The Company develops, manufactures and markets value-adding technologies based on surface and materials science for a wide spectrum of served markets. The Company also provides its technology segments, their customers and others with precious and base metals and related services. The Company’s businesses are organized into four reportable segments that are discussed individually below. Additional detailed descriptive material is included in “ITEM 1. BUSINESS” and “NOTE 19. BUSINESS SEGMENT AND GEOGRAPHIC AREA DATA” in the Company’s 2003 Form 10-K. Comparative financial data is also given in Note 19 of the Company’s 2003 Form 10-K and on page 5 of this Form 10-Q.
One of the strengths of the Company is that its segments serve diverse markets, which is important for assessing the variability of future cash flows. The following economic comments also provide a useful context for evaluating the Company’s performance: (1) worldwide auto builds continue to be relatively flat, albeit at fairly high levels - industry growth for auto-emission catalysts will benefit from tougher environmental regulation throughout the world over the next 5-10 years as well as developing economies, especially new Asian production; (2) more stringent diesel-emission regulations are being phased in, affording the Company additional opportunities for catalyst solutions; (3) worldwide petroleum refineries are operating close to capacity generating demand for the extra yields provided by Engelhard’s ad vanced fluid cracking catalysts and performance additives; (4) markets for effect pigments and colors in cosmetics, personal care, auto finishes and coatings have remained positive during the recent economic downturns and tend to be less cyclical; (5) although there are signs of recovery, there has been little change in chemical industry customers’ continued ability to delay large replacement catalyst orders and the related demand for platinum-group-metal refining services; (6) the coated, free-sheet paper market is strengthening, but pricing continues to negatively impact the Company; and (7) margins related to the supply of metal to industrial customers are low because of changes in pricing and supply arrangements.
Comparison of the Third Quarter of 2004
with the Third Quarter of 2003
Net earnings decreased to $59.1 million in the third quarter of 2004 compared with $59.8 million in the same period of 2003. Operating earnings for the third quarter of 2004 increased 11% to $73.6 million from $66.1 million in the same period of 2003. Total Company operating results were mixed as higher operating earnings from the Environmental Technologies segment, Appearance and Performance Technologies segment, Materials Services segment and the “All Other” category were partially offset by lower operating earnings from the Process Technologies segment.
In respect of recurring worldwide business operations, the Company's effective tax rate ("ETR") was estimated to be 22% for 2004. The ETR for 2004 will be lower than 22%, however, due to the conclusion of an IRS audit of the Company's 1998-2000 tax returns in the second quarter, as previously disclosed. Together with the one-time impact relating to the conclusion of the IRS audit, the ETR for 2004 is forecasted to be approximately 19.5%.
The Company believes that its ETR will be in the 22-24% range through 2007 with a potential increase of one percentage point in years after 2007 due to the effect of new tax laws enacted in October 2004. The recent changes in the Federal income tax laws result in the phase-out of extraterritorial income (“ETI”) tax benefits and the gradual phase-in of new U.S. production related tax benefits. Assuming these tax benefits are treated as a special deduction, the net impact of these changes is estimated to be neutral to the Company through 2007 with a potential negative impact of one percentage point to its ETR in years after 2007.
The Company is assessing the new tax rules relating to the repatriation of offshore earnings from its foreign subsidiaries and it will take appropriate measures in 2005. It is too early to reasonably predict what steps the Company will take in this regard and the corresponding impact to the Company's financial statements in 2005.
The Company’s share of equity earnings from affiliates was $6.1 million for the third quarter of 2004 compared with $14.5 million for the same period in 2003. Higher equity earnings from the Company’s Asia joint ventures, N.E. Chemcat and Heesung, were due to stronger results from mobile-source environmental markets. These earnings were more than offset by current absence of $10.2 million of equity earnings recognized in 2003 associated with the liquidation of the Engelhard-CLAL joint venture.
Net sales increased 9% to $1,002.0 million in the third quarter of 2004 from $915.4 million for the same period in 2003. Sales increases were reported in all segments. Higher prices and volumes of platinum-group-metal sales from the Materials Services segment were the largest contributors to the increase. Sales from the Materials Services segment include significant precious metal values, which are also included in cost of goods sold. As a result, gross margins on these sales tend to be low in relation to the gross margins generated by sales from the Company’s technology segments.
Environmental Technologies
Operating earnings increased 6% to $33.0 million in the third quarter of 2004 from $31.0 million in the same period of 2003. Net sales for the third quarter of 2004 increased 7% to $217.3 million from $202.2 million in the same period of 2003.
