Exhibit No. 99.2
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Introduction
This management’s discussion and analysis of financial condition and results of operations (“MD&A”) is intended to provide investors with an understanding of the Corporation’s past performance, its financial condition and its prospects. The following will be discussed and analyzed:
| • | Overview of Business |
| • | Overview of 2005 Results |
| • | Results of Operations and Related Information |
| • | Liquidity and Capital Resources |
| • | Variable Interest Entities |
| • | Critical Accounting Policies and Use of Estimates |
| • | Legal Matters |
| • | New Accounting Standard |
| • | Business Outlook |
| • | Forward-Looking Statements |
1
Overview of Business
The Corporation is a global health and hygiene company with manufacturing facilities in 37 countries and its products are sold in more than 150 countries. The Corporation’s products are sold under such well-known brands as Kleenex, Scott, Huggies, Pull-Ups, Kotex and Depend. The Corporation has four reportable global business segments: Personal Care, Consumer Tissue, K-C Professional & Other and Health Care. These global business segments are described in greater detail in Item 8, Note 17 to the Consolidated Financial Statements.
In managing its global business, the Corporation’s management believes that developing new and improved products, responding effectively to competitive challenges, obtaining and maintaining leading market shares, controlling costs, and managing currency and commodity risks are important to the long-term success of the Corporation. The discussion and analysis of results of operations and other related information will refer to these factors.
| • | Product innovation – Past results and future prospects depend in large part on product innovation. The Corporation relies on its ability to develop and introduce new or improved products to drive sales and volume growth and to achieve and/or maintain category leadership. In order to develop new or improved products, the technology to support those products must be acquired or developed. Research and development expenditures are directed towards new or improved personal care, tissue and health care products and nonwoven materials. |
| • | Competitive environment – Past results and future prospects are significantly affected by the competitive environment in which we operate. We experience intense competition for sales of our principal products in our major markets, both domestically and internationally. Our products compete with widely advertised, well-known, branded products, as well as private label products, which are typically sold at lower prices. We have several major competitors in most of our markets, some of which are larger and more diversified. The principal methods and elements of competition include brand recognition and loyalty, product innovation, quality and performance, price, and marketing and distribution capabilities. |
| Aggressive competitive actions in 2004 and 2005 have required increased promotional spending to support new product introductions and enable competitive pricing in order to protect the position of the Corporation’s products in the market. We expect competition to continue to be intense in 2006. |
| • | Market shares – Achieving leading market shares in our principal products has been an important part of our past performance. We hold number 1 or 2 share positions in more than 80 countries. Achieving and maintaining leading market shares is important because of ongoing consolidation of retailers and the trend of leading merchandisers seeking to stock only the top competitive brands. |
| • | Cost controls – To maintain our competitive position, we must control our manufacturing, distribution and other costs. We have achieved cost savings from reducing material costs and manufacturing waste and realizing productivity gains and distribution efficiencies in each of our business segments. Our ability to control costs can be affected by changes in the price of oil, pulp and other commodities we consume in our manufacturing processes. Our strategic investments in information systems should also allow further cost savings through streamlining administrative activities. |
| • | Foreign currency and commodity risks – As a multinational enterprise, we are exposed to changes in foreign currency exchange rates, and we are also exposed to changes in commodity prices. Our ability to effectively manage these risks can have a material impact on our results of operations. |
2
Overview of 2005 Results
During 2005, the Corporation continued to face intense competition in most of its markets. In particular, the diaper and pants categories in North America and Europe continued to be affected by the competitive pricing pressures that began in late 2002. The businesses were also adversely affected by higher materials input costs and higher energy and related costs.
| • | Net sales advanced 5.4 percent. |
| • | New and improved products such as Scott Extra Soft bathroom tissue, new Huggies toiletries, Pull-Ups Training Pants with Wetness Liner, WypAll X80 towels and Andrex Quilts bathroom tissue contributed to increased sales volumes. |
| • | Net sales of consumer products grew almost 16 percent in the developing and emerging markets with each geographic region contributing to the increase. |
| • | Operating profit decreased 7.8 percent and net income and diluted earnings per share decreased 12.9 percent and 9.1 percent, respectively. |
| • | Higher sales volumes and cost savings of nearly $210 million did not overcome cost inflation and charges related to the strategic cost reductions included in the Corporation’s Competitive Improvement Initiatives. |
| • | Cash flow from operations exceeded $2 billion. |
| • | The Corporation returned $2.3 billion to shareholders through dividends and share repurchases. |
Results of Operations and Related Information
This section contains a discussion and analysis of net sales, operating profit and other information relevant to an understanding of 2005 results of operations. This discussion and analysis compares 2005 results to 2004, and 2004 results to 2003. Each of those discussions focuses first on consolidated results, and then the results of each reportable business segment.
Analysis of Consolidated Net Sales
By Business Segment
| Year Ended December 31 | ||||||||||||
(Millions of dollars) | 2005 | 2004 | 2003 | |||||||||
Personal Care | $ | 6,287.4 | $ | 5,975.1 | $ | 5,652.9 | ||||||
Consumer Tissue | 5,781.3 | 5,343.0 | 5,046.7 | |||||||||
K-C Professional & Other | 2,595.7 | 2,757.7 | 2,363.2 | |||||||||
Health Care | 1,226.1 | 1,200.2 | 1,114.5 | |||||||||
Corporate & Other | 31.4 | 24.3 | 3.7 | |||||||||
Intersegment sales | (19.3 | ) | (217.1 | ) | (154.7 | ) | ||||||
Consolidated | $ | 15,902.6 | $ | 15,083.2 | $ | 14,026.3 | ||||||
3
By Geographic Area
| Year Ended December 31 | ||||||||||||
(Millions of dollars) | 2005 | 2004 | 2003 | |||||||||
United States | $ | 9,093.1 | $ | 8,683.5 | $ | 8,335.8 | ||||||
Canada | 516.4 | 911.0 | 801.8 | |||||||||
Intergeographic sales | (254.7 | ) | (554.4 | ) | (515.6 | ) | ||||||
Total North America | 9,354.8 | 9,040.1 | 8,622.0 | |||||||||
Europe | 3,072.8 | 3,098.3 | 2,892.5 | |||||||||
Asia, Latin America and other | 4,019.2 | 3,488.8 | 3,061.6 | |||||||||
Intergeographic sales | (544.2 | ) | (544.0 | ) | (549.8 | ) | ||||||
Consolidated | $ | 15,902.6 | $ | 15,083.2 | $ | 14,026.3 | ||||||
Commentary:
2005 versus 2004
| Percent Change in Sales Versus Prior Year | ||||||||||||||||
| Total Change | Change Due To | |||||||||||||||
| Volume | Net Price | Currency | Mix/ Other | Pulp Sales | ||||||||||||
Consolidated | 5 | 3 | 1 | 2 | — | (1 | ) | |||||||||
Personal Care | 5 | 4 | — | 2 | (1 | ) | — | |||||||||
Consumer Tissue | 8 | 4 | 2 | 1 | 1 | — | ||||||||||
K-C Professional & Other | (6 | ) | 3 | 1 | 1 | — | (11 | ) | ||||||||
Health Care | 2 | 3 | (1 | ) | — | — | — | |||||||||
Consolidated net sales increased 5.4 percent from 2004. Sales volumes rose more than 3 percent with each of the business segments contributing to the increase. Currency effects added nearly 2 percent to the increase primarily due to strengthening of the South Korean won, the Brazilian real, the Canadian dollar and the Australian dollar. Net selling prices increased 1 percent offset by a reduction in net sales due to the divestiture of the pulp operations as part of the spin-off of Neenah Paper on November 30, 2004.
