Average total debt outstanding was $690 million in the 2005 first half as compared to $674 million in the 2004 first half. The average interest rate was 6.7% in the 2005 first half as compared to 5.9% in the 2004 first half. These average rates represent the average rates on total debt outstanding and include the benefits of our interest rate swaps.
We recorded interest income in the 2004 first half of $1 million primarily attributable to interest earned on cash proceeds from the issuance and sale of the Debentures.
Provision for income taxes was a charge of $7 million in the 2005 first half as compared to a charge of $5 million in the 2004 first half. The effective income tax rate was approximately 50% in the 2005 first half as compared to approximately 22% in the 2004 first half. The higher effective income tax rate in the 2005 first half was primarily due to a $1.6 million, non-cash, charge related to an Ohio state tax law change. The impact of the Ohio State tax law change resulted in an effective income tax rate 13 percentage points higher than what the effective income tax rate would have been without the impact of this tax law change.
As a result of the matters described above, net income was $7 million in the 2005 first half as compared to $18 million in the 2004 first half.
PART I (CONT'D)
GRAFTECH INTERNATIONAL LTD. AND SUBSIDIARIES
unfavorable product mix reduced net sales by $9 million. Net sales of cathodes increased $4 million, or 7%, due equally to higher sales volumes and the favorable effect of exchange rates.
Cost of sales increased $10 million, or 4%, from $273 million in the 2004 first half to $283 million in the 2005 first half. Cathodes cost of sales increased $9 million, or 21%, of which $6 million was due to increased volumes and product mix and $3 million was due to the effect of changes in currency exchange rates. Advanced synthetic graphite products cost of sales increased $5 million, or 19%, primarily due to higher sales volumes. Graphite electrodes cost of sales decreased $4 million, or 2%, due primarily to decreased sales volumes.
As a result, gross profit in the 2005 first half was $95 million, 7% or $6 million higher than the $89 million in the 2004 first half. Gross margin was 25.1% of net sales in the 2005 first half as compared to 24.6% of net sales in the 2004 first half.
Other Segment. Net sales of $53 million in the 2005 first half represented a $5 million, or 12%, increase from net sales of $48 million in the 2004 first half. Net sales of natural graphite materials increased $2 million, or 18%, primarily due to an increase in ETM sales. Higher sales volumes of carbon electrodes increased net sales by $2 million, or 9%. Higher sales volumes of refractories increased net sales by $1 million, or 7%.
Cost of sales increased $4 million, or 13%, from $38 million in the 2004 first half to $42 million in the 2005 first half. Cost of sales of natural graphite materials increased $2 million, or 15%, primarily due to an increase in ETM sales. Higher volumes along with an unfavorable product mix of carbon electrodes increased cost of sales by $2 million, or 16%, from the 2004 first half as compared to the 2005 first half.
As a result, gross profit in the 2005 first half was $11 million, 6% or $1 million higher than the 2004 first half of $10 million. Gross margin was 20.6% of net sales in the 2005 first half as compared to 21.8% of net sales in the 2004 first half.
Effects of Inflation
We incur costs in the U.S. and each of the six non-U.S. countries in which we have a manufacturing facility. In general, our results of operations, cash flows and financial condition are affected by the effects of inflation on our costs incurred in each of these countries. See “– Currency Translation and Transactions” for a further discussion of highly inflationary countries.
During the past three years, we experienced higher freight, energy and other raw material costs primarily due to substantial increases in regional and worldwide market prices of natural gas and other petroleum-based raw materials. We seek to mitigate the effects of those increases on our cost of sales through improved operating efficiencies, higher prices for our products and ongoing cost savings, and, in some cases, fixed price or derivative hedging contracts. We have in the past entered into, and may in the future enter into, natural gas hedge contracts to effectively fix our direct and indirect natural gas cost exposure in North America. In addition, we have in the past entered into and may in the future enter into, short duration fixed rate
44
PART I (CONT'D)
GRAFTECH INTERNATIONAL LTD. AND SUBSIDIARIES
purchase contracts with certain of our natural gas suppliers in order to mitigate seasonal increases in our natural gas costs. We currently do not have any natural gas derivative contracts.
We cannot assure you that future increases in our costs will not occur or exceed the rate of inflation or the amounts, if any, by which we may be able to increase prices for our products.
Currency Translation and Transactions
We account for our non-U.S. subsidiaries under SFAS No. 52, “Foreign Currency Translation.” Accordingly, except for highly inflationary countries, the assets and liabilities of our non-U.S. subsidiaries are translated into dollars for consolidation and reporting purposes. Foreign currency translation adjustments are generally recorded as part of stockholders’ deficit and identified as part of accumulated other comprehensive loss on the Consolidated Balance Sheets until such time as their operations are sold or substantially or completely liquidated.