The majority of this segment’s sales are derived from technologies to control pollution from mobile sources, including gasoline- and diesel-powered passenger cars, sport-utility vehicles, trucks, buses, motorcycles and off-road vehicles. This segment’s customers are generally driven by increasingly stringent environmental regulations. The remainder of this segment’s sales are derived from products sold into a variety of industrial markets including aerospace, power generation, process industries, and utility engine manufacturers.
Sales to mobile-source environmental markets increased $17.2 million in the third quarter of 2004 compared with the same period a year ago. Higher pass-through substrate costs and foreign currency exchange rate differences accounted for 90% of the increase in sales. Market acceptance of catalytic solutions to meet environmental regulations is key to the Company achieving its growth objectives. The mobile-source diesel market is expected to be this segment’s primary growth area.
Operating earnings from mobile-source environmental markets was up 11% in the third quarter of 2004 versus the same quarter in 2003. The Company serves a wide base of customers within these markets. As changes in the mix of customers and their vehicles occur, operating earnings may be affected. For example, the composition of the catalytic solutions required will vary depending on vehicle and engine size. Profitability will be impacted by the mix of vehicle platforms as well as by the ultimate sales of particular vehicles for which the Company provides catalyst. In the mix for the current quarter, profitability from the mobile-source diesel markets increased while other mobile-source markets were flat versus the prior year. Additionally, operating earnings from mobile-source environmental markets were favorably impacted by the reversal of a $1.5 million warranty accrual due to favorable experience, and a $0.7 million impact from favorable exchange rates, partially offset by higher information technology costs of approximately $1 million. Increasingly stringent environmental regulations are expected to positively impact mobile-source markets commencing in 2006. Until then, the segment will be negatively impacted by the ability of auto manufacturers to reduce the amount of catalyst employed on certain platforms and still comply with current environmental regulations, as well as the mix of vehicles produced.
Sales derived from products sold to industrial markets decreased $2.1 million in the third quarter of 2004 compared with the same period last year, as decreases in sales to the power-generation market of approximately $5 million were partially offset by increased sales to other served markets. The Company anticipated a decline in demand for products sold to the power-generation markets and reduced costs accordingly. Despite these cost-cutting measures, operating earnings on sales to the power-generation market declined $1.4 million. The Company has maintained the technical ability and capacity to serve this market when demand returns and will continue to manage costs accordingly. Earnings from other served markets were down modestly compared to the prior period. While cash flows from other served markets remain sufficien t to support the existing assets, certain operations within these businesses are being evaluated from a strategic standpoint. At or before the completion of this evaluation, it is possible that some assets may be deemed impaired. Long-lived assets associated with these operations are approximately $10 million.
Process Technologies
Operating earnings decreased 16% to $20.7 million in the third quarter of 2004 from $24.6 million in the same period of 2003. Net sales for the third quarter of 2004 increased 3% to $147.8 million from $143.6 million in the same period of 2003.
Sales of catalyst and additives to the petroleum-refining market increased $2.0 million in the third quarter of 2004 compared with the third quarter of 2003. Demand for the Company’s Distributed Matrix Structure (DMS) technology platform remains strong, but was tempered in the current quarter by disruptions associated with a particularly harsh hurricane season in the Gulf of Mexico, which impacted operating facilities of the Company, its suppliers and customers. These disruptions continued into October. Previously disclosed productivity initiatives focused on debottlenecking and converting capacity for displaced product offerings to DMS technology production continue and are expected to favorably impact 2005 results. The Company commenced these productivity initiatives late in the second quarter of 2004 to cost effe ctively meet the increased demand for the Company’s DMS technology. Operating earnings generated from sales of catalyst and additives to the petroleum refining market rose modestly as increased profits from greater sales overcame higher manufacturing costs associated with increased demand, decreased earnings associated with disruptions caused by hurricanes exceeding $1.0 million, and higher natural gas costs of $0.8 million.
Sales of catalyst to the chemical-process markets increased $2.2 million in the third quarter of 2004 compared with the same period in 2003. This increase was due to increased sales ofLynx catalyst, the approximately $1.0 million impact of a stronger euro compared to the dollar, and higher precious metal value included in sales of $1.2 million, partially offset by decreased selling prices of older product offerings to the polyolefins market of $2.0 million. Sales to certain chemical catalyst markets tend to be large and infrequent relative to the overall operations, and, therefore the timing and the mix of sales can cause fluctuations in revenues and operating earnings from period to period. Operating earnings in the quarter were lower versus the same period last year primarily due to the aforementioned decrease in prices of older product offerings to the polyolefins market; an unfavorable mix of sales to certain markets; higher costs for nickel of $1.5 million; and higher information technology expenses of approximately $1.0 million, partially offset by a favorable foreign exchange impact and increasedLynx profits. There are indications that the chemical-process markets are improving. So far, however, this has not translated into significantly increased orders for catalyst.
