10-Q 1 chemco2q05.txt 2ND QUARTER 2005 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended JULY 3, 2005 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number 333-17827-01 ISP CHEMCO INC. (Exact name of registrant as specified in its charter) DELAWARE 51-0382622 (State or other Jurisdiction of (IRS Employer Incorporation or Organization) Identification No.) 300 DELAWARE AVENUE, SUITE 303, WILMINGTON, DELAWARE 19801 (Address of principal executive offices) (Zip Code) (302) 427-5818 (Registrant's telephone number, including area code) NONE (Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report) ----------------------------------- See Table of Additional Registrants Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /X/ No / / Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes / / No /X/ As of August 17, 2005, 100 shares of the registrant's common stock (par value $.01 per share) were outstanding. There is no trading market for the common stock of the registrant. As of August 17, 2005, each of the additional registrants had the number of shares outstanding which is shown on the table below. There is no trading market for the common stock of the additional registrants. No shares of the registrant or the additional registrants are held by non-affiliates. THE REGISTRANT AND THE ADDITIONAL REGISTRANTS MEET THE CONDITIONS SET FORTH IN GENERAL INSTRUCTIONS H(1)(a) AND (b) OF FORM 10-Q AND ARE THEREFORE FILING THIS FORM WITH THE REDUCED DISCLOSURE FORMAT. ADDITIONAL REGISTRANTS

PART I - FINANCIAL INFORMATION ITEM 1 - FINANCIAL STATEMENTS ISP CHEMCO INC. CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) (THOUSANDS)

The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 1 ISP CHEMCO INC. CONSOLIDATED BALANCE SHEETS (UNAUDITED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) JULY 3, DECEMBER 31, 2005 2004 ----------- ----------- ASSETS Current Assets: Cash and cash equivalents.......................... $ 17,107 $ 32,939 Accounts receivable, trade, less allowance of $6,808 and $6,794 at July 3, 2005 and December 31, 2004, respectively.................. 132,502 105,737 Accounts receivable, other......................... 29,817 21,464 Receivables from related parties................... 22,389 15,186 Inventories........................................ 229,725 191,735 Deferred income tax assets......................... 19,065 14,833 Prepaid expenses................................... 8,069 6,973 --------- ---------- Total Current Assets............................. 458,674 388,867 Property, plant and equipment, net................... 618,217 599,085 Goodwill, net of accumulated amortization of $180,486 339,775 337,794 Intangible assets, net of accumulated amortization of $2,927 and $2,259 at July 3, 2005 and December 31, 2004, respectively................................. 18,009 18,677 Long-term receivable from related party.............. 35,064 34,043 Other assets......................................... 76,288 64,450 ---------- ---------- Total Assets......................................... $1,546,027 $1,442,916 ========== ========== LIABILITIES AND SHAREHOLDER'S EQUITY Current Liabilities: Short-term debt................................... $ 72 $ 71 Current maturities of long-term debt.............. 2,908 2,932 Accounts payable.................................. 77,219 65,799 Accrued liabilities............................... 63,793 84,549 Income taxes payable.............................. 46,424 56,484 ---------- ---------- Total Current Liabilities....................... 190,416 209,835 ---------- ---------- Long-term debt less current maturities.............. 651,165 649,368 ---------- ---------- Deferred income tax liabilities..................... 125,926 122,822 ---------- ---------- Other liabilities................................... 90,110 88,961 ---------- ---------- Shareholder's Equity: Common stock, $.01 par value per share; 1,000 shares authorized; 100 shares issued and outstanding ................................ - - Additional paid-in capital........................ 417,763 327,763 Retained earnings................................. 72,810 36,542 Accumulated other comprehensive income (loss)..... (2,163) 7,625 ---------- ---------- Total Shareholder's Equity...................... 488,410 371,930 ---------- ---------- Total Liabilities and Shareholder's Equity.......... $1,546,027 $1,442,916 ========== ========== The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 2 ISP CHEMCO INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (THOUSANDS) SIX MONTHS ENDED -------------------- JULY 3, JULY 4, 2005 2004 -------- ---------- Cash flows from operating activities: Net income............................................. $ 36,268 $ 41,178 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Impairment of fixed assets......................... 10,532 - Depreciation....................................... 34,239 31,827 Amortization of intangible assets.................. 668 439 Noncash interest charges........................... 1,007 1,100 Deferred income taxes.............................. (1,128) 14,135 Increase in working capital items...................... (88,588) (50,316) Proceeds from sale of accounts receivable.............. 6,242 4,074 Increase in receivables from related parties........... (8,224) (3,559) Other, net............................................. 3,174 1,022 --------- --------- Net cash provided by (used in) operating activities...... (5,810) 39,900 --------- --------- Cash flows from investing activities: Capital expenditures and acquisitions.................. (100,513) (58,233) --------- --------- Net cash used in investing activities.................... (100,513) (58,233) --------- --------- Cash flows from financing activities: Increase in short-term debt............................ 1 - Proceeds from issuance of debt......................... - 31,188 Increase in borrowings under revolving credit facility. 2,650 400 Repayments of long-term debt........................... (970) (1,472) Loans from related party............................... - 34,000 Increase in loan to related party...................... - (7,760) Debt issuance costs.................................... - (1,725) Dividend to parent company............................. - (67,163) Capital contribution from parent company............... 90,000 - --------- --------- Net cash provided by (used in) financing activities...... 91,681 (12,532) --------- --------- Effect of exchange rate fluctuations on cash and cash equivalents................................... (1,190) (351) --------- --------- Net change in cash and cash equivalents.................. (15,832) (31,216) Cash and cash equivalents, beginning of period........... 32,939 56,426 --------- --------- Cash and cash equivalents, end of period................. $ 17,107 $ 25,210 ========= ========= The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 3 ISP CHEMCO INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) - (CONTINUED) (THOUSANDS) SIX MONTHS ENDED -------------------- JULY 3, JULY 4, 2005 2004 -------- ---------- Supplemental Cash Flow Information: Cash paid during the period for: Interest (net of amount capitalized)................. $ 47,433 $ 46,873 Income taxes (including taxes paid pursuant to the Tax Sharing Agreement)........................ 28,945 11,056 Acquisitions: Estimated fair market value of assets acquired........ $ 29,578 $ 30,425 Purchase price of acquisitions........................ 28,861 27,284 -------- -------- Liabilities assumed................................... $ 717 $ 3,141 ======== ======== Supplemental disclosure of financing activities: In April 2004, the Company declared dividends totaling $106.2 million to its parent company, International Specialty Holdings Inc., including cash dividends paid of $67.2 million. In connection with these dividends, the Company's total long-term loan receivable of $39.0 million from a related party was eliminated. The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 4 ISP CHEMCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) The consolidated financial statements for ISP Chemco Inc. (the "Company") reflect, in the opinion of management, all adjustments necessary to present fairly the financial position of the Company and its consolidated subsidiaries at July 3, 2005, and the results of operations and cash flows for the three- and six-month periods ended July 3, 2005 and July 4, 2004. All adjustments are of a normal recurring nature. Certain amounts in the 2004 consolidated financial statements have been reclassified to conform to the 2005 presentation. These consolidated financial statements should be read in conjunction with the annual consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2004 filed with the Securities and Exchange Commission on March 31, 2005 (the "2004 Form 10-K"). NOTE 1. OTHER OPERATING CHARGES The Company has implemented a program for the restructuring and consolidation of production capacity in the foods product line within the specialty chemicals business segment. In March 2005, the Company entered into a long-term supply contract with an international company for the purchase of a product in the specialty chemicals business that the Company currently manufactures at its San Diego, California alginates plant. Accordingly, the Company performed an impairment review in the first quarter of 2005 and recorded a $10.5 million non-cash fixed asset impairment charge related to the San Diego facility. The impairment charge was determined based on a review of anticipated future cash flows related to this facility compared with the carrying value of the facility's fixed assets. NOTE 2. COMPREHENSIVE INCOME (LOSS)