Highly inflationary economies are defined as having cumulative inflation of about 100% or more over a period of three calendar years. In general, the financial statements of foreign operations in highly inflationary economies are remeasured as if the functional currency of their economic environments were the dollar and translation gains and losses relating to these foreign operations are included in other (income) expense, net, on the Consolidated Statements of Operations rather than as part of stockholders’ deficit on the Consolidated Balance Sheets. We have subsidiaries in Russia, Mexico, Brazil and other countries which have had in the past, and may have in the future, highly inflationary economies.
We account for our Mexican and Russian subsidiaries using the dollar as its functional currency, as sales and purchases for each subsidiary are predominantly dollar-denominated. Our remaining subsidiaries use their local currency as their functional currency.
We also record foreign currency transaction gains and losses as part of other (income) expense, net.
Significant changes in currency exchange rates impacting us are described under “Effects of Changes in Currency Exchange Rates” and “Results of Operations – Items Affecting Us as a Whole.”
Effects of Changes in Currency Exchange Rates
We incur costs in dollars and the currency of each of the six non-U.S. countries in which we have a manufacturing facility, and we sell our products in multiple currencies. In general, our results of operations, cash flows and financial condition are affected by changes in currency exchange rates affecting these currencies relative to the dollar and, to a limited extent, each other.
When the currencies of non-U.S. countries in which we have a manufacturing facility decline (or increase) in value relative to the dollar, this has the effect of reducing (or increasing) the dollar equivalent cost of sales and other expenses with respect to those facilities. This effect
45
PART I (CONT'D)
GRAFTECH INTERNATIONAL LTD. AND SUBSIDIARIES
is, however, partially offset by the cost of petroleum coke, a principal raw material used by us, which is priced in dollars. In certain countries where we have manufacturing facilities, and in certain instances where we price our products for sale in export markets, we sell in currencies other than the dollar. Accordingly, when these currencies increase (or decline) in value relative to the dollar, this has the effect of increasing (or reducing) net sales. The result of these effects is to increase (or decrease) operating profit and net income.
Many of the non-U.S. countries in which we have a manufacturing facility have been subject to significant economic changes, which have significantly impacted currency exchange rates. We cannot predict changes in currency exchange rates in the future or whether those changes will have net positive or negative impacts on our net sales, cost of sales or net income. We cannot assure you that we would be able to mitigate any adverse effects of such changes.
During the 2005 first half, the average exchange rate of the Euro, the South African Rand, the Brazilian Real and the Mexican Peso increased about 6%, 10%, 14% and 1%, respectively, when compared to the average exchange rate for the 2004 first half.
In the case of net sales of graphite electrodes, the impact of these events was an increase of about $3 million in the 2005 first half as compared to the 2004 first half. In the case of cost of sales of graphite electrodes, the impact of these events was an increase of about $8 million in the 2005 first half as compared to the 2004 first half.
The impact of these events on net sales of cathodes was an increase of about $2 million in the 2005 first half as compared to the 2004 first half. The impact of these events on cost of sales of cathodes was an increase of about $3 million in the 2005 first half as compared to the 2004 first half.
We have non-dollar denominated intercompany loans between GrafTech Finance and some of our foreign subsidiaries. At June 30, 2005, the aggregate principal amount of these loans was $420 million (based on currency exchange rates in effect at June 30, 2005). These loans are subject to remeasurement gains and losses due to changes in currency exchange rates. A portion of these loans are deemed to be essentially permanent and, as a result, remeasurement gains and losses on these loans are recorded in accumulated other comprehensive loss in the stockholders’ deficit section of the Consolidated Balance Sheets. The balance of these loans are deemed to be temporary and, as a result, remeasurement gains and losses on these loans are recorded as currency (gains) losses in other (income) expense, net, on the Consolidated Statements of Operations. In the 2004 first half, we had a net total of $5 million in currency losses, including $6 million of exchange losses due to the remeasurement of intercompany loans and translation of financial statements of foreign subsidiaries which use the dollar as their functional currency. In the 2005 first half, we had a net total of $12 million in currency losses, including $15 million of exchange losses due to the remeasurement of intercompany loans and translation of financial statements of foreign subsidiaries which use the dollar as their functional currency. To manage certain exposures to specific financial market risks caused by changes in
46
PART I (CONT'D)
GRAFTECH INTERNATIONAL LTD. AND SUBSIDIARIES
currency exchange rates, we use various financial instruments as described under “Item 3 – Qualitative and Quantitative Disclosures about Market Risk.”
Liquidity and Capital Resources
Our sources of funds have consisted principally of invested capital, cash flow from operations and debt and equity financings. Our uses of those funds (other than for operations) have consisted principally of debt reduction, capital expenditures, payment of fines, liabilities and expenses in connection with antitrust investigations, lawsuits and claims, payment of restructuring costs and other obligations and operating costs.
We are highly leveraged and have other substantial obligations. At June 30, 2005, we had total debt of $703 million, cash and cash equivalents of $10 million and a stockholders’ deficit of $64 million.
