations cease. While we believe that changes to our estimates are unlikely, the accuracy of our estimates depends on the successful completion of numerous actions. Delays in moving continuing operations to other facilities or increased cash outlays will increase our restructuring costs to such an extent that it could have a material impact on the Company’s results of operations, financial position, or cash flows. Other events, for example, a delay in completion of construction of new facilities, may also delay the resulting cost savings.

 

For the European restructurings initiated in 2006, we established a goal of $40.0 million to $50.0 million in annual cost savings by the end of 2009, with the full benefits realized in 2010. The initial phase of restructuring efforts began in July 2006 and targeted our Performance Coatings and Color and Glass Performance Materials segments in our European operations with an annual cost savings goal of $10.0 million. This restructuring should result in significant manufacturing efficiencies and will contribute to increased production capacity to support our revenue growth. The current actions taking place are a consolidation of our Cassiglie, Italy, manufacturing operations and administrative functions, as well as the consolidation of decoration and certain color manufacturing operations from Frankfurt, Germany, into a European center of excellence in Colditz, Germany. We are in consultation with various works councils regarding the effects of these restructuring programs. We estimate the total termination benefits for the 150 employees affected by the European restructuring to be approximately $4.7 million to $4.9 million. We recorded $3.9 million of termination benefits related to this action during 2006, and we expect to record an additional $0.8 million to $1.0 million in 2007. We also recorded $1.0 million of impairment charges for equipment made obsolete due to this plan.

 

A second restructuring program involves our Electronic Materials segment and will result in the closing of our manufacturing facilities in Niagara Falls, New York by the end of 2007. This action is expected to result in annual cost reduction of approximately $7.5 million. As part of the restructuring activities, we will redistribute the production at that facility to other existing Electronic Materials manufacturing facilities and we anticipate that we will reduce our workforce by 110 employees, net of an estimated addition of 43 employees at locations to which production will be transferred. Of the employees who will be terminated, 115 are represented by a union. We believe

that the total estimated restructuring costs will be approximately $20.0 million. In the table below, we have summarized the charges recorded during 2006 and the estimated future charges to be incurred related to this action:

 

 

We are currently in negotiation with the union that represents the hourly workers in our Niagara Falls, New York manufacturing plant to determine termination benefits as the result of the closing. We accrued the estimated termination costs based upon our current contract with the union.

 

Revenue Recognition

 

We recognize sales typically when we ship goods to our customers and when all of the following criteria are met:

 

 

Because we sell our many products throughout the world, we use varying sales and payments terms as agreed to with our customers. In the U.S., our standard payment terms vary by industry and business unit, but are generally 30 to 60 days. Substantial amounts of our consolidated revenues are derived from foreign countries and in many of those countries the standard payment terms are longer than those prevalent in the U.S. In order to ensure the revenue recognition in the proper period, we review material sales contracts for proper cut-off based upon the business practices and legal requirements of each country. For sales of products containing precious metals, we report revenues gross with a separate display of cost of sales to arrive at gross profit. We record revenues this way because we act as the principal in the transactions we enter into and take title and the risks and rewards of ownership of the inventory we process, although the timing of when we take title to the inventory during the production process may vary.

 

The amount of shipping and handling fees invoiced to our customers at the time our product is shipped is included in net sales. Shipping and handling fees included in net sales were $38.4 million in 2006 and $37.9 million in 2005. Credit memos issued to customers for sales returns, discounts allowed and sales adjustments are recorded when they are incurred as a reduction of sales. We use estimated allowances to provide for future sales returns and adjustments in order to record revenues in the proper accounting period and to state the related accounts receivable at their net realizable value. We estimate these allowances based upon historical sales return and adjustment rates. Actual allowances may be more or less than the amount we estimate. In the past these differences have not been material and we do not expect any material differences in the future.

 

Additionally, we provide certain of our customer with incentive rebate programs to promote customer loyalty and encourage greater product sales. We accrue customer rebates over the rebate periods based upon estimated attainments of the provisions in the rebate agreements using available information and record these rebate accruals as reductions of sales. We incurred $12.5 million of customer rebates in 2006 and $12.4 million in 2005. We do not expect customer rebates to increase significantly in future periods.