Changes in the components of accumulated other comprehensive income (loss) for the six months ended July 3, 2005 are as follows: 5 ISP CHEMCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - (CONTINUED) NOTE 2. COMPREHENSIVE INCOME (LOSS) - (CONTINUED) Cumulative Additional Foreign Minimum Accumulated Currency Pension Other Translation Liability Comprehensive Adjustment Adjustment Income (Loss) ----------- ---------- -------------- (Thousands) Balance, December 31, 2004....... $ 16,229 $ (8,604) $ 7,625 Change for the period............ (9,788) - (9,788) ---------- --------- --------- Balance, July 3, 2005............ $ 6,441 $ (8,604) $ (2,163) ========== ========= ========= NOTE 3. INVENTORIES Inventories comprise the following: July 3, December 31, 2005 2004 --------- ------------ (Thousands) Finished goods................ $136,801 $109,366 Work-in-process............... 50,155 34,665 Raw materials and supplies.... 42,769 47,704 -------- -------- Inventories................... $229,725 $191,735 ======== ======== At July 3, 2005 and December 31, 2004, $65.0 million and $60.4 million, respectively, of domestic inventories were valued using the LIFO method. If the FIFO inventory method had been used for these inventories, the value of inventories would have been $11.7 million and $4.0 million higher at July 3, 2005 and December 31, 2004, respectively. NOTE 4. GOODWILL AND INTANGIBLE ASSETS The following schedule reconciles the changes in the carrying amount of goodwill, by business segment, for the six months ended July 3, 2005.

The following is information as of July 3, 2005 and December 31, 2004 related to the Company's acquired intangible assets: 6 ISP CHEMCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - (CONTINUED) NOTE 4. GOODWILL AND INTANGIBLE ASSETS - (CONTINUED)

Estimated amortization expense: Year ending December 31, (Thousands) ----------- 2005................................................ $ 1,336 2006................................................ 1,336 2007................................................ 1,072 2008................................................ 1,072 2009................................................ 774 NOTE 5. RELATED PARTY TRANSACTIONS During the second quarter of 2005, the Company amended its management agreement (the "Management Agreement"), effective January 1, 2005, whereby the Company, through a subsidiary, provides certain general management services to Building Materials Corporation of America ("BMCA"), an affiliate, ISP, International Specialty Holdings Inc., the Company's parent company, ISP Investco LLC, and ISP Synthetic Elastomers LP. The purpose of the amendment was to adjust the management fees payable by the parties under the Management Agreement. Charges by the Company for the year 2005 for providing such services under the amended Management Agreement will aggregate approximately $24.9 million. In addition, during the second quarter of 2005, a subsidiary of the Company entered into a management services agreement with Heyman Properties, LLC and Heyman Investment Associates Limited Partnership (collectively, the "Heyman Entities"), effective as of January 1, 2005. The term of the management services agreement is from January 1, 2005 through December 31, 2005, and may be renewed for additional one-year terms. Under the agreement, the Company will provide certain general management services, and the Heyman Entities will provide certain advisory services for specified fees. The Company will receive a net amount of approximately $0.3 million related to these services in 2005. 7 ISP CHEMCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - (CONTINUED) NOTE 6. BENEFIT PLANS Defined Benefit Plans The Company provides a noncontributory defined benefit retirement plan for certain hourly employees in the United States (the "Hourly Retirement Plan"). At several locations, new employees may not participate and benefits have been frozen for most participants. Benefits under this plan are based on stated amounts for each year of service. The Company's policy is to fund this plan consistent with the minimum funding requirements of ERISA. ISP Marl GmbH, a wholly-owned German subsidiary of the Company, provides a noncontributory defined benefit retirement plan for its hourly and salaried employees (the "ISP Marl Plan"). Benefits under the ISP Marl Plan are based on average earnings over each employee's career with the Company. The Company's net periodic pension cost for the second quarter and first six months of 2005 and 2004 for the Hourly Retirement Plan included the following components:

The Company's net periodic pension cost for the second quarter and first six months of 2005 and 2004 for the ISP Marl Plan included the following components:

Postretirement Medical and Life Insurance The Company generally does not provide postretirement medical and life insurance benefits, although it subsidizes such benefits for certain employees and certain retirees. 8 ISP CHEMCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - (CONTINUED) NOTE 6. BENEFIT PLANS - (CONTINUED) The net periodic postretirement benefit (income) cost for the second quarter and first six months of 2005 and 2004 included the following components:

Long-Term Incentive Plans The Company has two long-term incentive plans, the 2000 Long-Term Incentive Plan and the 2003 Executive Long-Term Incentive Plan, which provide long-term compensation to executives, key management personnel and certain other employees based on ISP's "Book Value" (as defined in the plans). The value of incentive units granted under the plans is determined at the end of each fiscal quarter based on ISP's total Shareholder's Equity. The value on the date of grant is compared to the value as remeasured at the end of each quarter in order to determine compensation expense. Compensation expense related to these plans was $2.5 and $2.4 million for the second quarter of 2005 and 2004, respectively, and $5.5 and $5.7 million for the first six months of 2005 and 2004, respectively. 9 ISP CHEMCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - (CONTINUED) NOTE 7. BUSINESS SEGMENT INFORMATION