| • | Worldwide net sales of personal care products increased 5.2 percent due to higher sales volumes, primarily in North and Latin America, and favorable currency effects related to the previously mentioned currencies and higher net selling prices in the developing and emerging markets. These positive factors were partially offset by lower net selling prices in North America and Europe. |
| In North America, net sales increased more than 1 percent resulting from 3 percent higher sales volumes reflecting higher sales of Huggies diapers, growth in child care products – GoodNites youth underpants, Pull-Ups training pants and Little Swimmers swimpants – and incontinence brands Poise and Depend, partially offset by lower feminine care sales volumes. Lower net selling prices of about 1 percent and an unfavorable product mix tempered the effect of the overall higher sales volumes. |
| Net sales in Europe declined nearly 5 percent. Higher sales volumes for diapers were more than offset by reduced sales volumes for feminine care products. Overall net selling prices decreased about 7 percent due to continued competitive pressure. Currency effects provided a more than 1 percent favorable impact on the comparison. |
4
| In the developing and emerging markets, net sales grew nearly 16 percent driven by about 6 percent higher sales volumes and favorable currency effects of the same magnitude. The advance in sales volume was led by double-digit growth in Latin America with increases across the region. Asia also contributed to the sales volume increase. The favorable currency effects occurred primarily in Korea, Brazil and Australia. Net selling prices increased about 3 percent with gains in each of the geographic regions. |
| • | Worldwide net sales of consumer tissue products rose 8.2 percent on the strength of increased sales volumes and net selling prices in North America, higher sales volumes in the developing and emerging markets and favorable currency effects. These favorable impacts were tempered by lower net selling prices in Europe. |
| In North America, net sales advanced nearly 11 percent as higher sales volumes and higher net selling prices each contributed about 5 percent to the improvement. A more favorable product sales mix also added about 1 percent. The higher sales volumes were driven by the introduction of Scott Extra Soft bathroom tissue in February 2005. List price increases on bathroom and facial tissue and on towels that occurred in August 2004 resulted in the higher net selling prices. Kleenex Anti-Viral facial tissue, introduced in September 2004, was the primary leader in the improved product mix. |
| In Europe, net sales decreased nearly 2 percent principally due to over 3 percent lower net selling prices reflecting continuing competitive pressures. Sales volumes were even with the prior year and currency provided about a 1 percent favorable effect. |
| In the developing and emerging markets, net sales increased approximately 16 percent primarily due to about 8 percent higher sales volumes and approximately 6 percent favorable currency effects. Korea, Australia and Brazil were the most significant contributors to both sales volume and currency gains. |
| • | Worldwide net sales for K-C Professional & Other products decreased 5.9 percent. The divestiture of the pulp operations included in the Neenah Paper spin-off reduced net sales by about 11 percent. Overall sales volumes increased approximately 3 percent while net selling prices and favorable currency effects each added about 1 percent. |
| • | Worldwide net sales of health care products increased 2.2 percent on sales volume growth of nearly 3 percent partially offset by lower net selling prices of about 1 percent. |
2004 versus 2003
| Percent Change in Sales Versus Prior Year | ||||||||||||||||
Total | Change Due To | |||||||||||||||
| Volume | Net Price | Currency | Other | |||||||||||||
| Total Volume | Organic Growth | Acquisitions | ||||||||||||||
Consolidated | 8 | 5 | 4 | 1 | (1 | ) | 3 | 1 | ||||||||
Personal Care | 6 | 4 | 4 | — | (2 | ) | 3 | 1 | ||||||||
Consumer Tissue | 6 | 3 | 1 | 2 | — | 4 | (1 | ) | ||||||||
K-C Professional & Other | 17 | 6 | 6 | — | (1 | ) | 4 | 8 | ||||||||
Health Care | 8 | 8 | 8 | — | (2 | ) | 2 | — | ||||||||
5
Consolidated net sales increased 7.5 percent from 2003. Sales volumes advanced approximately 5 percent with contributions from each of the business segments. About 1 percentage point of the increase in sales volumes was due to the consolidation, in August 2003, of Klabin Kimberly S.A. (“Klabin”), a former equity affiliate and Brazil’s largest tissue manufacturer. Currency effects added more than 3 percent to the increase primarily due to strengthening of the euro, British pound, and Australian and Canadian dollars. Slightly lower net selling prices were offset by a more favorable product mix.
| • | Worldwide personal care net sales rose 5.7 percent due to higher sales volumes, mainly in North America, favorable currency effects in Europe and Australia and better product mix in Central America, partially offset by lower net selling prices primarily in North America and Europe. |
| In North America, net sales increased nearly 5 percent driven by a more than 6 percent sales volume increase reflecting higher sales of Huggies diapers and double-digit growth for child care products – GoodNites youth underpants, Pull-Ups training pants, Little Swimmers swimpants – and incontinence brands Poise and Depend. Net selling prices declined about 2 percent primarily in response to competitive activity. Favorable Canadian dollar exchange rate effects also contributed to the increase in net sales. The increased child care volumes are due to strong category growth through increased consumer usage. Market share for feminine care products declined as a result of significant competitive activity. |
| Net sales in Europe were even with last year as 10 percent favorable currency effects were offset by almost 7 percent lower sales volumes and a 3 percent reduction in net selling prices. Lower sales volumes for diapers and feminine care products were a result of aggressive competitive price reductions and promotion spending. This more than offset higher sales volumes for child and adult care products. Except for child care, which benefited from a prior year price increase, net selling prices declined due to competitive activity. |
| In the developing and emerging markets, net sales increased about 10 percent with higher sales volumes and favorable currency effects each contributing about 5 percent, while improved product mix essentially offset lower net selling prices. Advances in sales volumes and favorable currency were realized in both Korea and Australia. Latin America and Israel also recorded higher sales volumes. |
| • | Worldwide consumer tissue net sales increased 5.9 percent on higher sales volumes, primarily in North America, the consolidation of Klabin and favorable currency effects, principally in Europe, partially offset by lower intersegment sales. Net selling prices were even with the prior year. |
| In North America, net sales increased almost 4 percent with higher sales volumes and net selling prices each contributing about 2 percent. The higher sales volumes were led by increased sales for Scott bathroom tissue and private label, partially offset by lower sales volumes for Kleenex facial tissue. In the third quarter of 2004, the Corporation implemented list price increases on its bathroom and facial tissue products and on paper towels. These price increases along with a reduction in trade promotion spending in the fourth quarter contributed to the higher net selling prices. In facial tissue products, the Corporation’s main competitor did not match the Corporation’s price increases in some product codes, which is reflected in the Corporation’s lower market share for the category. The third quarter 2004 introduction of Kleenex Anti-Viral facial tissue contributed to a slight increase in net sales due to product mix. |
| In Europe, net sales increased nearly 9 percent because of an almost 11 percent favorable effect from currency tempered by lower net selling prices that reflect the continuing competitive marketplace. Sales volumes were nearly 1 percent higher primarily due to increased sales of Andrex products in the United Kingdom. |
6
| In the developing and emerging markets, net sales advanced approximately 20 percent on a sales volume increase of more than 11 percent, of which about 7 percentage points was attributable to the consolidation of Klabin, favorable currency effects of almost 5 percent, primarily in Australia, and a favorable product mix. |
| • | Worldwide net sales for K-C Professional & Other products increased 16.7 percent on the strength of nearly 6 percent higher sales volumes, about 8 percent higher intersegment sales and favorable currency effects of about 4 percent, tempered by approximately 1 percent lower net selling prices. |
| Professional products achieved more than 5 percent higher sales volumes and higher sales of nonwoven products provided additional benefit. The favorable currency effects were principally due to Europe. Despite price increases in the fourth quarter for professional products in North America, net selling prices for the year declined due to price erosion in contract business across the segment. |