 

Valuation of Goodwill and Other Intangibles

 

While goodwill and intangible assets with indefinite useful lives recorded on our balance sheet are no longer amortized, we review these assets for impairment each year on a measurement date of October 31st. We estimate the fair value of each business unit using a discounted cash flow method based on historical results and trends and our projections of market growth, internal sales efforts, input cost movements, and cost reduction opportunities. We then allocate certain corporate expenses, assets and liabilities to the business units in this process. Using a risk adjusted, weighted average cost-of-capital, we discount the cash flow projections to measurement date. If the fair value of any of the units were determined to be less than its carrying value, we would proceed to the second step and obtain comparable market values or independent appraisals of its assets to determine the amount of any impairment.

 

Our estimates of fair value can be affected by a variety of factors. Reductions in actual or projected growth or profitability due to unfavorable market conditions in our business units, or significant increases in previous levels of capital spending, could lead to the impairment of any related goodwill. Additionally, an increase in inflation, interest rates or the risk adjusted weighted-average cost of capital could also lead to a reduction in the value of one or more of our business units and therefore lead to the impairment of goodwill.

 

Assessment of Long-Lived Assets

 

Our long-lived assets include property, plant, equipment, goodwill and other intangible assets. We depreciate property, plant and equipment on a straight-line basis over the estimated useful lives of the assets. We continually assess long-lived assets for the appropriateness of their estimated useful lives. When circumstances indicate that there has been a reduction in the economic useful life of an asset or an asset group, we revise our estimates. As discussed above, in 2006 we shortened our estimates of the useful lives for several asset groups due to our restructuring activities.

 

We also review property, plant and equipment and intangibles for impairment whenever events or circumstances indicate that the undiscounted net cash flows to be generated by their use and eventual disposition are less than the assets’ recorded value. In the event of impairment, we recognize a loss for the excess of the recorded value of the asset over its fair value. The long-term nature of these assets requires that we estimate cash inflows and outflows for several years into the future and only take into consideration technological advances known at the time of impairment.

 

Due to depressed conditions in the electronics industry in late 2004 and in 2005, we specifically evaluated our electronics assets in Holland. Also in 2005, we evaluated our Italian tile and Belgian polymer additives manufacturing assets because of sluggish market conditions in these regions. In each situation, we concluded that the assets were not impaired. In 2006, we recorded impairment charges for both property, plant and equipment and intangibles due to the restructuring activities discussed above.

 

Derivative Financial Instruments

 

We use derivative financial instruments in the normal course of business to manage our exposure to fluctuations in commodity prices and foreign currency exchange rates. The accounting for derivative financial instruments can be complex and require significant judgments. Generally, the derivative financial instruments that we use are not complex and quoted market prices are available through financial institutions. We do not engage in speculative transactions for trading purposes. Financial instruments, including derivative financial instruments, expose us to counterparty credit risk for non-performance. We manage our exposure to counterparty credit risk through minimum credit standards and procedures to monitor concentrations of credit risk. We enter into these derivative financial instruments with major reputable multinational financial institutions. Accordingly, we do not anticipate counter-party default. We continuously evaluate the effectiveness of derivative financial instruments designated as hedges to ensure that they are highly effective. In the event the hedge becomes ineffective, we discontinue hedge treatment.

 

We manage foreign currency risks in a wide variety of foreign currencies principally by entering into forward contracts to mitigate the impact of currency fluctuations on transactions arising from international trade. Our objective in entering into these forward contracts is to preserve the economic value of non-functional currency cash

flows. Our principal foreign currency exposures relate to the Euro, the British Pound Sterling, the Japanese Yen, and the Chinese Yuan. We mark these forward contracts to fair value at the end of each reporting period and recognize the resulting gains or losses as other income or expense from foreign currency transactions. We recorded mark-to-market losses from forward currency contracts of $0.8 million in 2006 and mark-to-market gains of $0.8 million in 2005. The amounts of gains or losses we record depend on a variety of factors including the notional amount of the forward contracts entered into and the fluctuation of the underlying currency exchange rates. We do not expect any change in our foreign currency risk policies or in the nature of the transactions were enter into to mitigate foreign currency risk.

