UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

FORM 10-K

 

 

 

OR

 

 

OM GROUP, INC.

(Exact name of Registrant as specified in its charter)

 

 

216-781-0083
Registrant’s telephone number, including area code

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

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

 

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

 

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 o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

 

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

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of Act).  Yes o     No x

 

The aggregate market value of Common Stock, par value $.01 per share, held by nonaffiliates (based upon the closing sale price on the NYSE) on June 29, 2007 was approximately $1,589.3 million.

 

As of January 31, 2008 there were 30,067,780 shares of Common Stock, par value $.01 per share, outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Company’s Proxy Statement for the 2008 Annual Meeting of Stockholders are incorporated by reference in Part III.

 

OM Group, Inc.

 

TABLE OF CONTENTS

 

 

General

OM Group, Inc. (the “Company”) is a diversified global developer, producer and marketer of value-added specialty chemicals and advanced materials that are essential to complex chemical and industrial processes. The Company believes it is the world’s largest refiner of cobalt and producer of cobalt-based specialty products, and the largest producer of electroless nickel plating chemistry for memory disk applications.

 

The Company is executing a deliberate and aggressive strategy to grow its value-added Specialties businesses through continued product innovation, as well as tactical and strategic acquisitions. The strategy is part of a transformational process to leverage the Company’s core strengths in developing and producing value-added specialty products for dynamic markets while reducing the impact of metal price volatility on financial results. The strategy is designed to allow the Company to deliver sustainable and profitable volume growth in order to drive consistent financial performance and enhance the Company’s ability to continue to build long-term shareholder value. During 2007, the Company completed three important transactions in connection with its long-term strategy:

 

 

The REM and Borchers acquisitions represent an important step in the Company’s effort to transform itself into a diversified, market-facing global provider of specialty chemicals and advanced materials. These events are discussed further in the “2007 Events” section below.

 

As a result of the acquisition of REM, beginning January 1, 2008, the Company reorganized its management structure and external reporting around two segments: Specialty Chemicals and Advanced Materials (as set forth at the end of the products description below). However, the Company operated only one business segment throughout 2007: Specialties. Since the acquisition of REM was completed on December 31, 2007, the Company’s results of operations for 2007 do not include the results of the REM businesses. Unless indicated otherwise, the discussion contained in Item 1 of this Form 10-K relates solely to the Company’s Specialties business and does not include REM.

 

The Specialties business produces products using unrefined cobalt and other metals including nickel, copper, zinc, manganese and calcium. The Company’s products are essential components in numerous complex chemical and industrial processes, and are used in many end markets, such as rechargeable batteries, coatings, custom catalysts, liquid detergents, lubricants and fuel additives, plastic stabilizers, polyester promoters, adhesion promoters for rubber tires, colorants, petroleum additives, magnetic media, metal finishing agents, cemented carbides for mining and machine tools, diamond tools used in construction, stainless steel, alloy and plating applications. The Company’s products are sold in various forms such as solutions, crystals, cathodes and powders.

 

The Company’s Specialties business is critically connected to both the price and availability of raw materials. The primary raw material used by the Company is unrefined cobalt. Cobalt raw materials include ore, concentrate, slag and scrap. The Company attempts to mitigate changes in availability by maintaining adequate inventory levels and long-term supply relationships with a variety of suppliers. The cost of the Company’s raw materials fluctuates due to actual or perceived changes in supply and demand of raw materials, changes in cobalt reference price and changes in availability from suppliers. Fluctuations in the prices of cobalt have been significant in the past and the Company believes that cobalt price fluctuations are likely to continue in the future. The Company attempts to pass increases in raw material prices through to its customers by increasing the prices of its products. The Company’s profitability is largely dependent on the Company’s ability to maintain the differential between its product prices and product costs. Certain sales contracts and raw material purchase contracts contain variable pricing that adjusts based on changes in the price of cobalt. During periods of rapidly changing metal prices, however, there may be price lags that

can impact the short-term profitability and cash flow from operations of the Company both positively and negatively. Reductions in the price of raw materials or declines in the selling prices of the Company’s finished goods could also result in the Company’s inventory carrying value being written down to a lower market value.