(1) Includes sales to BMCA and its subsidiaries of $27.3 million and $24.9 million for the second quarter of 2005 and 2004, respectively, and $54.9 million and $49.1 million for the first six months of 2005 and 2004, respectively. (2) Operating income for the Specialty Chemicals business segment for the first six months of 2005 includes a $10.5 million non-cash charge for the impairment of fixed assets. See Note 1. NOTE 8. ACQUISITION In March 2005, the Company acquired a 1,4-butanediol ("BDO") production facility in Lima, Ohio, and related working capital. BDO is a key building block for many of the core specialty chemicals that the Company markets for pharmaceutical, personal care, food, beverage, coatings, oil field and other market applications. The preliminary purchase price of the acquisition has been allocated to the estimated fair value of the assets acquired pending the determination of any additional contingent consideration. This acquisition is not expected to be material to the Company's results of operations in 2005. 10 ISP CHEMCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - (CONTINUED) NOTE 9. RECENT ACCOUNTING PRONOUNCEMENTS In November 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 151, "Inventory Costs," an amendment of Accounting Research Bulletin ("ARB") No. 43, Chapter 4, which discussed the general principles applicable to the pricing of inventory. SFAS No. 151 amends ARB No. 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs, and spoilage should be recognized as current-period charges. In addition, SFAS No. 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company does not expect the adoption of SFAS No. 151 to have a material effect on the Company's consolidated financial statements. In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets," an amendment of Accounting Principles Board ("APB") Opinion No. 29. SFAS No. 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets and replaces it with an exception for exchanges that do not have commercial substance. A nonmonetary exchange has commercial substance if the entity's future cash flows are expected to significantly change as a result of the exchange. SFAS No. 153 will be effective for nonmonetary asset exchanges occurring in fiscal reporting periods beginning after June 15, 2005. The Company does not expect the adoption of SFAS No. 153 to have an immediate effect on the Company's consolidated financial statements. In December 2004, the FASB issued a revised SFAS No. 123 ("SFAS No. 123R"), "Share-Based Payment." SFAS No. 123R requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. SFAS No. 123R establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all entities to apply a fair-value-based measurement method in accounting for share-based payment transactions with employees. In February 2003, the Company's indirect parent company, International Specialty Products Inc. ("ISP") completed a going private transaction. As a result, stock-based compensation plans were terminated and payments were made in accordance with the terms of the merger agreement. In addition, the Company currently accounts for incentive units granted to eligible Company employees pursuant to ISP's 2000 Long-Term Incentive Plan and the 2003 Executive Long-Term Incentive Plan under the accounting prescribed by FASB Interpretation No. ("FIN") 28, "Accounting for Stock Appreciation Rights and Other Variable Stock Option and Award Plans." FIN 28 requires an entity to measure compensation as the amount by which the Book Value (as defined in the plans) of the incentive units covered by the grant exceeds the option price or value specified of such incentive units between the date of grant and the measurement date, resulting in a change in the measure of compensation for the right or award. Since compensation expense related to such incentive units is currently included in the actual Consolidated Statement of Operations, the Company does not expect SFAS No. 123R to have an impact on the Company's consolidated financial statements. 11 ISP CHEMCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - (CONTINUED) NOTE 9. RECENT ACCOUNTING PRONOUNCEMENTS - (CONTINUED) In December 2004, the FASB issued FASB Staff Position ("FSP") Nos. FAS 109-1 and FAS 109-2, each as a result of the passage in October 2004 of the American Jobs Creation Act of 2004 (the "Jobs Act"). FSP No. FAS 109-1 relates to a provision in the Jobs Act that provides a tax deduction of up to nine percent (when fully phased-in) on qualified production activities. The FASB indicated in FSP No. FAS 109-1 that this deduction should be accounted for as a special deduction in accordance with SFAS No. 109, "Accounting for Income Taxes," rather than as a tax rate reduction. This FSP was effective upon issuance. The Company does not expect the adoption of this FSP to have a material effect on its 2005 consolidated financial statements. FSP No. FAS 109-2 relates to a provision in the Jobs Act that introduces a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer, provided certain criteria are met. This FSP was effective upon issuance. This FSP will not have an impact on the Company's consolidated financial statements. In March 2005, the FASB issued FIN 47, "Accounting for Conditional Asset Retirement Obligations," an interpretation of SFAS No. 143, "Accounting for Asset Retirement Obligations." SFAS No. 143 states that an entity shall recognize the fair value of a liability for an asset retirement obligation ("ARO") in the period in which it is incurred if a reasonable estimate of fair value can be made. The term "conditional asset retirement obligation" refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. FIN 47 states that if an entity has sufficient information to reasonably estimate the fair value of an ARO, it must recognize a liability at the time the liability is incurred. An entity would have sufficient information to apply an expected present value and therefore an ARO would be reasonably estimable if either of the following conditions exist: (a) the settlement date and method of settlement for the ARO have been specified by others, such as by law, regulation or contract or (b) the information is available to reasonably estimate the settlement date or the range of potential settlement dates, the method of settlement, and the probabilities associated with the potential settlement dates and methods of settlements. FIN 47 will be effective for the Company as of December 31, 2005. The Company is currently reviewing its AROs to determine the potential impact of FIN 47 on its consolidated financial statements, and, at this time, the Company does not believe that FIN 47 will have a material impact on the Company's consolidated financial statements. In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections." SFAS No. 154 eliminates the requirement in APB Opinion No. 20, "Accounting Changes," to include the cumulative effect of changes in accounting principles in the Consolidated Statement of Operations in the period of change. Instead, SFAS No. 154 requires that changes in accounting principles be retrospectively applied, whereby the new accounting principle is applied to prior accounting periods as if that principle had always been used. SFAS No. 154 also redefines "restatement" as the revision of previously issued financial statements to reflect the correction of an error. SFAS No. 154 is effective for accounting changes and corrections of errors made in 12 ISP CHEMCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - (CONTINUED) NOTE 9. RECENT ACCOUNTING PRONOUNCEMENTS - (CONTINUED) fiscal years beginning after December 15, 2005, although early adoption is permitted for accounting changes and correction of errors made after the date SFAS No. 154 was issued. SFAS No. 154 does not change the transition provisions of any existing accounting pronouncements. NOTE 10. GUARANTOR FINANCIAL INFORMATION In 2001, the Company and three of its wholly-owned subsidiaries jointly issued, in three separate transactions, a total of $405.0 million aggregate principal amount of 10 1/4% Senior Subordinated Notes due 2011 (the "2011 Notes"). The 2011 Notes are guaranteed by all of the Company's domestic subsidiaries, other than certain immaterial subsidiaries and the Company's accounts receivable financing subsidiary. These guarantees are full, unconditional and joint and several. ISP Global Technologies Inc., which is a guarantor of the 2011 Notes, is party to a License and Royalty Agreement with non-guarantor foreign affiliates. Under this agreement, ISP Global Technologies granted a license to certain non-guarantor foreign affiliates for the use of the patent rights, know-how and trademarks in connection with the manufacture, use and sale of the Company's products. Presented below is condensed consolidating financial information for the Company, the guarantor subsidiaries and the non-guarantor subsidiaries. This financial information should be read in conjunction with the consolidated financial statements and other notes related thereto. 13 ISP CHEMCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - (CONTINUED) NOTE 10. GUARANTOR FINANCIAL INFORMATION - (CONTINUED)

14 ISP CHEMCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - (CONTINUED) NOTE 10. GUARANTOR FINANCIAL INFORMATION - (CONTINUED)

15 ISP CHEMCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - (CONTINUED) NOTE 10. GUARANTOR FINANCIAL INFORMATION - (CONTINUED)

16 ISP CHEMCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - (CONTINUED) NOTE 10. GUARANTOR FINANCIAL INFORMATION - (CONTINUED)

17 ISP CHEMCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - (CONTINUED) NOTE 10. GUARANTOR FINANCIAL INFORMATION - (CONTINUED)

18 ISP CHEMCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - (CONTINUED) NOTE 10. GUARANTOR FINANCIAL INFORMATION - (CONTINUED)