 

Our exposure to market risk from commodity prices relate primarily to commodity raw materials and energy used in the production of a portion of our products. We purchase portions of our natural gas requirements under fixed price contracts to reduce the volatility of cost changes. For contracts entered into prior to April 2006, we marked these contracts to fair value and recognized the resulting gains or losses as miscellaneous income or expense, respectively. Beginning April 2006, we designated new natural gas contracts as normal purchase contracts, which are not marked-to-market. During 2006, we recognized $2.6 million in mark-to-market losses and in 2005 we recognized $3.0 million in mark-to-market gains. Due to the designation of these contracts as normal purchase contracts, we do not expect to recognize mark-to-market gains or losses in future periods. Our purchase commitments for natural gas under normal purchase contracts was $6.3 million at December 31, 2006, for 0.7 million MBTUs.

 

We also manage a portion of our exposure to market risk for changes in the pricing of certain raw material commodities using derivative instruments. We hedge our exposure principally through swap arrangements that allow us to fix the price of the commodities for future purchases. These swap arrangements are settled in cash at their maturities. We mark these contracts to fair value and recognize the resulting gains or losses as other comprehensive income. After the contracts mature and the materials are sold, the gains and losses are recognized as a part of cost of sales. During 2006, we recognized $5.3 million of net gains in cost of sales related to the settlement of these swaps. For 2005, the amount was not material. At December 31, 2006, $3.1 million of gains remained in other comprehensive income and inventories. We do not expect any change in our commodity risk policies or in the nature of the transactions we enter into to mitigate commodity market risk.

 

Impact of Newly Issued Accounting Pronouncements

 

In March 2006, the FASB issued Statement No. 156, Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140, (“FAS No. 156”). This statement requires an entity to recognize at fair value, if practicable, a servicing asset or liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations primarily relating to off-balance sheet arrangements. Entities may choose between two subsequent measurement methods for each class of separately recognized servicing assets and servicing liabilities. FAS No. 156 is effective for fiscal years beginning after September 15, 2006. The provisions of FAS No. 156 are to be applied prospectively to transactions entered into after its adoption. We will adopt FAS No. 156 as of January 1, 2007, as permitted, and are currently evaluating the implementation options; at this time, we are uncertain as to the impact on our results of operations and financial position.

 

In June 2006, the FASB published Interpretation No. 48, Accounting for Uncertainty in Income Taxes, (“Interpretation No. 48”). This interpretation requires an entity to recognize the benefit of a tax position only when it is more likely than not, based on the position’s technical merits, that the position would be sustained upon examination by the respective taxing authority. We will adopt Interpretation No. 48 as of January 1, 2007. The cumulative effect of adopting Interpretation No. 48, if material, is required to be reported separately as an adjustment to retained earnings as of the beginning of 2007. We are currently evaluating the impact of Interpretation No. 48 and, at this time, are unable to determine whether the cumulative adjustment is material.

 

In September 2006, the FASB published Staff Position No. AUG AIR-1, Accounting for Planned Maintenance Activities. This staff position prohibits the use of the accrue-in-advance method of accounting for planned major maintenance activities. It is effective for fiscal years beginning after December 15, 2006, and is to be applied retrospectively. When adopted in fiscal 2007, the staff position will increase our retained earnings as of the

beginning of 2005 by $1.6 million, increase 2005 income from continuing operations by $0.4 million ($0.3 million net of tax), and decrease 2006 income from continuing operations by $0.4 million ($0.3 million net of tax).

 

In September 2006, the FASB issued Statement No. 157, Fair Value Measurements, (“FAS No. 157”). FAS No. 157 defines fair value, establishes a framework and gives guidance regarding the methods used for measuring fair value, and expands disclosures about fair value measurements. Accordingly, FAS No. 157 does not require any new fair value measurements, but will change current practice for some entities. FAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We will apply this standard prospectively, as permitted.

 

In September 2006, the FASB issued Statement No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB Statements No. 87, 88, 106, and 132(R), (“FAS No. 158”). We are required to adopt the measurement provisions of FAS No. 158 as of December 31, 2008. The measurement provisions require companies to measure defined benefit plan assets and obligations as of the balance sheet date. Currently, we use September 30 as the measurement date for U.S. pension and other postretirement benefits. We are evaluating these requirements and have not yet determined the impact this may have on our consolidated financial statements.

 

In February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, (“FAS No. 159”). This statement permits all entities to choose, at specified election dates, to measure eligible items at fair value (the “fair value option”). A business entity should report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Upfront costs and fees related to items for which the fair value option is elected shall be recognized in earnings as incurred and not deferred. FAS No. 159 is effective as of the beginning of the first fiscal year that begins after November 15, 2007. We are currently evaluating the impact of the adoption of this statement; at this time, we are uncertain as to the impact on our results of operations and financial position.