| • | Worldwide net sales of health care products increased 7.7 percent primarily due to higher sales volumes, as 2 percent lower net selling prices were offset by favorable currency effects. |
Analysis of Consolidated Operating Profit
By Business Segment
| Year Ended December 31 | ||||||||||||
(Millions of dollars) | 2005 | 2004 | 2003 | |||||||||
Personal Care | $ | 1,242.2 | $ | 1,253.2 | $ | 1,221.0 | ||||||
Consumer Tissue | 805.8 | 803.1 | 728.2 | |||||||||
K-C Professional & Other | 446.9 | 387.1 | 353.0 | |||||||||
Health Care | 226.3 | 269.5 | 249.8 | |||||||||
Other income (expense), net | (27.2 | ) | (51.2 | ) | (112.5 | ) | ||||||
Corporate & Other | (383.4 | ) | (155.3 | ) | (107.9 | ) | ||||||
Consolidated | $ | 2,310.6 | $ | 2,506.4 | $ | 2,331.6 | ||||||
By Geographic Area
| Year Ended December 31 | ||||||||||||
(Millions of dollars) | 2005 | 2004 | 2003 | |||||||||
United States | $ | 1,973.5 | $ | 1,953.1 | $ | 1,862.7 | ||||||
Canada | 107.7 | 122.0 | 131.7 | |||||||||
Europe | 165.9 | 221.0 | 202.9 | |||||||||
Asia, Latin America and other | 474.1 | 416.8 | 354.7 | |||||||||
Other income (expense), net | (27.2 | ) | (51.2 | ) | (112.5 | ) | ||||||
Corporate & Other | (383.4 | ) | (155.3 | ) | (107.9 | ) | ||||||
Consolidated | $ | 2,310.6 | $ | 2,506.4 | $ | 2,331.6 | ||||||
| Note: | Corporate & Other for 2005 includes $228.6 million of costs for the Competitive Improvement Initiatives discussed below and other expenses not associated with the business segments or geographic areas. |
7
Commentary:
2005 versus 2004
| Percentage Change in Operating Profit Versus Prior Year | |||||||||||||||||||
| Change Due To | |||||||||||||||||||
| Total Change | Volume | Net Price | Raw Materials Cost | Energy and | Currency | Other(a) | |||||||||||||
Consolidated | (8 | ) | 7 | 4 | (9 | ) | (7 | ) | 1 | (4 | )(b) | ||||||||
Personal Care | (1 | ) | 6 | (2 | ) | (12 | ) | (2 | ) | 3 | 6 | ||||||||
Consumer Tissue | - | 7 | 11 | (4 | ) | (14 | ) | 1 | (1 | ) | |||||||||
K-C Professional & Other | 15 | 9 | 8 | (4 | ) | (7 | ) | 2 | 7 | (c) | |||||||||
Health Care | (16 | ) | 7 | (4 | ) | (10 | ) | (3 | ) | - | (6 | ) | |||||||
| (a) | Includes the benefit of cost savings achieved, net of increased costs for marketing and research. |
| (b) | Includes costs aggregating $228.6 million for the Competitive Improvement Initiatives. |
| (c) | Operating losses from divested pulp operations were included in 2004. |
Consolidated operating profit decreased 7.8 percent. Significant factors that negatively affected operating profit were approximately $229 million of charges related to the Competitive Improvement Initiatives that are not included in the business segments (as discussed later in this MD&A and in Item 8, Note 3 to the Consolidated Financial Statements), cost inflation of about $400 million and higher marketing, research and general expenses. Those factors were partially offset by gross cost savings of nearly $210 million, increased sales volumes and higher net selling prices. Operating profit as a percent of net sales declined to 14.5 percent from 16.6 percent for 2004.
| • | Operating profit for personal care products decreased .9 percent. Cost savings, higher sales volumes and favorable currency effects were offset by materials cost inflation – particularly for polymer resins and superabsorbents, lower net selling prices and increased costs for marketing and research activities. The year-over-year change in operating profit was also affected by about $37 million of costs in 2004 to improve the efficiency of the Corporation’s diaper operations. |
| Operating profit in North America declined about 3 percent as materials cost inflation, lower net selling prices and higher distribution costs more than offset cost savings and the higher sales volumes. In Europe, operating profit decreased primarily due to the lower net selling prices. Operating profit in the developing and emerging markets increased nearly 16 percent due to the higher sales volumes, higher net selling prices and favorable currency effects, tempered by higher marketing and administrative costs. |
| • | Operating profit for consumer tissue products was essentially even with last year, an increase of .3 percent. The higher net selling prices, higher sales volumes and cost savings were offset by cost inflation for materials, energy and distribution, and higher marketing and research expenses. |
| In North America, operating profit grew almost 8 percent because the higher net selling prices and increased sales volumes more than offset the cost inflation. Operating profit in Europe decreased principally due to the effects of the competitive lower net selling prices. In the developing and emerging markets, operating profit advanced approximately 19 percent on the strength of the higher sales volumes and a favorable product mix. |
8
| • | Operating profit for the K-C Professional & Other segment increased 15.4 percent. The higher sales volumes and higher net selling prices combined with cost savings and the absence of operating losses related to the divested pulp operations allowed the segment to overcome materials and energy related cost inflation. |
| • | Operating profit for the health care segment decreased 16.0 percent. Increased raw materials costs, principally for polymers, higher energy and distribution costs and the lower net selling prices more than offset the benefits of the higher sales volumes and cost savings. |
Competitive Improvement Initiatives
In July 2005, the Corporation authorized the initial phase of a multi-year program to further improve its competitive position by accelerating investments in targeted growth opportunities and strategic cost reductions aimed at streamlining manufacturing and administrative operations, primarily in North America and Europe (the “Competitive Improvement Initiatives”).
The Competitive Improvement Initiatives commenced in the third quarter of 2005 and are expected to be substantially completed by December 31, 2008. Based on current estimates, the strategic cost reductions are expected to result in cumulative charges of approximately $900 million to $1.1 billion before tax ($625 - $775 million after tax) over that three and one-half year period. These reductions are expected to yield annual pretax savings that increase to $300-$350 million by 2009. Continuous productivity gains over the last several years along with investments in state-of-the-art manufacturing capacity are enabling the Corporation to consolidate production at fewer facilities. Cash costs related to the sale, closure or streamlining of operations, relocation of equipment, severance and other expenses are expected to account for approximately 45 percent of the charges. Noncash charges will consist primarily of incremental depreciation and amortization and asset write downs.
By the end of 2008, it is anticipated there will be a net workforce reduction of about 10 percent, or approximately 6,000 employees. As of December 31, 2005, a net workforce reduction of more than 400 had occurred. Approximately 20 manufacturing facilities, or 17 percent of the Corporation’s worldwide total, are expected to be sold or closed and an additional 4 facilities are expected to be streamlined. There is a particular focus on Europe, aimed at improving business results in the region. The Corporation intends to consolidate and streamline manufacturing facilities, further improve operating efficiencies, and reduce selling, general and administrative expenses while reinvesting in key growth opportunities there. As of December 31, 2005, charges have been recorded related to the initiatives for 14 facilities.
The initial phase of the Competitive Improvement Initiatives will occur between 2005 and mid-2007 and will include the sale, closure or streamlining of 15 of the facilities and the expansion of 3 others. After-tax charges in connection with these projects are expected to total approximately $355-$390 million. The Corporation anticipates that the pretax charges for the initial phase of the strategic cost reductions will be incurred for the following categories at the indicated estimated amounts: workforce reduction costs (approximately $150 million); incremental depreciation and amortization (approximately $225 million); asset impairments (approximately $100 million); and other associated costs (approximately $55 million). During 2005, the Corporation incurred charges totaling $228.6 million in connection with the initiatives; $167.6 million after tax.
The strategic cost reductions included in the Competitive Improvement Initiatives are corporate decisions and are not included in the business segments’ operating profit performance. See Item 8, Note 17 to the Consolidated Financial Statements for the 2005 costs of the strategic cost reductions by business segment and geographic area. Certain actions yet to be announced for the strategic cost reductions are still being evaluated. Accordingly, it is difficult at this time to estimate the total costs to be incurred by business segment over the life of the initiatives. The 2005 charges have been recorded in Cost of Products Sold ($201.6 million) and Marketing, Research and General Expenses ($27.0 million).