 

The Company has manufacturing and other facilities in North America, Europe, Africa and Asia-Pacific, and markets its products worldwide. Although most of the Company’s raw material purchases and product sales are based on the U.S. dollar, prices of certain raw materials, non-U.S. operating expenses and income taxes are denominated in local currencies. As such, the results of operations are subject to the variability that arises from exchange rate movements (particularly the Euro). In addition, fluctuations in exchange rates may affect product demand and profitability in U.S. dollars of products provided by the Company in foreign markets in cases where payments for its products are made in local currency. Accordingly, fluctuations in currency prices affect the Company’s operating results.

 

The Company has a 55% interest in a smelter joint venture (“GTL”) in the Democratic Republic of Congo (the “DRC”). The GTL smelter is a primary source for cobalt raw material feed. GTL is consolidated in the Company’s financial statements because the Company has a controlling interest in the joint venture.

 

2007 Events

REM Acquisition:  On December 31, 2007, the Company acquired the Electronic businesses of Rockwood Specialties Group, Inc., which consist of its Printed Circuit Board (“PCB”) business, its Ultra-Pure Chemicals (“UPC”) business, and its Compugraphics business. The businesses supply customers with chemicals used in the manufacture of semiconductors and printed circuit boards as well as photo-imaging masks primarily for semiconductor and photovoltaic manufacturers. REM employs approximately 700 people, has locations in the United States, the United Kingdom, France, Taiwan, Singapore and China and had combined sales of approximately $200 million in 2007.

 

Borchers Acquisition:  On October 1, 2007, the Company acquired Borchers GmbH, a European-based specialty coatings additive supplier, with locations in France and Germany. Borchers had sales in the first nine months of 2007 of approximately $42 million.

 

Sale of the Nickel business:  On March 1, 2007, the Company completed the sale of its Nickel business to Norilsk Nickel (“Norilsk”). The Nickel business consisted of the Harjavalta, Finland nickel refinery, the Cawse, Australia nickel mine and intermediate refining facility, a 20% equity interest in MPI Nickel Pty. Ltd. and an 11% ownership interest in Talvivaara Mining Company, Ltd. The Company received cash proceeds of $490.0 million, net of transaction costs, for the Nickel business, including a final purchase price adjustment primarily related to working capital for the net assets sold. In connection with the sale of the Nickel business, the Company entered into five-year supply agreements with Norilsk for cobalt and nickel raw materials, as described under “Raw Materials” below.

 

Redemption of Senior Subordinated Notes:  On March 7, 2007, the Company redeemed the entire $400.0 million of its outstanding 9.25% Senior Subordinated Notes due 2011 (the “Notes”) at a redemption price of 104.625% of the principal amount, or $418.5 million, plus accrued interest of $8.4 million.

 

Products

Specialties Business

 

The Company’s Specialties business develops, processes, manufactures and markets specialty chemicals, powders, metals and related products from various base metals feeds, primarily cobalt. The Company offers more than 1,300 Specialties products to customers in more than 40 industries, including aerospace, hard metal tools, appliance, rubber, automotive, ceramics, coatings and ink, catalysts, electronics, petrochemicals, magnetic media, rechargeable battery chemicals and other manufacturers who use specialty chemicals. Key technology-based end-use applications include affordable energy, portable power, clean air, clean water and proprietary products and services for the microelectronics industry. The Company’s Specialties products leverage the Company’s production capabilities and bring value to its customers through superior product performance. Typically, these products represent a small portion of the customer’s total cost of manufacturing or processing, but are critical to the customer’s product

performance. The products frequently are essential components in chemical and industrial processes where they facilitate a chemical or physical reaction and/or enhance the physical properties of end-products. The Company’s Specialties products are sold in various forms such as solutions, crystals, cathodes and powders.