We use cash and cash equivalents, funds available under the Revolving Facility, subject to continued compliance with the financial covenants and representations under the Revolving Facility, as well as cash flow from operations as our primary sources of liquidity. The Revolving Facilities provides for maximum borrowings of up to $215 million. At June 30, 2005, $177 million was available (after consideration of outstanding Revolving and swingline loans of $31 million and outstanding letters of credit of $7 million). It is possible that our future ability to borrow under the Revolving Facility may effectively be less because of the impact of additional borrowings upon our compliance with the maximum net senior secured debt leverage ratio permitted or minimum interest coverage ratio required under the Revolving Facility.
At June 30, 2005, we were in compliance with all financial and other covenants contained in the Senior Notes, the Debentures and the Revolving Facility, as applicable. Based on expected operating results and expected cash flows, we expect to be in compliance with these covenants over the next twelve months. If we were to believe that we would not continue to comply with these covenants, we would seek an appropriate waiver or amendment from the lenders thereunder. We cannot assure you that we would be able to obtain such waiver or amendment on acceptable terms or at all.
At June 30, 2005, 27% (or $182 million) of our total debt, excluding the fair value adjustments to debt and unamortized bond premium, had effectively been converted to variable rate obligations. At June 30, 2005, we had interest rate swaps for a notional amount of $150 million that effectively convert a portion of our fixed rate debt (represented by the Senior Notes) into variable rate debt. At June 30, 2005, variable interest was calculated based on the six month LIBOR plus 5.7967%.
At June 30, 2005, we also had interest rate caps for a total notional amount of $150 million through August 2007. These instruments effectively cap our interest rate exposure, represented by the net impact of our swaps on the Senior Notes, to no greater than 11.3% per annum.
47
PART I (CONT'D)
GRAFTECH INTERNATIONAL LTD. AND SUBSIDIARIES
At June 30, 2005, the Revolving Facility had an effective interest rate of 6.0%, our $435 million principal amount of Senior Notes had an effective rate of 9.5% (i.e., a fixed rate of 10.25%, with $150 million effectively swapped to a variable rate of the LIBOR plus 5.7949%)
and our $225 million principal amount of Debentures had a fixed rate of 1.625%. We estimate interest expense to be approximately $51 million to $52 million for 2005, an increase of $2 million to $3 million from original estimates primarily due to the termination of $285 million notional amount of interest rate swaps in the second quarter of 2005 and higher average debt balances.
We continue to implement interest rate management initiatives to seek to minimize interest expense and optimize the risk in our portfolio of fixed and variable interest rate obligations as described under “Item 3 – Quantitative and Qualitative Disclosures about Market Risk” in this Report.
Cash Flow and Plans to Manage Liquidity. We use cash and cash equivalents, funds available under the Revolving Facility and cash flow from operations as our primary sources of liquidity.
As a result of our significant leverage and other substantial obligations, our business strategies include efforts to enhance our capital structure by further reducing our gross obligations. Accordingly, we have placed the highest priority on accelerating the amount and speed of cash generated every day. Our efforts include leveraging our unique global manufacturing network by driving higher utilization rates and more productivity from our existing assets, accelerating commercialization initiatives across all of our businesses and realizing other global efficiencies.
As part of our cash management activities, we seek to manage accounts receivable credit risk and collections and payment of accounts payable to maximize our free cash at any given time and minimize accounts receivable losses. We may from time to time and at any time exchange or purchase Senior Notes or Debentures in open market or privately negotiated transactions, opportunistically on terms that we believe to be favorable. We also continue to evaluate other opportunities to reduce our obligations, including the obligations associated with our U.S. defined benefit plan, which was frozen in 2003. We intend to continue to sell real estate, non-strategic businesses and certain other non-strategic assets. Such sales could result in impairment charges. We cannot assure you if or when we will be able to complete these sales or that we will realize proceeds therefrom that meet our current expectations.
Our high leverage and other substantial obligations could have a material impact on our liquidity. Cash flow from operations services payment of our debt and other obligations, thereby reducing funds available to us for other purposes.
We believe that the long term fundamentals of our business continue to be sound. Accordingly, although we cannot assure you that such will be the case, we believe that, based on our expected cash flow from operations, our existing capital resources, and taking into account our working capital needs and our efforts to reduce costs, improve efficiencies and product
48
PART I (CONT'D)
GRAFTECH INTERNATIONAL LTD. AND SUBSIDIARIES
quality, and accelerate commercialization of new products and cash flow, we will be able to manage our liquidity to permit us to service our debt and meet our obligations when due. Based on expected operating results and expected cash flows, we expect to be in compliance with all financial and other covenants over the next twelve months.
Cash Flows. In general, during the 2004 first half and the 2005 first half, we used cash in operating activities (including payments related to restructurings and antitrust investigations, lawsuits and claims) as well as for capital expenditures. Financing for these uses was provided primarily by our incurrence of long-term and short-term debt.
Cash Flow Used in Operating Activities. Cash flow used in operating activities was $8 million in the 2005 first half and $152 million in the 2004 first half, an improvement of $144 million.