9
Other Income (expense), net
Other income (expense), net decreased compared with 2004 primarily due to income in 2005 of approximately $22 million from an insurance claim for partial recovery of damages related to a fire in 2004 at a facility in Europe. Increased currency transaction losses in 2005 were mitigated by lower write-offs related to the Corporation’s investments in historic real estate restoration projects.
2004 versus 2003
| Percentage Change in Operating Profit Versus Prior Year | |||||||||||||||||
| Total Change | Change Due To | ||||||||||||||||
| Volume | Net Price | Raw Materials Cost | Energy and | Currency | Other(a) | ||||||||||||
Consolidated | 8 | 11 | (8 | ) | (4 | ) | (3 | ) | 3 | 9 | |||||||
Personal Care | 3 | 12 | (9 | ) | (3 | ) | (1 | ) | 2 | 2 | |||||||
Consumer Tissue | 10 | 4 | — | (7 | ) | (6 | ) | 4 | 15 | ||||||||
K-C Professional & Other | 10 | 14 | (8 | ) | (10 | ) | (4 | ) | 3 | 15 | |||||||
Health Care | 8 | 15 | (10 | ) | (5 | ) | (1 | ) | 4 | 5 | |||||||
| (a) | Includes the benefits of cost savings programs. |
Consolidated operating profit increased 7.5 percent as the higher sales volumes, about $160 million of benefit from cost savings programs and total favorable currency effects of over $70 million more than offset the lower net selling prices, higher fiber costs and increased energy and distribution expenses. Operating profit as a percentage of net sales was 16.6 percent, the same as 2003.
| • | Operating profit for personal care products increased 2.6 percent. The higher sales volumes, more than $85 million in cost savings and favorable currency effects, primarily in Australia and Canada, were partially offset by the lower net selling prices, higher raw material and distribution costs, increased advertising expenses, and costs associated with a plan to streamline diaper operations. Primarily as a result of significant productivity gains, the Corporation had available diaper manufacturing capacity in North America and Europe. Therefore, the Corporation executed a plan to cease diaper manufacturing and scale-back distribution operations at its facility in New Milford, Connecticut. Some production capacity was also redeployed from the Barton-upon-Humber facility in the U.K. Diaper machines from these locations will now support growth in other markets, thereby reducing the capital spending required for this business. These steps are consistent with the Corporation’s strategies to drive growth in developing and emerging markets and improve its cost structure in North America and Europe. |
| Costs to implement the infant care plan described above total approximately $40 million before tax, including about $37 million recorded in 2004. The balance of the plan costs were recorded in 2005 as they were incurred. Of the total 2004 cost, approximately $10 million was for employee severance recorded at the time employees were notified of their termination benefits, about $3 million for other cash costs, principally for equipment removal, and $24 million for asset write-offs primarily related to the original equipment installation costs. These costs were recorded in Cost of Products Sold. |
| Operating profit in North America increased about 1 percent as the benefits of the higher sales volumes and cost savings programs were partially offset by the lower selling prices, costs of the infant care plan and higher advertising and distribution costs. In Europe, operating profit declined because of the negative impacts of the competitive environment on selling prices and sales volumes. Operating profit in the developing and emerging markets increased over 7 percent, principally due to higher sales volumes and favorable currency effects, partially offset by higher marketing expenses. |
10
| • | Operating profit for consumer tissue products improved 10.3 percent driven by cost savings of almost $60 million, favorable currency effects of about $25 million and lower marketing expenses tempered by approximately $45 million of higher fiber costs, higher other raw material and energy costs and increased distribution expense. In North America, operating profit grew nearly 6 percent because of the higher sales volumes and net selling prices, cost savings, and lower marketing expenses, partially offset by higher fiber costs and increased costs for energy and distribution. Operating profit in Europe advanced more than 8 percent principally on the strength of cost savings and favorable currency, tempered by the lower net selling prices. In the developing and emerging markets, operating profit rose more than 20 percent primarily due to favorable product mix, the higher sales volumes and currency effects. |
| • | Operating profit for the K-C Professional & Other segment increased 9.7 percent. The higher sales volumes, benefits from cost savings and favorable currency effects more than offset the lower net selling prices, raw materials inflation and increased costs of energy and distribution. |
| • | Operating profit for the health care segment increased 7.9 percent. The higher sales volumes, favorable currency effects and improved manufacturing operations were tempered by the lower net selling prices and materials cost inflation. |
| • | Other income (expense), net in 2003 included charges of $34 million consisting of $15.6 million for a legal judgment in Europe and $18.4 million for the costs associated with the redemption of $400 million of debentures; and nearly $20 million for charges to write-off an equity investment in an historic restoration project and the write-down of a nonstrategic facility outside of North America. |
| • | In 2004 Corporate & Other included the write-off of a consolidated investment in an historic renovation project, higher corporate charitable contributions and increased general business taxes. |
Additional Income Statement Commentary
Synthetic Fuel Partnerships
As described in Item 8, Note 14 to the Consolidated Financial Statements, the Corporation owns minority interests in two synthetic fuel partnerships. Pretax losses from participation in these partnerships are recorded as nonoperating expenses in the Consolidated Income Statement. The $20.6 million increase in these losses in 2005 compared with 2004 was primarily due to the Corporation’s full-year participation in one of the partnerships versus a partial year in 2004. The Corporation’s income tax provision was lowered by $34.5 million as a result of increased income tax credits and tax benefits of the higher nonoperating expenses. The continuing rise in crude oil prices may initiate the phase out of the synthetic fuel tax credits derived from production of the synthetic fuels, and if the credits are phased out, the partnerships are expected to cease production. Based on year-to-date prices of crude oil and expected pricing for the balance of 2006, the Corporation anticipates that it could receive only modest benefits, if any, from these partnerships in 2006.
2005 versus 2004
| • | Interest expense increased due to both a higher average level of debt and higher interest rates. |
| • | The Corporation’s effective income tax rate was 22.3 percent in 2005 compared with 22.0 percent in 2004. The most significant factors causing the increase were the taxes on the dividends received under the American Jobs Creation Act partially offset by the increased synthetic fuel credits. |
11
| • | The Corporation’s share of net income of equity affiliates increased $11.8 million from 2004 primarily due to higher earnings at Kimberly-Clark de Mexico, S.A. de C.V. (“KCM”). KCM’s results were driven by a nearly 16 percent increase in sales due to volume growth in its consumer businesses and higher selling prices. However, its earnings growth was tempered by currency losses. |
| • | Minority owners’ share of subsidiaries’ net income increased $12.6 million primarily due to higher earnings of companies in the developing and emerging markets. |
| • | As a result of the Corporation’s share repurchase program, the average number of common shares outstanding declined, which benefited 2005 results by $.14 per share. |
2004 versus 2003
| • | Interest expense decreased primarily because of a lower average level of debt, partially offset by higher interest rates. |
| • | The Corporation’s effective income tax rate was 22.0 percent in 2004 compared with 23.3 percent in 2003. The lower effective tax rate was primarily due to the incremental benefits from the synthetic fuel partnership entered into in 2004. |
| • | The Corporation’s share of net income of equity affiliates increased $17.8 million from 2003 primarily due to higher earnings at KCM. Its results were boosted by a sales gain of more than 10 percent, with continued double-digit volume growth in its consumer businesses and higher selling prices. |
| • | Minority owners’ share of subsidiaries’ net income increased $18.3 million primarily due to higher returns on the preferred securities held by the minority interest in the Corporation’s consolidated foreign financing subsidiary. (See Item 8, Note 6 to the Consolidated Financial Statements for additional detail regarding these securities.) |
| • | Income from discontinued operations, net of income taxes decreased 41.1 percent due to transaction costs for the Spin-off and to a lesser extent because 2004 includes 11 months’ results versus 12 months in 2003 as the Spin-off occurred on November 30, 2004. |
| • | As a result of the Corporation’s share repurchase program, the average number of common shares outstanding declined, which benefited 2004 results by $.07 per share. |
Liquidity and Capital Resources
| Year Ended December 31 | ||||||||
(Millions of dollars) | 2005 | 2004 | ||||||
Cash provided by operations | $ | 2,311.8 | $ | 2,726.2 | ||||
Capital spending | 709.6 | 535.0 | ||||||
Acquisitions of businesses, net of cash acquired | 17.4 | — | ||||||
Ratio of total debt and preferred securities to capital(a) | 43.5 | % | 37.7 | % | ||||
Pretax interest coverage - times | 9.3 | 11.5 | ||||||
| (a) | Capital is total debt and preferred securities plus stockholders’ equity and minority owners’ interest in subsidiaries. |
12
Cash Flow Commentary:
| • | Cash provided by operations decreased $414.4 million, or 15.2 percent, primarily due to an increased investment in working capital and higher income tax payments, partially offset by lower cash contributions to the U.S. defined benefit pension plan. |
Contractual Obligations:
The following table presents the Corporation’s total contractual obligations for which cash flows are fixed or determinable.