 

The Specialties business includes products manufactured using cobalt and other metals such as copper, zinc, manganese and calcium. The Specialties business is made up of three business units that represent product line groupings around end markets: Advanced Organics, Inorganics and Electronic Chemicals. Advanced Organics offers products for the tire, coatings and inks, additives and chemical markets. Inorganics serves the battery, powder metallurgy, ceramics and chemicals markets. Electronic Chemicals develops products for the electronic packaging, memory disk, general metal finishing and printed circuit board finishing markets. The Specialties business also includes certain other operations, primarily the DRC smelter operations, which are not classified into one of these groupings.

 

The following table sets forth key applications for the Company’s products in the Specialties business:

 

 

In addition, Borchers, which is included in the Advanced Organics product line grouping, offers products to enhance the performance of coatings and ink systems from the production stage through customer end use. The Borchers business supplies customers with antiskinning agents/antioxidants, catalysts/accelerators, deaeration/antifoaming agents, specialties (moisture scavengers and adhesion promoters), driers, rheological additives, silicone additives, stabilizers and wetting and dispersing agents. These products improve processing options, free-flowing properties, consistency and gloss, control surface drying and drying-out properties, enhance rheology and dispersency, optimize resistance to the most diverse range of stresses and shape the environmental compatibility of contemporary surface hardening.

REM Businesses

 

The REM businesses supply customers with chemicals used in the manufacture of printed circuit boards and semiconductors as well as photo-imaging masks primarily for semiconductor and photovoltaic manufacturers. Key products of the REM businesses are described below.

 

Printed Circuit Boards:  The PCB business, operated as Electrochemicals, Inc., produces specialty and proprietary chemicals used in the manufacture of printed circuit boards widely used in computers, communications, military/aerospace, automotive, industrial and consumer electronics applications. The PCB business develops and manufactures chemicals for the printed circuit board industry, such as oxide treatments, electroplating additives, etching technology, electroless copper processes, Co-Bra Bond^®, the newer oxide replacement technology and a proprietary direct metallization process known as Shadow^®.

 

Ultra-Pure Chemicals:  The UPC business develops and manufactures a wide range of ultra-pure chemicals used in the manufacture of electronic and computer components such as semiconductors, silicon chips, wafers, and liquid crystal displays. These products include chemicals used to remove controlled portions of silicon and metal, cleaning solutions, photoresist strippers, which control the application of certain light-sensitive chemicals, edge bead removers, which aid in the uniform application of other chemicals, and solvents. The UPC business also develops and manufactures a broad range of chemicals used in the manufacture of photomasks and provides a range of analytical, logistical and development support services to the semiconductor industry. These include total chemicals management, primarily offered in Singapore, under which the Company manages the clients’ entire electronic process chemicals operations including providing logistics services, development of application-specific chemicals, analysis and control of customers’ chemical distribution systems and quality audit and control of all inbound chemicals, including third party products.

 

Photomasks:  The Photomasks business manufactures photo-imaging masks (high-purity quartz or glass plates containing precision, microscopic images of integrated circuits) and reticles for the semiconductor, optoelectronics and microelectronics industries under the Compugraphics brand name. Photomasks are a key enabling technology to the semiconductor and integrated circuit industries, and perform a function similar to that of a negative in conventional photography.

 

Financial information, including reportable segment and geographic data, is contained in Note 18 to the consolidated financial statements contained in Item 8 of this Annual Report.

 

2008 Business Segments:  As a result of the acquisition of REM, beginning January 1, 2008, the Company reorganized its management structure and external reporting around two reportable segments: Specialty Chemicals and Advanced Materials.

 

The Specialty Chemicals segment will consist of the Electronic Chemicals, Ultra Pure Chemicals, Photomasks and Advanced Organic product line groupings. The Electronic Chemicals product line grouping will include the PCB business.

 

The Advanced Materials segment will consist of the Inorganics product line grouping and the DRC smelter operations.

 

Competition

The Company encounters a variety of competitors in each of its product lines, but no single company competes with the Company across all of its existing product lines. For 2007, the Company believes that it was the largest refiner of cobalt and producer of cobalt-based specialty products and the largest producer of electroless nickel plating chemistry for memory disk applications in the world. Competition in these markets is based primarily on product quality, supply reliability, price, service and technical support capabilities. The markets in which the Company participates have historically been competitive and this environment is expected to continue.