Cash used in operating activities was $8 million in the 2005 first half. Net income, after adding back the net effect from non-cash items, amounted to $39 million. Such income was used in operating activities as follows: a reduction in payables of $23 million primarily due to timing of payment patterns, an increase in inventories of $34 million, necessary to enhance the reliability and stability of our graphite electrode network, increase productivity and reduce overtime and distribution costs, an increase of $2 million in other current assets offset by a decrease in accounts receivables of $28 million due to improved collection efforts.
Other uses in the 2005 first half consisted of $8 million of payments for antitrust investigations and related lawsuits and claims, $4 million of restructuring costs related to severance and related payments and $4 million of other payments consisting primarily of pension and post-retirement contributions and payments.
Cash used in operating activities was $152 million in the 2004 first half. Net income, after adding back the net effect from non-cash items, amounted to $60 million. Such income was used in operating activities as follows: a reduction in payables of $38 million primarily due to timing of payment patterns (including our semi-annual interest payment on the Senior Notes), an increase in accounts receivables of $60 million primarily from the discontinuance of accounts receivable factoring, and an increase in inventories of $6 million in anticipation of increased demand.
Other uses in the 2004 first half consisted primarily of $77 million of payments for antitrust investigations and related lawsuits and claims, $14 million of restructuring costs related to severance and related payments and $17 million of other payments consisting primarily of pension and post retirement contributions and payments.
Cash Flow Used in Investing Activities.Cash flow used in investing activities was $22 million in the 2005 first half and $22 million in the 2004 first half. The majority of such investing activities consisted of capital expenditures.
49
PART I (CONT'D)
GRAFTECH INTERNATIONAL LTD. AND SUBSIDIARIES
Capital expenditures amounted to $25 million for the 2005 first half and related primarily to graphite electrode productivity and production stability initiatives and other essential capital maintenance.
Virtually all of such investing activities for the 2004 first half consisted of capital expenditures. Capital expenditures in the 2004 first half related primarily to the expansion of graphite electrode manufacturing capacity, including expansion of our graphite electrode manufacturing facilities in Spain, implementation of J.D. Edwards information systems and essential capital maintenance.
Cash Flow Provided by Financing Activities. Cash flow provided by financing activities was $18 million in the 2005 first half and $195 million during 2004 first half.
During the 2005 first half, we borrowed $48 million under the Revolving Facility and made payments of $20 million and borrowed $3 million of other short term debt. We used these borrowings to fund working capital requirements, primarily inventory that we have replenished and built in anticipation of stronger demand. In the 2005 first half, we also paid $5 million of financing costs in conjunction with the refinancing of the Revolving Facility and $8 million in connection with the sale of $450 million notional amount of interest rate swaps.
Overall debt increased in the 2004 first half due to the issuance and sale of the Debentures. During the 2004 first half, we received gross proceeds of $225 million (less issuance costs of $7 million) from the issuance and sale of the Debentures. We used these proceeds primarily to repay term loans of $21 million outstanding under the Senior Facilities. We also used these proceeds to make a provisional payment to the EU Competition Authority against the EU antitrust fine and to replace cash previously provided by factoring of accounts receivable as described above in “– Cash Flow Used in Operating Activities”. In addition, we purchased $8 million aggregate principal amount of Senior Notes, plus accrued interest, for $9 million in cash.
Restrictions on Dividends and Stock Repurchases
A description of the restrictions on our ability to pay dividends and our ability to repurchase common stock is set forth under “Item 5 – Dividend Policies and Restrictions” in the Annual Report. Such description contains all of the information required with respect thereto.
Recent Accounting Pronouncements
A description of recent accounting pronouncements is set forth under “New Accounting Standards” in Note 2 to the Notes to the Consolidated Financial Statements contained in this Report, and such description is incorporated herein by reference. Such description contains all of the information required with respect thereto.
50
PART I (CONT'D)
GRAFTECH INTERNATIONAL LTD. AND SUBSIDIARIES
Description of Our Financing Structure
The description of the Revolving Facility, the Senior Notes and the Debentures set forth under “Long-Term Debt and Liquidity” and “Subsequent Events” in the Annual Report is incorporated by reference, subject to the additional or different information set forth in this Report.
Revolving Facility
On February 8, 2005, we entered into an Amended and Restated Credit Agreement, dated as of February 8, 2005, among GTI, GrafTech Finance, GrafTech Global, the LC Subsidiaries from time to time party thereto, the lenders from time to time party thereto and JP Morgan Chase Bank, N.A., as Administrative Agent, Collateral Agent and Issuing Bank.
As amended and restated, the Credit Agreement provides for, among other things, an extension until July 15, 2010 of the maturity of the Revolving Facility, lower interest rates, less restrictive financial covenants, additional flexibility for investments and acquisitions and, subject to certain conditions (including a maximum senior secured leverage ratio test), an accordion feature that permits GrafTech Finance to establish additional credit facilities thereunder in an aggregate amount, together with the Revolving Facility, of up to $425 million.