(Millions of dollars) | Total | 2006 | 2007 | 2008 | 2009 | 2010 | 2011+ | ||||||||||||||
Contractual obligations | |||||||||||||||||||||
Long-term debt | $ | 2,662 | $ | 67 | $ | 338 | $ | 49 | $ | 8 | $ | 33 | $ | 2,167 | |||||||
Interest payments on long-term debt | 1,392 | 154 | 146 | 122 | 118 | 117 | 735 | ||||||||||||||
Operating leases | 258 | 86 | 48 | 34 | 26 | 17 | 47 | ||||||||||||||
Unconditional purchase obligations | 1,756 | 416 | 352 | 273 | 226 | 157 | 332 | ||||||||||||||
Open purchase orders | 985 | 985 | — | — | — | — | — | ||||||||||||||
Total contractual obligations | $ | 7,053 | $ | 1,708 | $ | 884 | $ | 478 | $ | 378 | $ | 324 | $ | 3,281 | |||||||
Obligations Commentary:
| • | Projected interest payments for variable-rate debt were calculated based on the outstanding principal amounts and prevailing market rates as of December 31, 2005. |
| • | The unconditional purchase obligations are for the purchase of raw materials, primarily pulp and utilities. Although the Corporation is primarily liable for payments on the above operating leases and unconditional purchase obligations, based on historic operating performance and forecasted future cash flows, management believes the Corporation’s exposure to losses, if any, under these arrangements is not material. |
| • | The open purchase orders displayed in the table represent amounts the Corporation anticipates will become payable within the next year for goods and services it has negotiated for delivery. |
The above table does not include future payments that the Corporation will make for other postretirement benefit obligations. Those amounts are estimated using actuarial assumptions, including expected future service, to project the future obligations. Based upon those projections, the Corporation anticipates making annual payments for these obligations within a range from nearly $85 million in 2006 to more than $95 million by 2015.
Deferred taxes, minority interest and payments related to pension plans are also not included in the table.
A consolidated financing subsidiary has issued preferred securities that are in substance perpetual and are callable by the subsidiary in November 2008 and each 20-year anniversary thereafter. Management currently anticipates that these securities will not be called in November 2008, the next call date, and therefore they are not included in the above table. (See Item 8, Note 6 to the Consolidated Financial Statements for additional detail regarding these securities.)
13
Investing Commentary:
| • | During 2005, the Corporation’s capital spending of $709.6 million, which is equal to 4.5 percent of net sales, was below the long-term targeted range of 5 percent to 6 percent of net sales. The lower capital spending in 2005 resulted primarily from productivity gains and leveraging the global scale of existing production capacity. Management believes the capital spending target range of 5 percent to 6 percent of net sales is appropriate. |
| • | The net decrease in time deposits in 2005 was primarily due to the Korean business utilizing their investments to pay dividends and to fund their pension plan. |
Financing Commentary:
| • | At December 31, 2005, total debt and preferred securities was $4.6 billion, compared with $4.2 billion last year end. |
| • | During the third quarter of 2005, the Corporation issued $300 million of 4.875% Notes due August 15, 2015. Proceeds from the sale of the notes were used for general corporate purposes and for the reduction of existing indebtedness, including portions of the Corporation’s outstanding commercial paper program. |
| • | At December 31, 2005, the Corporation had fixed-to-floating interest rate swap agreements related to a $500 million 5.0% Note that matures on August 15, 2013. |
| • | There were no changes in the Corporation’s credit ratings in 2005. The Corporation’s long-term debt securities have an Aa2 rating from Moody’s Investor Service and an AA- from Standard & Poor’s. Its commercial paper is rated in the top category. |
| • | At December 31, 2005, the Corporation had $1.5 billion of revolving credit facilities. These facilities, unused at December 31, 2005, permit borrowing at competitive interest rates and are available for general corporate purposes, including backup for commercial paper borrowings. The Corporation pays commitment fees on the unused portion but may cancel the facilities without penalty at any time prior to their expiration. These facilities expire in June 2010. The Corporation anticipates that these facilities will be renewed when they expire. |
| • | During the fourth quarter of 2005, a three-year bank credit facility was established for the purpose of funding American Jobs Creation Act dividends. The Corporation has the option to repay the facility in any month until the facility expires in October 2008. Currently, the Corporation plans to repay this obligation by the end of 2006; therefore, it has been classified as short-term debt. The facility is denominated in Australian dollars and euros, and interest charges are based on the prevailing local short-term interest rates plus 12.5 basis points. As of December 31, 2005, approximately $308 million was outstanding. No additional draws against the facility are permitted. |
| • | For the full year 2005, the Corporation repurchased approximately 24.3 million shares of its common stock at a cost of approximately $1.5 billion, including 8.6 million shares repurchased during the fourth quarter at a cost of approximately $500 million. The monthly detail of share repurchases for the fourth quarter of 2005 is included in Part II Item 5 of this Form 10-K. On September 15, 2005, the Corporation’s Board of Directors authorized the repurchase of an additional 50 million shares of the Corporation’s common stock during the next several years. |
Management believes that the Corporation’s ability to generate cash from operations and its capacity to issue short-term and long-term debt are adequate to fund working capital, capital spending, payment of dividends, repurchases of common stock and other needs in the foreseeable future.
14
Variable Interest Entities
The Corporation has variable interests in the following financing and real estate entities and in the synthetic fuel partnerships described above.
Financing Entities
As explained in more detail in Item 8, Note 9 to the Consolidated Financial Statements, the Corporation holds a significant variable interest in two financing entities that were used to monetize long-term notes received from the sale of certain nonstrategic timberlands and related assets, which were sold in 1999 and 1989 to nonaffiliated buyers. These sales involved notes receivable, which are backed by irrevocable standby letters of credit issued by money center banks, that have an aggregate face value of $617 million.
In 1999 the Corporation transferred the notes received from the 1999 sale to a noncontrolled financing entity, and in 2000 it transferred the notes received from the 1989 sale to another noncontrolled financing entity. The Corporation has minority voting interests in each of the financing entities (collectively, the “Financing Entities”). The transfers of the notes and certain other assets to the Financing Entities were made at fair value, were accounted for as asset sales and resulted in no gain or loss. In conjunction with the transfer of the notes and other assets, the Financing Entities became obligated for $617 million in third-party debt financing. A nonaffiliated financial institution has made substantive capital investments in each of the Financing Entities, has majority voting control over them and has substantive risks and rewards of ownership of the assets in the Financing Entities. The Corporation also contributed intercompany notes receivable aggregating $662 million and intercompany preferred stock of $50 million to the Financing Entities, which serve as secondary collateral for the third-party lending arrangements. In the unlikely event of default by both of the money center banks that provided the irrevocable standby letters of credit, the Corporation could experience a maximum loss of $617 million under these arrangements.
The Corporation has not consolidated the Financing Entities because it is not the primary beneficiary of either entity. Rather, it will continue to account for its ownership interests in these entities using the equity method of accounting. The Corporation retains equity interests in the Financing Entities for which the legal right of offset exists against the intercompany notes. As a result, the intercompany notes payable have been offset against the Corporation’s equity interests in the Financing Entities for financial reporting purposes.