19 ISP CHEMCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - (CONTINUED) NOTE 11. CONTINGENCIES For information regarding contingencies, reference is made to Note 21 to consolidated financial statements contained in the 2004 Form 10-K. Environmental Litigation The Company, together with other companies, is a party to a variety of proceedings and lawsuits involving environmental matters ("Environmental Claims") under the Comprehensive Environmental Response Compensation and Liability Act, Resource Conservation and Recovery Act and similar state laws, in which recovery is sought for the cost of cleanup of contaminated sites or in which remedial obligations are imposed. A number of these Environmental Claims are in the early stages or have been dormant for protracted periods. While the Company cannot predict whether adverse decisions or events can occur in the future, in the opinion of the Company's management, the resolution of the Environmental Claims should not be material to the business, liquidity, results of operations, cash flows or financial position of the Company. However, adverse decisions or events, particularly as to increases in remedial costs, discovery of new contamination, assertion of natural resource damages, plans for development of the Company's Linden, New Jersey property, and the liability and the financial responsibility of the Company's insurers and of the other parties involved at each site and their insurers, could cause the Company to increase the estimate of its liability or decrease the estimate of insurance recoveries in respect of those matters. It is not currently possible to estimate the amount or range of any additional liability. Tax Claim Against G-I Holdings Inc. The predecessor of ISP and certain of its domestic subsidiaries were parties to tax sharing agreements with members of a consolidated group for federal income tax purposes that included G-I Holdings Inc. (the "G-I Holdings Group") in certain prior years. Until January 1, 1997, ISP and its domestic subsidiaries were included in the consolidated federal income tax returns of the G-I Holdings Group and, accordingly, would be severally liable for any tax liability of the G-I Holdings Group in respect of those prior years. Those tax sharing agreements are no longer applicable with respect to the tax liabilities of ISP for periods subsequent to January 1, 1997, because neither the Company nor any of its domestic subsidiaries have been members of the G-I Holdings Group for periods after January 1, 1997. In January 2001, G-I Holdings filed a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code due to its asbestos-related bodily injury claims relating to the inhalation of asbestos fiber. On September 15, 1997, G-I Holdings received a notice from the Internal Revenue Service ("IRS") of a deficiency in the amount of $84.4 million (after taking into account the use of net operating losses and foreign tax credits otherwise available for use in later years) in connection with the formation in 1990 of Rhone-Poulenc Surfactants and Specialties, L.P. (the "Surfactants Partnership"), a partnership in which G-I Holdings held an interest. On September 21, 2001, the IRS filed a proof of claim with respect to such deficiency in the 20 ISP CHEMCO INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - (CONTINUED) NOTE 11. CONTINGENCIES - (CONTINUED) G-I Holdings bankruptcy against G-I Holdings and ACI Inc., a subsidiary of G-I Holdings which also held an interest in the Surfactants Partnership and also has filed a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code. If the proof of claim is sustained, ISP and/or certain of its subsidiaries together with G-I Holdings and several current and former subsidiaries of G-I Holdings would be severally liable for taxes and interest in the amount of approximately $301 million, computed as of July 3, 2005. On May 7, 2002, G-I Holdings, together with ACI Inc., filed an objection to the proof of claim, which objection will be heard by the United States District Court for the District of New Jersey overseeing the G-I Holdings bankruptcy. G-I Holdings has advised the Company that it believes that it will prevail in this tax matter involving the Surfactants Partnership, although there can be no assurance in this regard. The Company believes that the ultimate disposition of this matter will not have a material adverse effect on its business, financial position or results of operations. For additional information relating to G-I Holdings, reference is made to Notes 7 and 21 to consolidated financial statements contained in the 2004 Form 10-K. 21 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Unless otherwise indicated by the context, "we," "us" and "our" refer to ISP Chemco Inc. and its consolidated subsidiaries. CRITICAL ACCOUNTING POLICIES There have been no significant changes in our critical accounting policies during the first six months of 2005. For a discussion of our critical accounting policies, reference is made to the "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2004 filed with the Securities and Exchange Commission on March 31, 2005. RESULTS OF OPERATIONS - SECOND QUARTER 2005 COMPARED WITH SECOND QUARTER 2004 Overview We recorded net income of $17.1 million for the second quarter of 2005 compared with net income of $19.3 million in the second quarter of 2004. The lower results for the second quarter of 2005 were mainly attributable to higher other expense, net, due to unfavorable foreign exchange, and also due to lower operating income and higher interest expense. Net Sales. Net sales by business segment for the second quarter of 2005 and 2004 were: Second Quarter Ended --------------------------- July 3, July 4, 2005 2004 --------- ---------- (Millions) Specialty chemicals.................... $ 183.1 $ 178.1 Industrial chemicals................... 63.7 49.1 Mineral products....................... 40.3 34.5 --------- --------- Net sales............................ $ 287.1 $ 261.7 ========= ========= Net sales for the second quarter of 2005 were $287.1 million compared with $261.7 million in the second quarter of 2004. The $25.4 million (10%) increase in sales resulted primarily from higher pricing and the favorable impact of the weaker U.S. dollar. Gross Margin. Our gross margin in the second quarter of 2005 was 33.0% compared with 36.3% in the second quarter of 2004. The lower margin was attributable to higher material, energy and manufacturing costs in all business segments, partially offset by favorable pricing and the favorable impact of the weaker U.S. dollar. Manufacturing costs in the second quarter of 2005 were adversely impacted by plant integration costs for the Lima, Ohio production facility acquired in the first quarter of 2005 (see further discussion below). 22 Selling, General and Administrative. Selling, general and administrative expenses increased 1.5% in the second quarter of 2005 to $49.9 million from $49.2 million in the second quarter of 2004; however, as a percent of sales, these expenses decreased to 17.4% in the second quarter of 2005 from 18.8% in the second quarter of 2004. The increase in selling, general and administrative expenses in the second quarter of 2005 related primarily to higher freight and distribution costs as a result of the higher sales levels. Operating Income. Operating income (loss) by business segment for the second quarter of 2005 and 2004 was: Second Quarter Ended -------------------------- July 3, July 4, 2005 2004 --------- --------- (Millions) Specialty chemicals.................... $ 37.9 $ 41.6 Industrial chemicals................... 0.2 (1.8) Mineral products....................... 6.5 5.6 --------- --------- Total segment operating income....... 