Customers

The Company’s Specialties business serves approximately 1,800 customers, excluding REM customers. During 2007, approximately 48% of the Company’s net sales were in Asia, 31% in Europe and 21% in the Americas. Sales to Nichia Chemical Corporation represented approximately 23%, 19% and 19% of net sales in 2007, 2006 and 2005, respectively. Sales to Luvata Pori Oy were approximately 11% of net sales in 2006. Sales to the Company’s top five customers represented approximately 40% of net sales in 2007. The loss of one or more of these customers could have a material adverse effect on the Company’s business, results of operations or financial position.

 

While customer demand for the Company’s Specialties products is generally non-seasonal, supply/demand and price perception dynamics of key raw materials do periodically cause customers to either accelerate or delay purchases of the Company’s products, generating short-term results that may not be indicative of longer-term trends. Historically, revenues during July and August have been lower than other months due to the summer holiday season in Europe. Furthermore, the Company uses the summer season to perform its annual maintenance shut-down at its refinery in Finland.

 

Raw Materials

The primary raw material used by the Specialties business in manufacturing its products is unrefined cobalt. Cobalt raw materials include ore, concentrates, slag and scrap. The cost of the Company’s raw materials fluctuates due to actual or perceived changes in supply and demand of raw materials, changes in the cobalt reference price and changes in availability from suppliers. The Company attempts to mitigate increases in raw material prices by passing through such increases to its customers in the prices of its products and by entering into sales contracts that contain variable pricing that adjusts based on changes in the price of cobalt.

 

A significant portion of the Company’s supply of cobalt historically has been sourced from the DRC, Australia and Finland. Upon closing the transaction to sell the Company’s Nickel business to Norilsk in the first quarter of 2007, the Company entered into five-year supply agreements with Norilsk for up to 2,500 metric tons per year of cobalt metal, up to 2,500 metric tons per year of crude in the form of cobalt hydroxide concentrate, up to 1,500 metric tons per year of cobalt in the form of crude cobalt sulfate, up to 5,000 metric tons per year of copper in the form of copper cake and various other nickel-based raw materials used in the Company’s Electronic Chemicals business. In addition, the Company entered into two-year agency and distribution agreements for nickel salts. The Norilsk agreements strengthen the Company’s supply chain and secure a consistent source of raw materials for its Specialties business. These agreements provide the Company with a stable supply of cobalt metal through the long-term supply agreements. Complementary geography and operations shorten the supply chain and allow the Company to leverage its cobalt-based refining and chemicals expertise with Norilsk’s cobalt mining and processing capabilities. The Company’s Specialties business will continue to sell Nickel-based specialty products to end markets in the electronic chemicals industry.

 

Production problems and political and civil instability in supplier countries, as well as increased demand in developing countries, have affected and may continue to affect the supply and market price of raw materials. During 2007, the reference price of low grade (formerly 99.3%) cobalt listed in the trade publication, Metal Bulletin, continued the increase which began in 2006, increasing from an average of $25.82 per pound in the first quarter of 2007 to an average of $32.68 per pound in the fourth quarter of 2007.

A graph of the end of the month reference price of low grade (formerly 99.3%) cobalt (as published in Metal Bulletin magazine) per pound for 2002 through 2007 is as follows:

 

 

GTL shut down its smelter as scheduled during January of 2005 for approximately four months for maintenance and production improvements. The smelter was re-opened in May of 2005. The Company expects the next maintenance shut-down will occur in late 2008 or early 2009.

 

Research and Development

The Company’s research and new product development program is an integral part of its business. Research and development focuses on adapting proprietary technologies to develop new products and working with customers to meet their specific requirements, including joint development arrangements with customers that involve innovative products. New products include new chemical formulations, metal-containing compounds, and concentrations of various components and product forms. Research and development expenses for the Company’s Specialties business were approximately $8.2 million in 2007, $8.1 million for 2006 and $8.3 million for 2005.