See Item 8, Note 6 to the Consolidated Financial Statements for a description of the Corporation’s Luxembourg-based financing subsidiary, which is consolidated because the Corporation is the primary beneficiary of the entity.
Real Estate Entities
As explained in greater detail in Item 8, Note 9 to the Consolidated Financial Statements, the Corporation participates in the U.S. affordable and historic renovation real estate markets through (i) partnership arrangements in which it is a limited partner, (ii) limited liability companies (“LLCs”) in which it is a nonmanaging member and (iii) investments in various funds in which the Corporation is one of many noncontrolling investors. These variable interest entities borrow money from third parties generally on a nonrecourse basis and invest in and own various real estate projects.
Effective March 31, 2004, the Corporation adopted FASB Interpretation No. 46 (Revised December 2003),Consolidation of Variable Interest Entities – an Interpretation of ARB 51 (“FIN 46R”), for these real estate entities. Adoption of FIN 46R required the Corporation to consolidate ten apartment projects and two hotels because it was the primary beneficiary of each of these real estate
15
ventures. Subsequently, three of the apartments and the two hotels became wholly-owned by the Corporation. For the entities that remain consolidated under FIN 46R, the carrying amount of the assets that serve as collateral for $42.7 million of obligations of these ventures was $47.0 million at December 31, 2005.
The Corporation is not the primary beneficiary for the remainder of the real estate entities and has not consolidated them. These entities are accounted for by the equity method of accounting or by the effective yield method, as appropriate. As of December 31, 2005, total permanent financing debt for the nonconsolidated entities was $255.8 million. A total of $19.7 million of the permanent financing debt is guaranteed by the Corporation. Except for the guaranteed portion, permanent financing debt is secured solely by the properties and is nonrecourse to the Corporation. From time to time, temporary interim financing is guaranteed by the Corporation. In general, the Corporation’s interim financing guarantees are eliminated at the time permanent financing is obtained. At December 31, 2005, $34.3 million of temporary interim financing associated with these nonconsolidated real estate entities was guaranteed by the Corporation.
If the Corporation’s investments in its nonconsolidated real estate entities were to be disposed of at their carrying amounts, a portion of the tax credits may be recaptured and may result in a charge to earnings. As of December 31, 2005, this recapture risk is estimated to be $34.5 million. The Corporation has no current intention of disposing of these investments during the recapture period, nor does it anticipate the need to do so in the foreseeable future in order to satisfy any anticipated liquidity need. Accordingly, the recapture risk is considered to be remote.
At December 31, 2005, the Corporation’s maximum loss exposure for its nonconsolidated real estate entities is estimated to be $109.4 million and is comprised of its net equity in these entities of $20.9 million, its permanent financing guarantees of $19.7 million, its interim financing guarantees of $34.3 million and the income tax credit recapture risk of $34.5 million.
Critical Accounting Policies and Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of net sales and expenses during the reporting period. The critical accounting policies used by management in the preparation of the Corporation’s consolidated financial statements are those that are important both to the presentation of the Corporation’s financial condition and results of operations and require significant judgments by management with regard to estimates used. The critical judgments by management relate to consumer and trade promotion and rebate accruals, pension benefits and other postretirement benefits, retained insurable risks, excess and obsolete inventory, allowance for doubtful accounts, useful lives for depreciation and amortization, future cash flows associated with impairment testing for goodwill and long-lived assets and for determining the primary beneficiary of variable interest entities, deferred tax assets and potential income tax assessments, and loss contingencies. The Corporation’s critical accounting policies have been reviewed with the Audit Committee of the Board of Directors.
Promotion and Rebate Accruals
Among those factors affecting the accruals for promotions are estimates of the number of consumer coupons that will be redeemed and the type and number of activities within promotional programs between the Corporation and its trade customers. Rebate accruals are based on estimates of the quantity of products distributors have sold to specific customers. Generally, the estimates for consumer coupon costs are based on historical patterns of coupon redemption, influenced by judgments about current market conditions such as competitive activity in specific product categories. Estimates of trade promotion liabilities for promotional program costs incurred, but unpaid, are generally based on estimates of the quantity of customer sales, timing of promotional activities and forecasted costs for
16
activities within the promotional programs. Settlement of these liabilities sometimes occurs in periods subsequent to the date of the promotion activity. Trade promotion programs include introductory marketing funds such as slotting fees, cooperative marketing programs, temporary price reductions, favorable end of aisle or in-store product displays and other activities conducted by the customers to promote the Corporation’s products. Promotion accruals as of December 31, 2005 and 2004 were $235.3 million and $263.3 million, respectively. Rebate accruals as of December 31, 2005 and 2004 were $160.2 million and $163.0 million, respectively.
Pension and Other Postretirement Benefits
Pension Benefits
The Corporation and its subsidiaries in North America and the United Kingdom have defined benefit pension plans (the “Principal Plans”) and/or defined contribution retirement plans covering substantially all regular employees. Certain other subsidiaries have defined benefit pension plans or, in certain countries, termination pay plans covering substantially all regular employees. The funding policy for the qualified defined benefit plans in North America and the defined benefit plans in the United Kingdom is to contribute assets to fully fund the accumulated benefit obligation (“ABO”). Subject to regulatory and tax deductibility limits, any funding shortfall will be eliminated over a reasonable number of years.
Nonqualified U.S. plans providing pension benefits in excess of limitations imposed by the U.S. income tax code are not funded. Funding for the remaining defined benefit plans outside the U.S. is based on legal requirements, tax considerations, investment opportunities, and customary business practices in such countries.
Consolidated pension expense for defined benefit pension plans was $156.8 million in 2005 compared with $154.8 million for 2004. Pension expense is calculated based upon a number of actuarial assumptions applied to each of the defined benefit plans. The weighted-average expected long-term rate of return on pension fund assets used to calculate pension expense was 8.29 percent in 2005 compared with 8.32 percent in 2004 and will be 8.28 percent in 2006. The expected long-term rate of return on pension fund assets was determined based on several factors, including input from the Corporation’s pension investment consultants and projected long-term returns of broad equity and bond indices. The U.S. plan’s historical 10-year and 15-year compounded annual returns of 9.36 percent and 10.28 percent, respectively, which have been in excess of these broad equity and bond benchmark indices, were also considered. On average, the investment managers for each of the plans comprising the Principal Plans are anticipated to generate annual long-term rates of return of at least 8.5 percent. The expected long-term rate of return on the assets in the Principal Plans is based on an asset allocation assumption of about 70 percent with equity managers, with expected long-term rates of return of approximately 10 percent, and 30 percent with fixed income managers, with an expected long-term rate of return of about 6 percent. Actual asset allocation is regularly reviewed and it is periodically rebalanced to the targeted allocation when considered appropriate. Also, when deemed appropriate, hedging strategies are executed using index options and futures to limit the downside exposure of certain investments by trading off upside potential above an acceptable level. This hedging strategy was last executed for 2003. No hedging instruments are currently in place. Long-term rate of return assumptions continue to be evaluated at least annually and are adjusted as necessary.
Pension expense is determined on the fair value of assets rather than a calculated value that averages gains and losses (“Calculated Value”) over a period of years. Investment gains or losses represent the difference between the expected return calculated using the fair value of assets and the actual return based on the fair value of assets. The variance between actual and expected gains and losses on pension assets are recognized in pension expense more rapidly than they would be if a Calculated Value was used for plan assets. As of December 31, 2005, the Principal Plans had cumulative unrecognized investment losses and other actuarial losses of approximately $1.7 billion. These unrecognized net losses may increase future pension expense if not offset by (i) actual
17
investment returns that exceed the assumed investment returns, or (ii) other factors, including reduced pension liabilities arising from higher discount rates used to calculate pension obligations, or (iii) other actuarial gains, including whether such accumulated actuarial losses at each measurement date exceed the “corridor” determined under SFAS No. 87,Employers’ Accounting for Pensions.