 

Our exposure to market risks is generally limited to fluctuations in interest rates, foreign currency exchange rates, and costs of raw materials and natural gas.

 

Our exposure to interest rate risk arises from our debt portfolio. We manage this risk by controlling the mix of fixed versus variable-rate debt after considering the interest rate environment and expected future cash flows. Our objective is to limit the negative effect of rising interest rates on earnings, cash flows and overall borrowing costs, while preserving flexibility and allowing us to benefit during periods of falling rates. In 2006, our level of fixed-rate debt decreased and variable-rate debt increased. As we anticipated and planned for, during July and August 2006, bondholders accelerated the payment of the principal amount of the Company’s fixed-rate debentures, of which $155 million was outstanding. The debentures were repaid through use of the variable-rate term loan facility.

 

We operate internationally and enter into transactions denominated in foreign currencies. These transactions expose us to gains and losses arising from exchange rate movements between the dates foreign currencies are recorded and the dates they are settled. We manage this risk by entering into forward currency contracts that offset these gains and losses.

 

We are also subject to cost changes with respect to our raw materials and natural gas purchases. We attempt to mitigate raw materials cost increases with price increases to our customers. We also hedge a portion of our exposure to changes in the pricing of certain raw material commodities using derivative financial instruments. We hedge our exposure principally through swap arrangements that allow us to fix the pricing of the commodities for future purchases. In addition, we purchase portions of our natural gas requirements under fixed price contracts to reduce the volatility of this cost. For contracts entered into prior to April 2006, we mark these contracts to fair value and recognize the resulting gains or losses as miscellaneous income or expense, respectively. Beginning April 2006, we designated new natural gas contracts as normal purchase contracts, which are not marked-to-market. Our purchase commitment for natural gas under normal purchase contracts was $6.3 million at December 31, 2006.

 

Information about our exposure to these market risks and sensitivity analyses about potential losses resulting from hypothetical changes in market rates is presented below:

 

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Shareholders of

Ferro Corporation

Cleveland, Ohio

 

We have audited the accompanying consolidated balance sheets of Ferro Corporation and subsidiaries (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of income, shareholders’ equity and comprehensive income, and cash flows for the years then ended. Our audits also included the financial statement schedule listed in the index at Item 15(b) for the years ended December 31, 2006 and 2005. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the consolidated financial statements and financial statement schedule based on our audits. The consolidated financial statements of the Company for the year ended December 31, 2004, were audited by other auditors whose report, dated March 31, 2006, except as to note 19, which is as of September 28, 2006, on those statements included an explanatory paragraph concerning the Company’s ability to continue as a going concern.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, such 2006 and 2005 consolidated financial statements present fairly, in all material respects, the financial position of Ferro Corporation and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United Sates of America. Also, in our opinion, such financial statement schedule for the years ended December 31, 2006 and 2005, when considered in relation to the basic 2006 and 2005 consolidated statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

 

As discussed in Notes 1, 9, and 12 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Share-Based Payment, and the recognition and disclosure provisions of SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, in 2006.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 1, 2007, expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an adverse opinion on the effectiveness of the Company’s internal control over financial reporting because of material weaknesses.

 

 

Cleveland, Ohio

March 1, 2007

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors and Shareholders

Ferro Corporation:

 

We have audited the accompanying consolidated statements of income, shareholders’ equity and comprehensive income, and cash flows of Ferro Corporation and subsidiaries for the year ended December 31, 2004. In connection with our audit of these consolidated financial statements, we have also audited the financial statement schedule listed in the index at Item 15(b) for the year ended December 31, 2004. These consolidated financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and the cash flows of Ferro Corporation and subsidiaries for the year ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

 

The accompanying financial statements have been prepared assuming the Company will continue as a going concern. As discussed in note 5 to the financial statements, the Company faces certain liquidity uncertainties that raise substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are also described in note 5. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

 

Cleveland, Ohio

March 31, 2006, except as to note 19,

  which is as of September 28, 2006

FERRO CORPORATION AND CONSOLIDATED SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF INCOME

 

 

See accompanying notes to consolidated financial statements.

FERRO CORPORATION AND CONSOLIDATED SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

 

 

See accompanying notes to consolidated financial statements.

FERRO CORPORATION AND CONSOLIDATED SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND

COMPREHENSIVE INCOME