44.6 45.4 Unallocated corporate office items..... - (0.1) --------- --------- Operating income..................... $ 44.6 $ 45.3 ========= ========= Operating income for the second quarter of 2005 was $44.6 million compared with $45.3 million in the second quarter of 2004. Operating income for the second quarter of 2005 was adversely affected by plant integration costs in the amount of $2.1 million for the Lima, Ohio production facility acquired in the first quarter of 2005 (see "Liquidity and Financial Condition"), and higher raw material and energy costs. The specialty chemicals segment recorded operating income of $37.9 million for the second quarter of 2005 compared with $41.6 million in the second quarter of 2004. The lower operating income was primarily due to higher raw material and energy costs. The industrial chemicals segment recorded operating income of $0.2 million in the second quarter of 2005 compared with an operating loss of $1.8 million in the second quarter of 2004. The segment's improved performance was achieved despite the $2.1 million one-time integration costs in connection with the Lima, Ohio production facility referenced above. Operating income for the mineral products segment was $6.5 million in the second quarter of 2005 compared with $5.6 million in the second quarter of 2004. The improved results were attributable to favorable pricing and higher unit volumes, partially offset by increased material costs and higher freight and distribution expenses. Interest Expense. Interest expense for the second quarter of 2005 was $14.2 million compared with $13.5 million in the same period in 2004. The $0.7 million (5%) higher interest expense was attributable to higher average interest rates ($1.1 million impact), partially offset by lower average borrowings ($0.4 million impact). Other Expense, Net. Other expense, net, comprises foreign exchange gains and losses resulting from the revaluation of foreign currency-denominated accounts receivable and payable as a result of changes in exchange rates, and other nonoperating items of expense. Other expense, net, was $5.1 million in the second quarter of 2005 compared with $2.8 million in the second quarter of 23 2004. The higher expense in the second quarter of 2005 was due to unfavorable foreign exchange. Income Taxes. In the second quarter of 2005, we recorded a provision for income taxes of $8.8 million. Our effective tax rate for the second quarter of 2005 was 34.1% compared with an effective tax rate of 34.6% in the second quarter of 2004. Business Segment Review A discussion of operating results for each of our business segments follows. We operate our business through three reportable business segments: specialty chemicals, industrial chemicals and mineral products. Specialty Chemicals Sales in the second quarter of 2005 were $183.1 million compared with $178.1 million in the same period in 2004. The 3% increase in sales was primarily due to the favorable impact of the weaker U.S. dollar ($3.3 million), and, to a lesser extent, favorable pricing. Operating income for the specialty chemicals segment was $37.9 million for the second quarter of 2005 compared with $41.6 million in the second quarter of 2004. The lower operating income was primarily attributable to higher raw material costs ($6.0 million impact), partially offset by the favorable impact of the weaker U.S. dollar ($1.6 million). Industrial Chemicals Sales in the second quarter of 2005 were $63.7 million compared with $49.1 million in the second quarter of 2004. The 30% increase in sales resulted primarily from favorable pricing ($13.9 million) and, to a lesser extent, the favorable effect of the weaker U.S. dollar, partially offset by lower unit volumes. The industrial chemicals segment recorded operating income of $0.2 million in the second quarter of 2005 compared with an operating loss of $1.8 million in the second quarter of 2004. The improvement in pricing for the industrial chemicals segment more than offset raw material, manufacturing and energy cost increases (totaling $10.0 million), as well as higher operating expenses. The segment's improved performance was achieved despite the $2.1 million one-time integration costs in connection with the Lima, Ohio production facility which was acquired in the first quarter of 2005. Mineral Products Sales for the mineral products segment for the second quarter of 2005 were $40.3 million compared with $34.5 million for the second quarter of 2004. The 17% increase in sales was due to higher unit volumes ($3.2 million), as a result of industry-wide growth, and favorable pricing and included 10% higher sales to Building Materials Corporation of America, an affiliate that we refer to as "BMCA." Operating income for the mineral products segment was $6.5 million in the second quarter of 2005 compared with $5.6 million for the second quarter of 2004. The 16% improvement in operating income was attributable to favorable pricing ($2.6 million) and the favorable impact of higher unit volumes, 24 partially offset by increased raw material and manufacturing costs (totaling $1.8 million) and higher freight and distribution expenses. RESULTS OF OPERATIONS - FIRST SIX MONTHS 2005 COMPARED WITH FIRST SIX MONTHS 2004 Overview We recorded net income of $36.3 million for the first six months of 2005, after a non-cash, pre-tax asset impairment charge of $10.5 million (see "Other Operating Charges" below), compared with net income of $41.2 million in the first six months of 2004. The decline in net income for the first six months of 2005 was primarily attributable to lower operating income, after including the $10.5 million charge, and higher other expense, net. Net Sales. Net sales by business segment for the first six months of 2005 and 2004 were: Six Months Ended -------------------------- July 3, July 4, 2005 2004 --------- --------- (Millions) Specialty chemicals.................... $ 369.5 $ 364.3 Industrial chemicals................... 122.4 97.8 Mineral products....................... 79.9 66.5 --------- --------- Net sales............................ $ 571.8 $ 528.6 ========= ========= Net sales for the first six months of 2005 were $571.8 million compared with $528.6 million in the first six months of 2004. The $43.2 million (8%) increase in sales resulted primarily from higher pricing, higher unit volumes, and the favorable impact of the weaker U.S. dollar. Gross Margin. Our gross margin in the first six months of 2005 was 35.5% compared with 36.5% in the first six months of 2004. The lower margin was attributable to higher raw material, energy and manufacturing costs in all business segments, partially offset by favorable pricing and the favorable impact of the weaker U.S. dollar. Manufacturing costs in the first six months of 2005 were adversely impacted by plant integration costs for the Lima, Ohio production facility acquired in the first quarter of 2005 (see further discussion below). Selling, General and Administrative. Selling, general and administrative expenses increased 2% in the first six months of 2005 to $100.0 million from $98.3 million in the first six months of 2004; however, as a percent of sales, these expenses decreased to 17.5% in the first six months of 2005 from 18.6% in the first six months of 2004. The increase in selling, general and administrative expenses in the first six months of 2005 related primarily to higher freight and distribution costs and increased selling expenses as a result of the higher sales levels. Other Operating Charges. Other operating charges of $10.5 million in the first six months of 2005 represent a non-cash fixed asset impairment charge related to our program for the restructuring and consolidation of production capacity in the foods product line within the specialty chemicals business segment. In March 2005, we entered into a long-term supply contract with an international company for the purchase of a product in the specialty chemicals business that we currently manufacture 25 at our San Diego, California alginates plant. Accordingly, we performed an impairment review in the first quarter of 2005 and recorded a $10.5 million non-cash fixed asset impairment charge related to the San Diego facility. The impairment charge was determined based on a review of anticipated future cash flows related to this facility compared with the carrying value of the facility's fixed assets. Operating Income. Operating income (loss) by business segment for the first six months of 2005 and 2004 was: Six Months Ended -------------------------- July 3, July 4, 2005 2004 --------- --------- (Millions) Specialty chemicals.................... $ 72.8 $ 87.8 Industrial chemicals................... 8.0 (1.6) Mineral products....................... 11.0 8.1 --------- --------- Total segment operating income....... 