 

The Company’s research staff conducts research and development in laboratories located in Westlake, Ohio; South Plainfield, New Jersey; Kuching, Malaysia; Manchester, England; Singapore; Lagenfeld, Germany and Kokkola, Finland. REM has research facilities in Riddings, England; Glenrothes, England; Chung Li, Taiwan; Los Gatos, California and Saint Fromond, France.

 

During 2007, the Company invested $2.0 million in Quantumsphere, Inc. (“QSI”) through the purchase of 615,385 shares of common stock and warrants to purchase an additional 307,692 shares of common stock. The Company and QSI have agreed to co-develop new, proprietary applications for the high-growth, high-margin clean-energy and portable power sectors. In addition, the Company will supply QSI with raw materials and has the right to market and distribute certain QSI products.

 

Patents and Trademarks

The Company holds patents registered in the United States and foreign countries relating to the manufacturing, processing and use of metal-organic and metal-based compounds. Specifically, the majority of these patents cover proprietary technology for base metal refining, metal and metal oxide powders, catalysts, metal-organic compounds and inorganic salts. The Company does not consider any single patent or group of patents to be material to its business as a whole.

 

Environmental Matters

The Company is subject to a wide variety of environmental laws and regulations in the United States and in foreign countries as a result of its operations and use of certain substances that are, or have been, used, produced or discharged by its plants. In addition, soil and/or groundwater contamination presently exists and may in the future be discovered at levels that require remediation under environmental laws at properties now or previously owned,

operated or used by the Company. At December 31, 2007 and 2006, the Company had environmental reserves of $4.9 million and $8.0 million, respectively.

 

Ongoing environmental compliance costs, which are expensed as incurred, were approximately $8.0 million in 2007 and $7.1 million in 2006 and included costs relating to waste water analysis, treatment, and disposal; hazardous and non-hazardous solid waste analysis and disposal; air emissions control; groundwater monitoring and related staff costs. The Company anticipates that it will continue to incur compliance costs at moderately increasing levels for the foreseeable future as environmental laws and regulations are becoming increasingly stringent.

 

The Company’s Specialties business also incurred capital expenditures of approximately $1.9 million and $0.8 million in 2007 and 2006, respectively, in connection with ongoing environmental compliance. The Company anticipates that capital expenditure levels for these purposes will increase to approximately $6.0 million in 2008, as it continues to modify certain processes that may have an environmental impact and undertakes new pollution prevention and waste reduction projects, including relating to the REM businesses.

 

The European Union’s Registration, Evaluation and Authorization of Chemicals (“REACH”) legislation establishes a new system to register and evaluate chemicals manufactured in, or imported to, the European Union and will require additional testing, documentation and risk assessments for the chemical industry. Due to the ongoing development and understanding of facts and remedial options and due to the possibility of unanticipated regulatory developments, the amount and timing of future environmental expenditures could vary significantly. Although it is difficult to quantify the potential impact of compliance with or liability under environmental protection laws, based on presently available information, the Company believes that its ultimate aggregate cost of environmental remediation as well as liability under environmental protection laws will not result in a material adverse effect upon its financial condition or results of operations.

 

Employees

At December 31, 2007, the Company had 2,096 full-time employees, of which 372 were located in North America, 808 in Europe, 392 in Africa and 524 in Asia-Pacific, including 719 REM employees. Employees at the Company’s production facilities in Franklin, Pennsylvania and Kuching, Malaysia are non-unionized. Employees at the Company’s facility in Kokkola, Finland are members of several national workers’ unions under various union agreements. Generally, these union agreements have two-year terms. Employees at the Company’s facility in Manchester, England are members of various trade unions under a recognition agreement. This recognition agreement has an indefinite term. Employees at the Belleville, Canada facility are members of the Communications, Energy and Paperworkers Union of Canada. The current Belleville union agreement was entered into in February 2008 and has a term extending until December 31, 2008. Employees in the DRC are members of various trade unions. The union agreements have a term of three years expiring in April 2008. The Company expects to enter into new agreements covering those employees upon expiration of the current agreements. Some REM and Borchers international employees are represented by either a labor union or a statutory work council arrangement. The Company believes that relations with its employees are good.