The Revolving Facility provides for revolving and swingline loans to GrafTech Finance and issuance of letters of credit for the account of GrafTech Finance and other designated subsidiaries from time to time in an aggregate principal and stated amount at any time not to exceed $215 million. Loans and letters of credit may be denominated in dollars, euros and certain other currencies and are available for working capital and other general corporate purposes.
The interest rate applicable to the Revolving Facility is, at our option, either LIBOR plus a margin ranging from 1.25% to 2.25% (depending on our leverage ratio or our senior unsecured (or corporate or implied issuer) rating) or, in the case of dollar denominated loans, the alternate base rate plus a margin ranging from 0.25% to 1.25% (depending on such ratio or rating). The alternate base rate is the higher of (i) the prime rate announced by JP Morgan Chase Bank, N.A. or (ii) the federal fund effective rate plus 0.50%. GrafTech Finance pays a per annum fee ranging from 0.250% to 0.500% (depending on such ratio or rating) on the undrawn portion of the commitments under the Revolving Facility.
Senior Notes
GrafTech Finance currently has $435 million aggregate principal amount of Senior Notes outstanding. Interest on the Senior Notes is payable semi-annually on February 15 and August 15 of each year at the rate of 10.25% per annum. The Senior Notes mature on February 15, 2012.
51
PART I (CONT'D)
GRAFTECH INTERNATIONAL LTD. AND SUBSIDIARIES
Unsecured intercompany term notes in an aggregate principal amount, at June 30, 2005, equal to $512 million (based on currency exchange rates in effect at June 30, 2005) issued by our operating subsidiaries in Mexico, South Africa and Switzerland and our holding company subsidiary in France and guarantees of those unsecured intercompany term notes by our principal foreign subsidiaries have been pledged by GrafTech Finance to secure the Senior Notes, subject to the limitation that at no time will the combined value of the pledged portion of any foreign subsidiary’s unsecured intercompany term note and unsecured guarantee of unsecured intercompany term notes issued by other foreign subsidiaries exceed 19.99% of the principal amount of the then outstanding Senior Notes. As a result of this limitation, the principal amount of unsecured intercompany term notes pledged to secure the Senior Notes at June 30, 2005 equals $329 million (based on currency exchange rates in effect at June 30, 2005), or about 76% of the principal amount of the outstanding Senior Notes. The remaining unsecured intercompany term notes held by GrafTech Finance in an aggregate principal amount at June 30, 2005 of $183 million (based on currency exchange rates in effect at June 30, 2005) and any pledged unsecured intercompany term notes that cease to be pledged due to a reduction in the principal amount of the then outstanding Senior Notes due to redemption, repurchase or other events, will not be subject to any pledge and will be available to satisfy the claims of creditors of GrafTech Finance (including the lenders under the Revolving Facility, the holders of the Senior Notes and the holders of the Debentures) as their interests may appear. The Senior Notes prohibit the pledge of these unsecured intercompany term notes or related guarantees to secure any other debt or obligation.
Our operating subsidiary in Russia, Carbone Savoie, AET and certain immaterial domestic and foreign operating and holding companies are neither guarantors of the secured intercompany revolving note of our Swiss subsidiary that is pledged to secure the Revolving Facility nor guarantors of the Senior Notes or the unsecured intercompany term notes pledged to secure the Senior Notes, nor guarantors of the Debentures. At December 31, 2004 and June 30, 2005, the aggregate combined book value of their assets was about $185 million and $204 million, respectively, and their debt and liabilities totaled $74 million (including intercompany trade and other miscellaneous liabilities of $19 million) and $80 million (including intercompany trade and other miscellaneous liabilities of $53 million), respectively. For the 2005 first half, their aggregate combined net loss was $1 million and for the 2004 first half their aggregate combined net income was about $2 million. For the 2005 first half and 2004 first half, their aggregate combined net source of cash from operations was about $21 million and $17 million, respectively.
Debentures
GTI currently has $225 million aggregate principal amount of Debentures outstanding. Interest on the Debentures is payable semi-annually on January 15 and July 15 of each year, commencing July 15, 2004, at the rate of 1.625% per annum. The Debentures mature on January 15, 2024, unless earlier converted, redeemed or required to be repurchased.
52
PART I (CONT'D)
GRAFTECH INTERNATIONAL LTD. AND SUBSIDIARIES
Antitrust Litigation Against Us
In 1997, the DOJ and the EU Competition Authority commenced investigations into alleged violations of the antitrust laws in connection with the sale of graphite electrodes. The antitrust authorities in Canada, Japan and Korea subsequently began similar investigations. The EU Competition Authority also commenced an investigation into alleged antitrust violations in connection with the sale of specialty graphite. These antitrust investigations have been finally resolved. Several of the investigations resulted in the imposition of fines against us. These fines, or payments in accordance with a payment schedule, in the case of the DOJ antitrust fine, have been timely paid.