91.8 94.3 Unallocated corporate office items..... (0.1) (0.1) --------- --------- Operating income..................... $ 91.7 $ 94.2 ========= ========= Operating income for the first six months of 2005 was $91.7 million, after the $10.5 million non-cash asset impairment charge discussed above. Excluding such charge, operating income increased by 8.5% to $102.2 million from $94.2 million in the first six months of 2004 (see "Non-GAAP Financial Measures" below) because of favorable pricing in all business segments. Increased operating income as a result of the 8% increase in sales for the first six months of 2005 was partially offset by increased manufacturing costs, including $2.4 million of integration costs in connection with the acquisition of the Lima, Ohio production facility in the first quarter of 2005, and higher raw material and energy costs. The specialty chemicals segment recorded operating income of $72.8 million in the first six months of 2005. Excluding the aforementioned non-cash impairment charge of $10.5 million, operating income for the segment was $83.3 million compared with $87.8 million in the first six months of 2004. The lower operating income was due to higher raw material and energy costs. The industrial chemicals segment recorded operating income of $8.0 million in the first six months of 2005 compared with an operating loss of $1.6 million in the first six months of 2004. The industrial chemicals segment's improved pricing more than offset material cost increases. The segment's improved performance was achieved despite the $2.4 million ($0.3 million in the first quarter and $2.1 million in the second quarter) one-time integration costs in connection with the Lima, Ohio production facility discussed above. Operating income for the mineral products segment was $11.0 million in the first six months of 2005 compared with $8.1 million in the first six months of 2004. The 36% improvement in operating income was attributable to favorable pricing and the favorable impact of higher unit volumes, partially offset by increased material and manufacturing costs and higher freight and distribution expenses. Interest Expense. Interest expense for the first six months of 2005 was $28.0 million compared with $27.6 million in the same period in 2004. The slightly higher interest expense was attributable to higher average interest 26 rates ($0.5 million impact), partially offset by lower average borrowings ($0.1 million impact). Other Expense, Net. Other expense, net, comprises foreign exchange gains and losses resulting from the revaluation of foreign currency-denominated accounts receivable and payable as a result of changes in exchange rates, and other nonoperating items of expense. Other expense, net, was $10.0 million in the first six months of 2005 compared with $4.5 million in the first six months of 2004. The higher expense in the first six months of 2005 was due to unfavorable foreign exchange. Income Taxes. In the first six months of 2005, we recorded a provision for income taxes of $18.6 million. Our effective tax rate for the first six months of 2005 was 33.9% and 34.7% for the first six months of 2004. Business Segment Review A discussion of operating results for each of our business segments follows. We operate our business through three reportable business segments: specialty chemicals, industrial chemicals and mineral products. The operating income for the first six months of 2005 for the specialty chemicals business segment discussed below is adjusted for the non-GAAP financial measures in the table below. Non-GAAP Financial Measures The business segment review below and the discussion of operating income above contain information regarding non-GAAP financial measures contained within the meaning of Item 10 of Regulation S-K promulgated by the Securities and Exchange Commission. As used herein, "GAAP" refers to U.S. generally accepted accounting principles. We use non-GAAP financial measures to eliminate the effect of certain other operating gains and charges on reported operating income. Management believes that these financial measures are useful to bondholders and financial institutions because such measures exclude transactions that are unusual due to their nature or infrequency and therefore allow bondholders and financial institutions to more readily compare our company's performance from period to period. Management uses this information in monitoring and evaluating our company's performance and the performance of individual business segments. The non-GAAP financial measures included herein have been reconciled to the most directly comparable GAAP financial measure as is required under Item 10 of Regulation S-K regarding the use of such financial measures. These non-GAAP financial measures should be considered in addition to, and not as a substitute, or superior to, operating income or other measures of financial performance in accordance with U.S. generally accepted accounting principles. 27 Six Months Ended --------------------- July 3, July 4, 2005 2004 --------- --------- (Millions) Reconciliation of non-GAAP financial measures: Operating income per GAAP............................... $ 91.7 $ 94.2 Non-GAAP adjustments: Add: Other operating charges(1)...................... 10.5 - --------- --------- Operating income as adjusted............................ $ 102.2 $ 94.2 ========= ========= Supplemental Business Segment Information: Operating income (loss): Operating Income per GAAP - Specialty Chemicals.... $ 72.8 $ 87.8 Non-GAAP adjustments (1)........................... 10.5 - --------- --------- Operating Income - Specialty Chemicals as adjusted. $ 83.3 $ 87.8 ========= ========= Operating Income (Loss) per GAAP - Industrial Chemicals........................................ $ 8.0 $ (1.6) Non-GAAP adjustments............................... - - --------- --------- Operating Income (Loss) - Industrial Chemicals as adjusted........................................ $ 8.0 $ (1.6) ========= ========= Operating Income per GAAP - Mineral Products....... $ 11.0 $ 8.1 Non-GAAP adjustments............................... - - --------- --------- Operating Income - Mineral Products as adjusted.... $ 11.0 $ 8.1 ========= ========= Total segment operating income as adjusted......... $ 102.3 $ 94.3 Unallocated corporate office per GAAP.............. (0.1) (0.1) --------- --------- Operating income as adjusted....................... $ 102.2 $ 94.2 ========= ========= (1) Non-GAAP adjustments in the first six months of 2005 represent a $10.5 million non-cash other operating charge for the impairment of fixed assets at one of our domestic manufacturing facilities related to a program for the restructuring and consolidation of production capacity in the specialty chemicals segment. See "Other Operating Charges" above. Specialty Chemicals Sales in the first six months of 2005 were $369.5 million compared with $364.3 million for the first six months of 2004. The increase in sales was primarily due to the favorable impact of the weaker U.S. dollar ($6.6 million), primarily in Europe, and, to a lesser extent, favorable pricing, partially offset by lower unit volumes ($2.4 million). The specialty chemicals segment recorded operating income of $72.8 million in the first six months of 2005. Excluding the aforementioned non-cash asset impairment charge of $10.5 million, operating income for the segment was $83.3 million compared with $87.8 million in the first six months of 2004. The lower operating income was primarily attributable to higher raw material costs ($9.5 million impact), partially offset by the favorable impact of the weaker U.S. dollar ($3.6 million). Industrial Chemicals Sales in the first six months of 2005 were $122.4 million compared with $97.8 million in the same period in 2004. The 25% increase in sales resulted primarily from favorable pricing ($23.6 million) and, to a lesser 28 extent, the favorable effect of the weaker U.S. dollar ($3.4 million), partially offset by lower unit volumes. The industrial chemicals segment recorded operating income of $8.0 million in the first six months of 2005 compared with an operating loss of $1.6 million in the first six months of 2004. The industrial chemicals segment's improved pricing more than offset higher raw material, energy and manufacturing costs (totaling $12.2 million). The segment's improved performance was achieved despite $2.4 of one-time integration costs in connection with the Lima, Ohio production facility acquired in the first quarter of 2005. Mineral Products Sales for the mineral products segment for the first six months of 2005 were $79.9 million compared with $66.5 million for the first six months of 2004. The 20% increase in sales was due to higher unit volumes ($8.4 million), as a result of industry-wide growth, and favorable pricing and included 12% higher sales to BMCA, an affiliate. Operating income for the mineral products segment was $11.0 million in the first six months of 2005 compared with $8.1 million for the first six months of 2004. The 36% improvement in operating income resulted from favorable pricing ($4.9 million) and the favorable impact of higher unit volumes, partially offset by increased raw material and manufacturing costs (totaling $3.7 million) and higher freight and distribution expenses. LIQUIDITY AND FINANCIAL CONDITION Cash Flows and Cash Position During the first six months of 2005, our net cash outflow before financing activities was $106.3 million, including $5.8 million used in operations and the reinvestment of $100.5 million for capital programs and an acquisition. Operating Activities. Net cash used in operating activities totaled $5.8 million for the first six months of 2005, principally related to a cash investment of $88.6 million in additional working capital, including a $32.5 million increase in receivables as a result of higher sales, a $26.2 million increase in inventories to support our sales growth and a $28.8 million net decrease in payables and accrued liabilities, mainly due to payments of accrued interest and income taxes. Investing Activities. Net cash used in investing activities in the first six months of 2005 totaled $100.5 million for capital expenditures and an acquisition. Capital expenditures in the first six months of 2005 included $33.6 million for the purchase of equipment at our Freetown, Massachusetts facility. We entered into an operating lease in 1998 for an equipment sale-leaseback transaction related to this equipment. The lease had an initial term of four years and, at our option, up to three one-year renewal periods. The lease provided for a substantial guaranteed payment by us, adjusted at the end of each renewal period, and included purchase and return options at fair market values determined at the inception of the lease. We had the right to exercise a purchase option with respect to the leased equipment, or the equipment could be returned to the lessor and sold to a third party. We exercised the purchase option in the first quarter of 2005 for a purchase price of $33.6 million. 