The discount (or settlement) rate used to determine the present value of the Corporation’s future U.S. pension obligations at December 31, 2005 was based on a yield curve constructed from a portfolio of high quality corporate debt securities with maturities ranging from 1 year to 30 years. Each year’s expected future benefit payments were discounted to their present value at the appropriate yield curve rate thereby generating the overall discount rate for U.S. pension obligations. For the non-U.S. Principal Plans, discount rates are established using the long-term local government bond rates increased by the interest rate spread between the U.S. discount rate and long-term U.S. government bond rates. The weighted-average discount rate for the Principal Plans decreased to 5.54 percent at December 31, 2005 from 5.77 percent at December 31, 2004.
Consolidated pension expense is estimated to approximate $165 million in 2006. This estimate reflects the effect of the actuarial losses and is based on an expected weighted-average long-term rate of return on assets in the Principal Plans of 8.5 percent, a weighted-average discount rate for the Principal Plans of 5.54 percent and various other assumptions. Pension expense beyond 2006 will depend on future investment performance, the Corporation’s contributions to the pension trusts, changes in discount rates and various other factors related to the covered employees in the plans. The estimated expense for 2006 does not include any potential effects related to subsequent phase projects under the Competitive Improvement Initiatives that have not yet been authorized.
If the expected long-term rate of return on assets for the Principal Plans was lowered by 0.25 percent, our annual pension expense would increase by approximately $9 million. If the discount rate assumptions for these same plans were reduced by 0.25 percent, annual pension expense would increase by approximately $14 million and the December 31, 2005 minimum pension liability would increase by about $158 million.
The fair value of the assets in the Corporation’s defined benefit plans was $4.1 billion and $4.0 billion at December 31, 2005 and December 31, 2004, respectively. Lower discount rates have caused the projected benefit obligations (the “PBO”) of the defined benefit plans to exceed the fair value of plan assets by approximately $1.4 billion and $1.2 billion at December 31, 2005 and December 31, 2004, respectively. Primarily due to the lower discount rates, the ABO of the defined benefit plans exceeded the fair value of plan assets by about $1.0 billion and about $.9 billion at the end of 2005 and 2004, respectively. On a consolidated basis, the Corporation contributed about $117 million to pension trusts in 2005 compared with $200 million in 2004. In addition, the Corporation made direct benefit payments of $11.9 million in 2005 compared to $21.4 million in 2004. While the Corporation is not required to make a contribution in 2006 to the U.S. plan, the benefit of a contribution will be evaluated. The Corporation currently anticipates contributing about $80 million to its pension plans outside the U.S. in 2006.
The discount rate used for each country’s pension obligation is identical to the discount rate used for that country’s other postretirement obligation. The discount rates displayed for the two types of obligations for the Corporation’s consolidated operations may appear different due to the weighting used in the calculation of the two weighted-average discount rates.
Other Postretirement Benefits
Substantially all North American retirees and employees are covered by health care and life insurance benefit plans. Certain benefits are based on years of service and/or age at retirement. The plans are principally noncontributory for employees who were eligible to retire before 1993 and contributory for
18
most employees who retire after 1992, except that the Corporation provides no subsidized benefits to most employees hired after 2003. These plans are not funded until the year in which payments are made for benefit claims.
The Corporation’s contributions to the plans were $66.5 million in 2005 compared with $59.4 million in 2004. The increase was due to a change in the timing of contributions to the plans to better align with the payments of benefit claims. The determination of the discount rates used to calculate the benefit obligations of the plans are discussed in the pension benefit section above. If the discount rate assumptions for these plans were reduced by 0.25 percent, our annual other postretirement benefit expense would increase by approximately $1 million and the December 31, 2005 benefit liability would increase by about $21 million.
Prior to 2004, certain U.S. plans limited the Corporation’s cost of future annual per capita retiree medical benefits to no more than 200 percent of the 1992 annual per capita cost. These plans reached this limitation (the “Cap”) and were amended during 2003. Among other things, the amendments index the Cap by 3 percent annually beginning in 2005 for certain employees retiring on or before April 1, 2004 and limit the Corporation’s future cost for retiree health care benefits to a defined fixed per capita cost for certain employees retiring after April 1, 2004.
The health care cost trend rate is based on a combination of inputs including the Corporation’s recent claims history and insights from external advisers regarding recent developments in the health care marketplace, as well as projections of future trends in the marketplace. The annual increase in the consolidated weighted-average health care cost trend rate is expected to be 9.91 percent in 2006, 8.86 percent in 2007 and to gradually decline to 5.19 percent in 2011 and thereafter. See Item 8, Note 12 to the Consolidated Financial Statements for disclosure of the effect of a one percentage point change in the health care cost trend rate.
Retained Insurable Risks
Selected insurable risks are retained, primarily those related to property damage, workers’ compensation, and product, automobile and premises liability based upon historical loss patterns and management’s judgment of cost effective risk retention. Accrued liabilities for incurred but not reported events, principally related to workers’ compensation and automobile liability, are based upon loss development factors provided to the Corporation by external insurance brokers and are not discounted.
Excess and Obsolete Inventory
All excess, obsolete, damaged or off-quality inventories including raw materials, in-process, finished goods, and spare parts are required to be adequately reserved for or to be disposed of. This process requires an ongoing tracking of the aging of inventories to be reviewed in conjunction with current marketing plans to ensure that any excess or obsolete inventories are identified on a timely basis. This process also requires judgments be made about the salability of existing stock in relation to sales projections. The evaluation of the adequacy of provision for obsolete and excess inventories is performed on at least a quarterly basis. No provisions for future obsolescence, damage or off-quality inventories are made.
Allowance for Doubtful Accounts
The allowance for doubtful accounts represents the Corporation’s best estimate of the accounts receivable that will not be collected. The estimate is based on, among other things, historical collection experience, a review of the current aging status of customer receivables, and a review of specific information for those customers that are deemed to be higher risk. At the time the Corporation becomes aware of a customer whose continued operating success is questionable, collection of their receivable balance is closely monitored and the customer may be required to prepay for shipments. If a customer
19
enters a bankruptcy action, the progress of that action is monitored to determine when and if an additional provision for non-collectibility is warranted. The adequacy of the allowance for doubtful accounts is evaluated on at least a quarterly basis. The allowance for doubtful accounts at December 31, 2005 and 2004 was $35.8 million and $42.5 million, respectively, and the write-off of uncollectible accounts was $15.0 million and $13.6 million in 2005 and 2004, respectively.
Property and Depreciation
Estimating the useful lives of property, plant and equipment requires the exercise of management judgment, and actual lives may differ from these estimates. Changes to these initial useful life estimates are made when appropriate. Property, plant and equipment are tested for impairment in accordance with SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets,whenever events or changes in circumstances indicate that the carrying amounts of such long-lived assets may not be recoverable from future net pretax cash flows. Impairment testing requires significant management judgment including estimating the future success of product lines, future sales volumes, growth rates for selling prices and costs, alternative uses for the assets and estimated proceeds from disposal of the assets. Impairment testing is conducted at the lowest level where cash flows can be measured and are independent of cash flows of other assets. An asset impairment would be indicated if the sum of the expected future net pretax cash flows from the use of the asset (undiscounted and without interest charges) is less than the carrying amount of the asset. An impairment loss would be measured based on the difference between the fair value of the asset and its carrying amount. The determination of fair value is based on an expected present value technique in which multiple cash flow scenarios that reflect a range of possible outcomes and a risk free rate of interest are used to estimate fair value.
The estimates and assumptions used in the impairment analysis are consistent with the business plans, including the Competitive Improvement Initiatives, and estimates used to manage business operations and to make acquisition and divestiture decisions. The use of different assumptions would increase or decrease the estimated fair value of the asset and the impairment charge. Actual outcomes may differ from the estimates. For example, if the Corporation’s products fail to achieve volume and pricing estimates or if market conditions change or other significant estimates are not realized, then revenue and cost forecasts may not be achieved, and additional impairment charges may be recognized.