Appearance and Performance Technologies
Operating earnings increased 7% to $19.3 million in the third quarter of 2004 from $18.0 million in the same period of 2003. Net sales increased 4% to $172.2 million for the third quarter of 2004 from $166.1 million in the same period of 2003.
Sales of products from the Company’s mineral-based operations increased less than 1% in the third quarter of 2004 compared with the same period of 2003, as increased sales of kaolin-based products to specialty markets and other mineral-based products were offset by lower volumes of kaolin-based products to the paper market. Operating earnings from the mineral operations were down $0.3 million in the current quarter compared with the year-ago period, as higher natural gas costs of $1.2 million were partially offset by the improved sales mix of kaolin-based products mentioned above. The segment continues to suffer from decreased sales volumes and mix to the paper market, primarily as a result of competitive pricing pressure. While the kaolin operations remain profitable and generate significant cash flow, the Company continues to evaluate expected cash flows from its kaolin operations in respect of the carrying value of its long-lived assets.
Sales of effect pigments and colorants to the cosmetics/personal care, coatings and other markets increased 7% in the third quarter of 2004 versus the same period in 2003. Sales increases to the cosmetic/personal care market were partially offset by lower sales of colorants to the coatings market due to an unusually large inventory replenishment by a major customer in the prior period. On July 30, 2004, the Company strengthened its position in the cosmetic/personal care market by acquiring The Collaborative Group, Ltd., including its wholly owned subsidiary Collaborative Laboratories, Inc. This acquisition increased sales in the quarter by $4.5 million and was mildly accretive. Operating earnings in the quarter were up $1.5 million as the increased sales to the cosmetic/personal care market and the benefits of productivi ty initiatives offset modest declines in other markets and increased information technology costs.
Materials Services
Operating earnings increased to $6.4 million in the third quarter of 2004 from $1.3 million in the same period of 2003. Net sales increased 17% to $449.2 million in the third quarter of 2004 from $385.3 million in the same period of 2003.
The increase in sales is primarily due to increased volumes and market prices of platinum group metals. Earnings increased due to higher profits from metal-sourcing operations and improved profitability from refining operations, partially offset by higher operating costs of $2.7 million. This segment’s operating earnings are expected to return to less than $3 million per quarter for the foreseeable future.
Comparison of the First Nine Months of 2004
with the First Nine Months of 2003
Net earnings increased to $177.4 million in the first nine months of 2004 compared with $170.5 million in the same period of 2003. Operating earnings for the first nine months of 2004 increased to $211.2 million from $210.0 million in the same period of 2003. Higher operating earnings were achieved in the Environmental Technologies segment, Appearance and Performance Technologies segment, and the Materials Services segment, offset by lower operating earnings in the Process Technologies segment and the “All Other” category. Operating earnings for the first nine months of 2003 included a charge of $7.8 million ($4.8 million after tax) for the fair value of the remaining lease costs of certain mineral-storage facilities the Company ceased to use, restructuring charges totaling $8.7 million ($5.6 million after tax) , and a royalty settlement gain of $28.4 million ($17.6 million after tax). In the first nine months of 2003, the Company recorded an after-tax transition charge of $2.3 million as a cumulative effect of an accounting change associated with the adoption of SFAS No. 143, “Accounting for Asset Retirement Obligations.”
The Company’s share of equity earnings from affiliates was $19.4 million for the first nine months of 2004 compared with $27.7 million for the same period in 2003. Higher equity earnings from N.E. Chemcat were due to stronger results in the current period from mobile-source environmental markets, absence of environmental remediation costs in 2003 and a loss on the sale of investment securities in 2003. These items were offset by decreased earnings resulting from the liquidation of the Engelhard-CLAL joint venture and modestly lower Heesung results due to higher operating costs.
Net sales increased 18% to $3,149.8 million in the first nine months of 2004 from $2,675.2 million for the same period in 2003. Sales increases were reported in all segments. Higher prices and volumes of platinum-group-metal sales from the Materials Services segment were the largest contributors to the increase.