29 Our total capital expenditures for the year 2005 are expected to be approximately $110 million. In March 2005, we acquired a 1,4-butanediol ("BDO") production facility in Lima, Ohio, and related working capital. BDO is a key building block for many of the core specialty chemicals that we market for pharmaceutical, personal care, food, beverage, coatings, oil field and other market applications. The preliminary purchase price of the acquisition has been allocated to the estimated fair value of the assets acquired pending the determination of any additional contingent consideration. This acquisition is not expected to be material to our results of operations in 2005. Financing Activities. Net cash provided by financing activities in the first six months of 2005 totaled $91.7 million, principally attributable to a $90.0 million capital contribution from our parent company. Financing activities in the first six months of 2005 also included $2.7 million in revolving credit borrowings under our senior credit facilities, offset by $1.0 million of repayments of long-term debt. As a result of the foregoing factors, cash and cash equivalents decreased by $15.8 million during the first six months of 2005 to $17.1 million. Current Maturities of Long-Term Debt As of July 3, 2005, our current maturities of long-term debt, scheduled to be repaid during the twelve-month period ended June 2006, totaled $2.9 million, including $2.5 million related to the term loan under our senior credit facilities. Contingencies See Note 11 to consolidated financial statements for information regarding contingencies. Contractual Obligations We have an acetylene supply contract for our requirements of acetylene delivery via pipeline to our Calvert City, Kentucky facility. The current term of this contract expires December 31, 2009 and allows us, at our sole option, to extend the agreement for two additional five-year terms. We are required by the contract to pay a monthly non-cancelable facility fee. Pricing under the contract is on a fixed basis with escalators related to changes in the Producer Price Index. In 2004, we entered into a long-term requirements contract for acetylene at our Texas City, Texas facility. Under this contract, we are obligated to purchase specified quantities of acetylene through the end of 2013. Pricing under this contract is on a fixed basis with escalators related to changes in actual costs and changes in the Producer Price Index. The annual unconditional purchase obligation related to the long-term acetylene supply contract at the Texas City plant, together with the non-cancelable facility fee associated with the acetylene contract for the Calvert City plant, is $5.1 million. 30 In March 2005, we entered into a long-term contract with an international company for us to purchase 100% of our global requirements of a product in the specialty chemicals business that we currently manufacture. Subject to limited conditions and commencing no later than April 2006, for a period of five years our annual purchase obligation related to this long-term supply contract will be approximately $6.5 million. In the event that we do not meet the annual purchase obligation, we must pay a penalty equal to 30% of the price of the volume shortfall. As previously discussed, in March 2005, we acquired a BDO production facility in Lima, Ohio. As part of this acquisition, we assumed responsibility for a long-term supply agreement for the purchase of 100% of our hydrogen gas requirements for the Lima facility from a supplier located within the same complex as our BDO production facility. The supply agreement was originally entered into in 1999 and has a term of 15 years beginning in March 2000. We are required to pay a minimum monthly charge (currently $3.1 million on an annualized basis), which increases at the rate of 3.5% per year for the remainder of the term of the agreement. Recent Accounting Pronouncements In November 2004, the Financial Accounting Standards Board, which we refer to as "FASB," issued Statement of Financial Accounting Standards, which we refer to as SFAS, No. 151, "Inventory Costs," an amendment of Accounting Research Bulletin, which we refer to as "ARB," No. 43, Chapter 4, which discussed the general principles applicable to the pricing of inventory. SFAS No. 151 amends ARB No. 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs, and spoilage should be recognized as current-period charges. In addition, SFAS No. 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We do not expect the adoption of SFAS No. 151 to have a material effect on our consolidated financial statements. In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets," an amendment of Accounting Principles Board, which we refer to as "APB," Opinion No. 29. SFAS No. 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets and replaces it with an exception for exchanges that do not have commercial substance. A nonmonetary exchange has commercial substance if the entity's future cash flows are expected to significantly change as a result of the exchange. SFAS No. 153 will be effective for nonmonetary asset exchanges occurring in fiscal reporting periods beginning after June 15, 2005. We do not expect the adoption of SFAS No. 153 to have an immediate effect on our consolidated financial statements. In December 2004, the FASB issued a revised SFAS No. 123, which we refer to as "SFAS No. 123R," "Share-Based Payment." SFAS No. 123R requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. SFAS No. 123R establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all entities to apply a fair-value-based measurement method in accounting for share-based payment transactions with employees. In February 2003, our indirect parent company, International Specialty Products Inc., which we refer to as "ISP," completed a going private transaction. As a result, stock-based compensation plans were 31 terminated and payments were made in accordance with the terms of the merger agreement. In addition, we currently account for incentive units granted to our eligible employees pursuant to ISP's 2000 Long-Term Incentive Plan and 2003 Executive Long-Term Incentive Plan under the accounting prescribed by FASB Interpretation No., which we refer to as "FIN" 28, "Accounting for Stock Appreciation Rights and Other Variable Stock Option and Award Plans." FIN 28 requires an entity to measure compensation as the amount by which the Book Value (as defined in the plans) of the incentive units covered by the grant exceeds the option price or value specified of such incentive units between the date of grant and the measurement date, resulting in a change in the measure of compensation for the right or award. Since compensation expense related to such incentive units is currently included in our actual Consolidated Statements of Operations, we do not expect SFAS No. 123R to have an impact on our consolidated financial statements. In December 2004, the FASB issued FASB Staff Position, which we refer to as "FSP," Nos. FAS 109-1 and FAS 109-2, each as a result of the passage in October 2004 of the American Jobs Creation Act of 2004, which we refer to as the "Jobs Act." FSP No. FAS 109-1 relates to a provision in the Jobs Act that provides a tax deduction of up to 9 percent (when fully phased-in) on qualified production activities. The FASB indicated in FSP No. FAS 109-1 that this deduction should be accounted for as a special deduction in accordance with SFAS No. 109, "Accounting for Income Taxes," rather than as a tax rate reduction. This FSP is effective upon issuance. We do not expect the adoption of this FSP to have a material effect on our 2005 consolidated