We have settled virtually all of the civil antitrust lawsuits (including class action lawsuits) previously pending against us, certain civil antitrust lawsuits threatened against us and certain possible civil antitrust claims against us arising out of alleged antitrust violations occurring prior to the date of the relevant settlement in connection with the sale of graphite electrodes, carbon electrodes and bulk graphite products. All settlement payments due have been timely paid. There remain, however, certain pending claims as well as pending lawsuits in the U.S. relating to the sale of graphite electrodes sold to foreign customers. It is also possible that additional antitrust lawsuits and claims could be asserted against us in the U.S. or other jurisdictions. We are currently not reserved for such matters.
Other Proceedings Against Us
We are involved in various other investigations, lawsuits, claims and other legal proceedings incidental to the conduct of our business. While it is not possible to determine the ultimate disposition of each of them, we do not believe that their ultimate disposition will have a material adverse effect on our financial position, results of operations or cash flows.
Product Warranties
We generally sell products with a limited warranty. We accrue for known warranty claims if a loss is probable and can be reasonably estimated. At December 31, 2004 and June 30, 2005, claims accrued but not yet paid amounted to $1 million. The following table presents the activity in this accrual for the 2005 first half:
| |
|---|
| Balance at December 31, 2004 | | | $ | 1 | |
| Product warranty charges | | | | 1 | |
| Payments and settlements | | | | (1 | ) |
|
| |
| Balance at June 30, 2005 | | | $ | 1 | |
|
| |
53
PART I (CONT'D)
GRAFTECH INTERNATIONAL LTD. AND SUBSIDIARIES
Item 3. Quantitative and Qualitative Disclosures about Market Risk
We are exposed to market risks primarily from changes in interest rates, currency exchange rates, commercial energy rates and changes to the fair value of the redemption option and related make-whole provision under the Debentures. We routinely enter into various transactions that have been authorized according to documented policies and procedures to manage these well-defined risks. These transactions relate primarily to financial instruments described below. Since the counterparties to these financial instruments are large commercial banks and similar financial institutions, we do not believe that we are exposed to material counterparty credit risk. We do not use financial instruments for trading purposes.
Our exposure to changes in interest rates results primarily from floating rate long-term debt tied to LIBOR or euro LIBOR. Our exposure to changes in currency exchange rates results primarily from:
| o | sales made by our subsidiaries in currencies other than local currencies; |
| o | raw material purchases made by our foreign subsidiaries in currencies other than local currencies; and |
| o | investments in and intercompany loans to our foreign subsidiaries and our share of the earnings of those subsidiaries, to the extent denominated in currencies other than the dollar. |
Our exposure to changes in energy costs results primarily from the purchase of natural gas and electricity for use in our manufacturing operations. Our exposure to changes in the fair value of the redemption make-whole option results primarily from changes in the closing price of our common stock during each quarterly period.
Interest Rate Risk Management.We implement interest rate management initiatives to seek to minimize our interest expense and optimize the risk in our portfolio of fixed and variable interest rate obligations. Use of these initiatives is allowed under the Senior Notes and the Revolving Facility. We have interest rate swaps that effectively convert fixed rate debt (represented by the Senior Notes) into variable rate debt.
At December 31, 2004, we had swaps for a notional amount of $450 million. At December 31, 2004, $435 million (out of our total outstanding $450 million notional amount) of interest rate swaps were designated as hedging the exposure to changes in the fair value of the related debt (called a fair value hedge). The related debt for those swaps is the Senior Notes, of which $435 million aggregate principal amount was outstanding at December 31, 2004.
During the first quarter of 2005, we sold $15 million notional amount of undesignated swaps and paid a nominal fee. Additionally, we sold $150 million notional amount of our fair value hedge swaps and paid $3 million in cash. Immediately thereafter, we repurchased $150 million notional amount of fair value hedge swaps with a different counterparty. During the second quarter of 2005, we sold $285 million notional amount of swaps and paid $5 million. As
54
PART I (CONT'D)
GRAFTECH INTERNATIONAL LTD. AND SUBSIDIARIES
a result of these transactions, we now hold $150 million notional amount of swaps related to the Senior Notes.
At December 31, 2004 and June 30, 2005 (excluding the offsetting value of our interest rate caps), the principal value of our debt was reduced by $10 million and $1 million, respectively, as a result of our fair value hedges. The market values of those interest rate swaps, excluding changes in value resulting from accrued interest payable or receivable from the counterparty, are currently recorded as part of other long-term obligations on the Consolidated Balance Sheets. Accrued interest receivable from or payable to the counterparty is recorded as a component of interest expense on the Consolidated Statement of Operations.
Such interest rate swaps have effectively converted our fixed rate debt (represented by the Senior Notes) into variable rate debt. At December 31, 2004, such variable interest was calculated based on the six month LIBOR rate as of the date of payment plus 5.7940%, calculated in arrears. At June 30, 2005, variable interest was calculated based on the six month LIBOR plus 5.7967%.
All of our swaps are valued monthly, and we are required to provide cash collateral to the counterparty to the extent that the fair market value of the swap liability, net of the fair market value of our interest rate caps, exceeds a specific threshold. At December 31, 2004 and June 30, 2005, all of our swaps were with one counterparty and this threshold was $15 million. We were not required to provide any cash collateral at December 31, 2004 or June 30, 2005.