Environmental Technologies
Operating earnings increased 18% to $102.7 million in the first nine months of 2004 compared with the same period in 2003. The year-ago period included a $5.3 million charge related to productivity initiatives. Sales for the first nine months of 2004 increased 9% to $680.0 million compared with the same period in 2003.
Sales to mobile-source environmental markets increased approximately $60 million for the first nine months of 2004 compared with the same period last year. Higher pass-through substrate and other costs and foreign currency exchange rate differences accounted for approximately 90% of the increase. Operating earnings from these markets improved 13% for the first nine months of this year compared with the same period of last year. This improvement is primarily due to absence of the charges related to productivity initiatives mentioned previously, the favorable impact of a change in the mix of products sold, a $1.7 million favorable impact from exchange rate differences, and the $1.5 million warranty accrual reversal in the third quarter, partially offset by higher information technology costs.
Sales derived from products sold to industrial markets decreased $5 million in the first nine months of 2004 compared with the first nine months of last year, as decreases in sales to the power-generation market more than offset sales increases to other served markets. Operating earnings from these markets improved due to an increase in gross profit from higher revenues in certain markets, absence of a provision for bad debts in the prior-year period of $1.2 million, and absence of a provision for obsolete inventory of $2.2 million.
Process Technologies
Operating earnings decreased 4% to $60.1 million in the first nine months of 2004 compared with the same period in 2003. The year-ago period included a $2.6 million charge related to productivity initiatives. Sales increased 9% to $439.2 million in the first nine months of 2004 compared with the same period in 2003.
Sales of catalyst and additives to the petroleum-refining market increased 18% in the first nine months of the year compared with the first nine months of 2003 due to continued success of the Company’s DMS technology platform. Operating earnings from sales of catalyst to the petroleum-refining market increased primarily due to the success of DMS technology, but were negatively impacted by approximately $4 million in higher costs to meet increased demand, and disruptions associated with the hurricane season exceeding $1 million. Sales and earnings of additives have grown substantially compared to 2003, but represent a small portion of sales and earnings.
Sales of catalyst to the chemical-process markets were up 3% for the first nine months of 2004 compared with the same period of last year. Operating earnings were lower due to the $5.2 million impact of decreased prices of older product offerings to the polyolefins market; $2.3 million of higher costs associated with the start-up of theLynx capacity expansion in Tarragona, Spain; higher costs for nickel of $4.0 million, and higher operating, pension and information technology expenses, partially offset by a favorable foreign exchange impact of approximately $2 million, absence of the charge related to productivity initiatives in 2003 of $2.6 mill ion, and increasedLynx volumes.
Appearance and Performance Technologies
Operating earnings increased 5% to $58.1 million in the first nine months of 2004 compared with the first nine months of 2003. The year-ago period included a provision of $7.8 million for the fair value of the remaining lease costs of certain mineral-storage facilities the Company ceased to use. Sales increased 5% to $523.7 million in the first nine months of 2004 compared with the first nine months of 2003.
Sales of products from mineral-based operations decreased 1% in the first nine months of 2004 compared with the first nine months of 2003, as lower volumes of kaolin-based products to the paper market were partially offset by improved sales of kaolin-based products to specialty markets. Operating earnings in the mineral-based operations improved due to absence of the previously mentioned $7.8 million charge concerning mineral-storage facilities partially offset by reduced profitability due to the decline in sales of kaolin-based products to the paper market and increased information technology costs of $2.6 million.
Sales of effect pigments and colorants to the cosmetics/personal care, coatings and other markets increased 12% in the first nine months of 2004 compared with the first nine months of 2003 primarily due to higher volumes and the third-quarter acquisition. Operating earnings were up modestly, as profits from increased sales and the benefits of productivity initiatives were significantly offset by higher information technology and other costs of $1.8 million and increased product development and commercialization costs.
Materials Services
Operating earnings increased 43% to $12.6 million in the first nine months of 2004 from $8.8 million in the same period of 2003. Net sales increased 32% to $1,465.5 million in the first nine months of 2004 from $1,108.8 million in the same period of 2003.
The increase in sales is primarily due to increased volumes and market prices of platinum group metals. Operating earnings were up due to improved profitability from refining operations and higher profits from metal-sourcing operations, partially offset by absence of a $9.3 million benefit from a contractual settlement in the prior period and increased operating costs of $2.8 million in the current period. The segment is continuing to experience the change that has been going on in material-sourcing markets, which involves different pricing formulas that have reduced current margins compared with historical margins. Volumes of recycled materials remain at recent low levels, reflecting the same order pattern experienced by our Process Technology segment’s chemical catalyst business.