Goodwill and Other Intangible Assets
The carrying amount of goodwill is tested annually as of the beginning of the fourth quarter and whenever events or circumstances indicate that impairment may have occurred. Impairment testing is performed in accordance with SFAS No. 142,Goodwill and Other Intangible Assets. Impairment testing is conducted at the operating segment level of the Corporation’s businesses and is based on a discounted cash flow approach to determine the fair value of each operating segment. The determination of fair value requires significant management judgment including estimating future sales volumes, selling prices and costs, changes in working capital, investments in property and equipment and the selection of an appropriate discount rate. Sensitivities of these fair value estimates to changes in assumptions for sales volumes, selling prices and costs are also tested. If the carrying amount of an operating segment that contains goodwill exceeds fair value, a possible impairment would be indicated. If a possible impairment is indicated, the implied fair value of goodwill would be estimated by comparing the carrying amount of the net assets of the unit excluding goodwill to the total fair value of the unit. If the carrying amount of goodwill exceeds its implied fair value, an impairment charge would be recorded. Judgment is used in assessing whether goodwill should be tested more frequently for impairment than annually. Factors such as unexpected adverse economic conditions, competition, product changes and other external events may require more frequent assessments. The Corporation’s annual goodwill impairment testing has been completed and it has been determined that none of its $2.7 billion of goodwill is impaired.
20
The Corporation has no intangible assets with indefinite useful lives. At December 31, 2005, the Corporation has other intangible assets with a gross carrying amount of approximately $277 million and a net carrying amount of about $164 million. These intangibles are being amortized over their estimated useful lives and are tested for impairment whenever events or circumstances indicate that impairment may have occurred. If the carrying amount of an intangible asset exceeds its fair value based on estimated future undiscounted cash flows, an impairment loss would be indicated. The amount of the impairment loss to be recorded would be based on the excess of the carrying amount of the intangible asset over its discounted future cash flows. Judgment is used in assessing whether the carrying amount of intangible assets is not expected to be recoverable over their estimated remaining useful lives. The factors considered are similar to those outlined in the goodwill impairment discussion above.
Primary Beneficiary Determination of Variable Interest Entities (“VIE”)
The determination of the primary beneficiary of variable interest entities under FIN 46R requires estimating the probable future cash flows of each VIE using a computer simulation model and determining the variability of such cash flows and their present values. Estimating the probable future cash flows of each VIE requires the exercise of significant management judgment. The resulting present values are then allocated to the various participants in each VIE in accordance with their beneficial interests. The participant that is allocated the majority of the present value of the variability is the primary beneficiary and is required to consolidate the VIE under FIN 46R.
Deferred Income Taxes and Potential Assessments
As of December 31, 2005, the Corporation has recorded deferred tax assets related to income tax loss carryforwards and income tax credit carryforwards totaling $789.4 million and has established valuation allowances against these deferred tax assets of $474.0 million, thereby resulting in a net deferred tax asset of $315.4 million. As of December 31, 2004, the net deferred tax asset was $267.1 million. These income tax losses and credits are in non-U.S. taxing jurisdictions, in the U.S. for excess foreign tax credits and in certain states within the U.S. In determining the valuation allowances to establish against these deferred tax assets, the Corporation considers many factors, including the specific taxing jurisdiction, the carryforward period, income tax strategies and forecasted earnings for the entities in each jurisdiction. A valuation allowance is recognized if, based on the weight of available evidence, the Corporation concludes that it is more likely than not that some portion or all of the deferred tax asset will not be realized.
As of December 31, 2005, United States income taxes and foreign withholding taxes have not been provided on approximately $3.7 billion of unremitted earnings of subsidiaries operating outside the U.S. in accordance with Accounting Principles Board (“APB”) Opinion No. 23,Accounting for Income Taxes, Special Areas. These earnings are considered by management to be invested indefinitely. However, they would be subject to income tax if they were remitted as dividends, were lent to the Corporation or a U.S. affiliate, or if the Corporation were to sell its stock in the subsidiaries. It is not practicable to determine the amount of unrecognized deferred U.S. income tax liability on these unremitted earnings. We periodically determine whether our non-U.S. subsidiaries will invest their undistributed earnings indefinitely and reassess this determination as appropriate. See Item 8, Note 15 to the Consolidated Financial Statements for disclosure of previously unremitted earnings that were repatriated in 2005 under the provisions of the American Jobs Creation Act.
The Corporation accrues liabilities in current income taxes for potential assessments which at December 31, 2005 and 2004 aggregated to $268.8 million and $356.4 million, respectively. The accruals relate to uncertain tax positions in a variety of taxing jurisdictions and are based on what management believes will be the ultimate resolution of these positions. These liabilities may be affected by changing interpretations of laws, rulings by tax authorities, or the expiration of the statute of limitations. The Corporation’s U.S. federal income tax returns have been audited through 2003. IRS assessments of additional taxes have been paid through 1998. Refund actions are pending with
21
the IRS Examination Division or Appeals Office for the years 1993 through 1998. Management currently believes that the ultimate resolution of these matters, individually or in the aggregate, will not have a material effect on the Corporation’s business, financial condition, results of operations or liquidity.
Loss Contingencies
The outcome of loss contingencies and legal proceedings and claims brought against the Corporation are subject to uncertainty. SFAS No. 5,Accounting for Contingencies, requires that an estimated loss contingency be accrued by a charge to earnings if it is probable that an asset has been impaired or a liability has been incurred and the amount can be reasonably estimated. Disclosure of the contingency is required if there is at least a reasonable possibility that a loss has been incurred. Determination of whether to accrue a loss requires evaluation of the probability of an unfavorable outcome and the ability to make a reasonable estimate. Changes in these estimates could affect the timing and amount of accrual of loss contingencies.
Legal Matters
See Item 8, Note 11 to the Consolidated Financial Statements for a description of legal matters.
Environmental Matters
The Corporation has been named a potentially responsible party under the provisions of the federal Comprehensive Environmental Response, Compensation and Liability Act, or analogous state statutes, at a number of waste disposal sites, none of which, individually or in the aggregate, in management’s opinion, is likely to have a material adverse effect on the Corporation’s business, financial condition, results of operations or liquidity.
New Accounting Standard
See Item 8, Note 1 to the Consolidated Financial Statements for a description of SFAS No. 123R,Share-Based Payment.
Business Outlook
Under its Global Business Plan, the Corporation expects net sales to continue to benefit from new and improved products and strong growth in developing and emerging markets. The Corporation is also confident that it will generate additional cost savings in 2006 and beyond. And while it is anticipated that inflationary pressures will continue, the Corporation is intent on delivering sustainable growth in net income. The Corporation will also remain focused on increasing cash flow from operations and further improving return on invested capital.
Forward-Looking Statements
Certain matters discussed in this Form 10-K or related documents, a portion of which are incorporated herein by reference, concerning, among other things, the business outlook, including new product introductions, cost savings, anticipated costs and savings related to the Competitive Improvement Initiatives, anticipated financial and operating results, strategies, contingencies and contemplated transactions of the Corporation, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and are based upon management’s expectations and beliefs concerning future events impacting the Corporation. There can be no assurance that these events will occur or that the Corporation’s results will be as estimated.
22
The assumptions used as a basis for the forward-looking statements include many estimates that, among other things, depend on the achievement of future cost savings and projected volume increases. In addition, many factors outside the control of the Corporation, including the prices and availability of the Corporation’s raw materials, potential competitive pressures on selling prices or advertising and promotion expenses for the Corporation’s products, energy costs, and fluctuations in foreign currency exchange rates, as well as general economic conditions in the markets in which the Corporation does business, could impact the realization of such estimates.
The factors described under Item 1A, “Risk Factors” in this Form 10-K, or in our other Securities and Exchange Commission filings, among others, could cause the Corporation’s future results to differ from those expressed in any forward-looking statements made by, or on behalf of, the Corporation. Other factors not presently known to us or that we presently consider immaterial could also affect our business operations and financial results.
23