When we sell a fair value hedge swap, the gain or loss is amortized as a credit or charge to interest expense over the remaining term of the Senior Notes. When we effectively reduce the outstanding principal amount of the Senior Notes (through debt-for-equity exchanges, repurchases or otherwise), the related portion of such credit or charge is accelerated and recorded in the period in which such reduction occurs. At December 31, 2004 and June 30, 2005, the principal value of our debt was increased by $25 million and $15 million, respectively, as a result of gains realized from previously sold swaps. The net impact of current and terminated hedge instruments was a $15 million and a $14 million increase in the fair value of our debt at December 31, 2004 and June 30, 2005, respectively, and was recorded on the Consolidated Balance Sheets on the line entitled “fair value adjustments for hedge instruments.”
Interest rate swaps reduced our interest expense by approximately $10 million in the 2004 first half. The reduction was due to the benefit from current interest rate swaps in the amount of $6 million, $1 million of amortization of fair value adjustments for previously sold interest rate swaps and $3 million due to the acceleration of the amortization of fair value adjustments for previously sold interest rate swaps due to a reduction of Senior Notes.
Interest rate swaps reduced our interest expense by $3 million in the 2005 first half. The reduction was due to the benefit from current interest rate swaps in the amount of $2 million and the amortization of fair value adjustments for previously sold interest rate swaps of $1 million.
55
PART I (CONT'D)
GRAFTECH INTERNATIONAL LTD. AND SUBSIDIARIES
We enter into agreements with financial institutions that are intended to limit, or cap, our exposure to incurrence of additional interest expense due to increases in variable interest rates. These instruments effectively cap our interest rate exposure, represented by the net impact of our swaps on the Senior Notes, to no greater than 11.3% per annum. At December 31, 2004, we had interest rate caps for a notional amount of $500 million. During the second quarter of 2005, we sold $350 million notional amount of caps and received a nominal amount. As a result, at June 30, 2005, we had interest rate caps for a notional amount of $150 million. All of our interest rate caps are marked-to-market monthly. Gains and losses are recorded in other (income) expense, net, on the Consolidated Statements of Operations. The fair value adjustment on caps was a nominal gain for the 2004 second quarter, a $1 million loss for the 2005 second quarter, a $2 million loss for the 2004 first half and a $1 million loss for the 2005 first half.
Currency Rate Management. We enter into foreign currency instruments to attempt to manage exposure to changes in currency exchange rates. These foreign currency instruments, which include, but are not limited to, forward exchange contracts and purchased currency options, attempt to hedge global currency exposures, net, relating to euro-denominated debt and identifiable foreign currency receivables, payables and commitments held by our foreign and domestic subsidiaries. Forward exchange contracts are agreements to exchange different currencies at a specified future date and at a specified rate. Purchased foreign currency options are instruments which give the holder the right, but not the obligation, to exchange different currencies at a specified rate at a specified date or over a range of specified dates. The result is the creation of a range in which a best and worst price is defined, while minimizing option cost. Forward exchange contracts and purchased currency options are carried at market value.
The notional amount of open foreign exchange contracts, used by us to minimize foreign currency exposure against euro depreciation, was $54 million at December 31, 2004. In the 2005 second quarter, we sold all open foreign exchange contracts. As a result, we received $2 million and recognized a gain of $1 million which was recorded in other (income) expense, net, on the Consolidated Statement of Operations. At June 30, 2005, we had no such contracts outstanding.
Commercial Energy Rate Management. We currently do not have any natural gas derivative or other commercial energy rate contracts. We have in the past entered, and may in the future enter, into short duration fixed rate purchase contracts with certain of our natural gas suppliers in order to mitigate seasonal increases in our natural gas costs.
Derivative Liability Associated with the Debentures. The redemption make-whole option is accounted for separately from the underlying debt and recorded as a derivative financial instrument. The embedded derivative financial instrument was classified as a derivative liability upon issuance and is included in the other long-term obligations in the Consolidated Balance Sheet. At each balance sheet date, we adjust the redemption make-whole option to its estimated fair value. Upon issuance at January 22, 2004, the estimated fair value of our derivative liability was $6 million. At December 31, 2004, the estimated fair value of our derivative liability was $4 million. At June 30, 2005, the estimated fair value of our derivative liability was a nominal amount. We estimate the fair value of the redemption make-whole option using a financial
56
PART I (CONT'D)
GRAFTECH INTERNATIONAL LTD. AND SUBSIDIARIES
model that uses several assumptions, including historical stock price volatility, risk-free interest rates, remaining maturity and the closing price of our common stock. We believe that the assumption that has the greatest impact on the determination of fair value is the closing price of our common stock during each quarterly period.