financial statements. FSP No. FAS 109-2 relates to a provision in the Jobs Act that introduces a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer, provided certain criteria are met. FSP No. FAS 109-2 was effective upon issuance. This FSP will not have an impact on our consolidated financial statements. In March 2005, the FASB issued FIN 47, "Accounting for Conditional Asset Retirement Obligations," an interpretation of SFAS No. 143, "Accounting for Asset Retirement Obligations." SFAS No. 143 states that an entity shall recognize the fair value of a liability for an asset retirement obligation ("ARO") in the period in which it is incurred if a reasonable estimate of fair value can be made. The term "conditional asset retirement obligation" refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. FIN 47 states that if an entity has sufficient information to reasonably estimate the fair value of an ARO, it must recognize a liability at the time the liability is incurred. An entity would have sufficient information to apply an expected present value and therefore an ARO would be reasonably estimable if either of the following conditions exist: (a) the settlement date and method of settlement for the ARO have been specified by others, such as by law, regulation or contract or (b) the information is available to reasonably estimate the settlement date or the range of potential settlement dates, the method of settlement, and the probabilities associated with the potential settlement dates and methods of settlements. FIN 47 will be effective for the Company as of December 31, 2005. We are currently reviewing our AROs to determine the potential impact of FIN 47 on our consolidated financial statements, and, at this time, we do not believe that FIN 47 will have a material impact on our consolidated financial statements. 32 In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections." SFAS No. 154 eliminates the requirement in APB Opinion No. 20, "Accounting Changes," to include the cumulative effect of changes in accounting principles in the Consolidated Statement of Operations in the period of change. Instead, SFAS No. 154 requires that changes in accounting principles be retrospectively applied, whereby the new accounting principle is applied to prior accounting periods as if that principle had always been used. SFAS No. 154 also redefines "restatement" as the revision of previously issued financial statements to reflect the correction of an error. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005, although early adoption is permitted for accounting changes and correction of errors made after the date SFAS No. 154 was issued. SFAS No. 154 does not change the transition provisions of any existing accounting pronouncements. * * * Forward-looking Statements This quarterly report on Form 10-Q contains both historical and forward-looking statements. All statements other than statements of historical fact are, or may be deemed to be, forward-looking statements within the meaning of section 27A of the Securities Act of 1933 and section 21E of the Securities Exchange Act of 1934. These forward-looking statements are only predictions and generally can be identified by use of statements that include phrases such as "believe", "expect", "anticipate", "intend", "plan", "foresee" or other words or phrases of similar import. Similarly, statements that describe our objectives, plans or goals also are forward-looking statements. Our operations are subject to certain risks and uncertainties that could cause actual results to differ materially from those contemplated by the relevant forward-looking statement. The forward-looking statements included herein are made only as of the date of this quarterly report on Form 10-Q and we undertake no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances. No assurances can be given that projected results or events will be achieved. 33 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Reference is made to Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended December 31, 2004, for a discussion of "Market-Sensitive Instruments and Risk Management." At December 31, 2004 and July 3, 2005, there were no equity-related financial instruments employed by us to reduce market risk. ITEM 4. CONTROLS AND PROCEDURES Disclosure Controls and Procedures: Our management, with the participation of the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this report. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer have each concluded that, as of the end of such period, our disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in the reports filed, furnished or submitted under the Exchange Act. Internal Control Over Financial Reporting: There were no significant changes in our internal control over financial reporting identified in management's evaluation during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 34 PART II OTHER INFORMATION ITEM 5. OTHER INFORMATION During the second quarter of 2005, the Company amended its management agreement (the "Management Agreement"), effective January 1, 2005, whereby the Company, through a subsidiary, provides certain general management services to Building Materials Corporation of America ("BMCA"), an affiliate, ISP, International Specialty Holdings Inc., the Company's parent company, ISP Investco LLC, and ISP Synthetic Elastomers LP. The purpose of the amendment was to adjust the management fees payable under the Management Agreement. The aggregate charges for providing such services are expected to be approximately $24.9 million during 2005. A breakout of charges to each party is set forth in the amendment to the Management Agreement, which is filed as Exhibit 10.1 to this report and incorporated by reference herein. In addition, during the second quarter of 2005, a subsidiary of the Company entered into a management services agreement with Heyman Properties, LLC and Heyman Investment Associates Limited Partnership (collectively, the "Heyman Entities"), effective as of January 1, 2005. The term of the agreement is from January 1, 2005, through December 31, 2005, and may be renewed for additional one-year terms. Under the agreement, the Company will provide certain general management services, and the Heyman Entities will provide certain advisory services. The Company will receive a net amount of approximately $0.3 million related to these services in 2005. A more detailed explanation of the charges is set forth in the management services agreement, which is filed as Exhibit 10.2 to this report and incorporated by reference herein. 35 ITEM 6. EXHIBITS Exhibits: Exhibit Number -------------- 10.1 Amendment No. 7 to the Amended and Restated Management Agreement dated as of January 1, 2005, by and among G-I Holdings Inc., Merick Inc., International Specialty Products Inc., International Specialty Holdings Inc., ISP Investco LLC, ISP Synthetic Elastomers LP, GAF Broadcasting Company, Inc., Building Materials Corporation of America and ISP Management Company, Inc., as assignee of ISP Chemco Inc. (incorporated by reference to Exhibit 10.1 to International Specialty Holdings Inc.'s Form 10-Q for the quarterly period ended July 3, 2005). 10.2 Management Services Agreement, dated as of January 1, 2005, by and among ISP Management Company, Inc., Heyman Properties, LLC, and Heyman Investment Associates Limited Partnership (incorporated by reference to Exhibit 10.2 to International Specialty Holdings Inc.'s Form 10-Q for the quarterly period ended July 3, 2005). 10.3 Form of International Specialty Products Inc. 2000 Long Term Incentive Plan Incentive Unit Grant Agreement (incorporated by reference to Exhibit 10.3 to International Specialty Holdings Inc.'s Form 10-Q for the quarterly period ended July 3, 2005). 10.4 Form of International Specialty Products Inc. 2003 Executive Long Term Incentive Plan Incentive Unit Grant Agreement (incorporated by reference to Exhibit 10.4 to International Specialty Holdings Inc.'s Form 10-Q for the quarterly period ended July 3, 2005). 31.1 Rule 13a-14(a)/Rule 15d-14(a) Certification of the Chief Executive Officer. 31.2 Rule 13a-14(a)/Rule 15d-14(a) Certification of the Chief Financial Officer. 32.1 Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350. 36 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, each registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. ISP CHEMCO INC. ISP CHEMICALS INC. ISP MINERALS INC. ISP TECHNOLOGIES INC. DATE: August 17, 2005 BY: /s/ Salvatore J. Guccione --------------- ------------------------- Salvatore J. Guccione Senior Vice President and Chief Financial Officer (Principal Financial Officer) DATE: August 17, 2005 BY: /s/Kenneth M. McHugh --------------- -------------------- Kenneth M. McHugh Vice President and Controller (Principal Accounting Officer) 37

ISP CHEMCO INC 10-Q