Sensitivity Analysis. We used a sensitivity analysis to assess the potential effect of changes in currency exchange rates, interest rates and the Debenture redemption make-whole option on results of operations for the 2005 first half. Based on this analysis, a hypothetical 10% weakening or strengthening in the dollar across all other currencies would have changed our reported gross margin for the 2005 first half by about $6 million. Based on this analysis, a hypothetical increase in interest rates of 100 basis points (including the impact of such increase on current interest rate swaps) would have increased our interest expense by about $2 million for the 2005 first half. Based on this analysis, a hypothetical 10% increase or decrease in the more relevant variables (particularly our current stock price, historical stock price volatility and borrowing costs) would have a nominal effect on the redemption make-whole option.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this Report, and, based on that evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that these controls and procedures are effective at the reasonable assurance level.
Disclosure controls and procedures are our controls that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Changes in Internal Controls Over Financial Reporting
Management’s evaluation of disclosure controls and procedures did not identify any change in our internal controls over financial reporting that occurred during the quarter ended June 30, 2005 that has materially affected or is reasonably likely to materially affect, our internal control over financial reporting.
57
PART II OTHER INFORMATION
GRAFTECH INTERNATIONAL LTD. AND SUBSIDIARIES
Item 1. Legal Proceedings
This information required in response to this Item is set forth in Note 13 to the Notes to Consolidated Financial Statements contained in this Report, and such information is hereby incorporated herein by reference. Such description contains all of the information required with respect thereto.
Item 4. Submission of Matters to a Vote of Security Holders
On May 25, 2005, GTI held its annual meeting of stockholders in Wilmington, Delaware.
At the meeting, the stockholders elected directors and the shares present at the meeting were voted for or withheld from each nominee, as follows:
Name of Director
| Number of
Shares
Cast For
| Percentage
of Votes
Cast For
| Number of
Shares Withheld
|
|---|
| R. Eugene Cartledge | 89,520,729 | 96.75 | 3,010,666 |
| Mary B. Cranston | 89,533,645 | 96.76 | 2,997,750 |
| John R. Hall | 89,557,359 | 96.79 | 2,974,036 |
| Harold E. Layman | 87,586,615 | 94.66 | 4,944,780 |
| Ferrell P. McClean | 87,383,322 | 94.44 | 5,148,073 |
| Michael C. Nahl | 85,952,519 | 92.89 | 6,578,876 |
| Frank A. Riddick, III | 89,686,032 | 96.92 | 2,845,363 |
| Craig S. Shular | 89,637,789 | 96.87 | 2,893,606 |
At the meeting, the stockholders voted on a proposal to approve the GrafTech International Ltd. 2005 Equity Incentive Plan. The proposal was approved. The shares present at the meeting were voted on the proposal as follows:
Number of
Shares Cast For
| Percentage of Shares
Cast For
| Number of Shares
Cast Against
| Number of
Shares Abstaining
| Number of
Broker Non-Votes
|
|---|
| 59,874,989 | 61.03 | 28,635,708 | 4,020,699 | 13,286,703 |
Item 6. Exhibits and Reports on Form 8-K
| | The exhibits listed in the following table have been filed as part of this Report. |
58
PART II (CONT’D)
GRAFTECH INTERNATIONAL LTD. AND SUBSIDIARIES
Exhibit
Number | | Description of Exhibit |
| 31.1 | | Certification pursuant to Rule 13a-14(a) under the Exchange Act by Craig S. Shular, Chief Executive Officer & President. |
| 31.2 | | Certification pursuant to Rule 13a-14(a) under the Exchange Act by Corrado F. De Gasperis, Vice President, Chief Financial Officer & Chief Information Officer. |
| 32.1 | | Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Craig S. Shular, Chief Executive Officer & President. |
| 32.2 | | Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Corrado F. De Gasperis, Vice President, Chief Financial Officer & Chief Information Officer. |
| | The following reports on Form 8-K were filed during the 2005 second quarter: |
| | (1) | Current Report on Form 8-K, dated May 5, 2005, filed with the SEC under Items 2.02 and 9.01 on May 5, 2005. |
| | (2) | Current Report on Form 8-K, dated April 4, 2005, filed with the SEC under Item 4.01 on April 5, 2005. |
59
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: August 4, 2005 | | GRAFTECH INTERNATIONAL LTD.
By: /s/ Corrado F. De Gasperis
Corrado F. De Gasperis
Vice President, Chief Financial Officer
& Chief Information Officer
(Principal Accounting Officer) |
60
EXHIBIT INDEX
Exhibit
Number | | Description of Exhibit |
| 31.1 | | Certification pursuant to Rule 13a-14(a) under the Exchange Act by Craig S. Shular, Chief Executive Officer & President. |
| 31.2 | | Certification pursuant to Rule 13a-14(a) under the Exchange Act by Corrado F. De Gasperis, Vice President, Chief Financial Officer & Chief Information Officer. |
| 32.1 | | Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Craig S. Shular, Chief Executive Officer & President. |
| 32.2 | | Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Corrado F. De Gasperis, Vice President, Chief Financial Officer & Chief Information Officer. |
61