 

SEC Reports

The Company makes available free of charge through its website (www.omgi.com) its reports on Forms 10-K, 10-Q and 8-K as soon as reasonably practicable after the reports are electronically filed with the Securities and Exchange Commission. A copy of any of these documents is available in print free of charge to any stockholder who requests a copy, by writing to OM Group, Inc., 127 Public Square, 1500 Key Tower, Cleveland, Ohio 44114-1221 USA, Attention: Troy Dewar, Director of Investor Relations.

 

Our business faces significant risks. These risks include those described below and may include additional risks and uncertainties not presently known to us or that we currently deem immaterial. Our business, financial condition and results of operations could be materially adversely affected by any of these risks. These risks should be read in conjunction with the other information in this report.

EXTENDED BUSINESS INTERRUPTION AT OUR FACILITIES COULD HAVE AN ADVERSE IMPACT ON OPERATING RESULTS.

Our results of operations are dependent in large part upon our ability to produce and deliver products promptly upon receipt of orders and to provide prompt and efficient service to our customers. Any disruption of our day-to-day operations could have a material adverse effect on our business, customer relations and profitability. Our Kokkola, Finland facility is the primary refining and production facility for our products. The GTL smelter in the DRC is the primary source for our cobalt raw material feed. Our Cleveland, Ohio facility serves as our corporate headquarters. These facilities are critical to our business, and a fire, flood, earthquake or other disaster or condition that damaged or destroyed any of these facilities could disable them. Any such damage to, or other condition interfering with the operation of these facilities would have a material adverse effect on our business, financial position and results of operations. Our insurance coverage may not be adequate to fully cover the potential risks described above. In addition, our insurance coverage may become more restrictive and/or increasingly costly, and there can be no assurance that we will be able to maintain insurance coverage in the future at an acceptable cost or at all.

 

WE ARE AT RISK FROM UNCERTAINTIES IN THE SUPPLY OF UNREFINED COBALT, WHICH IS OUR PRIMARY RAW MATERIAL.

There are a limited number of supply sources for unrefined cobalt. Production problems or political or civil instability in supplier countries, primarily the DRC, Australia, Finland and Russia, may affect the supply and market price of unrefined cobalt.

 

In particular, political and civil instability and unexpected adverse changes in laws or regulatory requirements, including with respect to export duties and quotas, may affect the availability of raw materials from the DRC. If a substantial interruption should occur in the supply of unrefined cobalt from the DRC or elsewhere, we may not be able to obtain as much unrefined cobalt from other sources as would be necessary to satisfy our requirements at prices comparable to our current arrangements and our operating results could be adversely impacted.

 

OUR SUBSTANTIAL INTERNATIONAL OPERATIONS SUBJECT US TO RISKS, WHICH MAY INCLUDE UNFAVORABLE SOCIAL, LEGAL, POLITICAL, REGULATORY AND ECONOMIC CONDITIONS IN OTHER COUNTRIES.

Our business is subject to risks related to the differing legal and regulatory requirements and the social, political and economic conditions of many jurisdictions. In addition to risks associated with fluctuations in foreign exchange rates, risks inherent in international operations include the following:

 

 

Our overall success as a global business depends, in part, upon our ability to succeed in differing legal, regulatory, economic, social and political conditions. We cannot assure you that we will implement policies and strategies that will be effective in each location where we do business. Furthermore, we cannot be sure that any of the foregoing factors will not have a material adverse effect on our business, financial condition or results of operations.

WE ARE AT RISK FROM FLUCTUATIONS IN THE PRICE OF UNREFINED COBALT AND OTHER RAW MATERIALS.

Unrefined cobalt is the principal raw material we use in manufacturing base metal chemistry products, and the cost of cobalt fluctuates due to actual or perceived changes in supply and demand, changes in the reference price and changes in availability from suppliers. Fluctuations in the prices of cobalt have been significant in the past and we believe price fluctuations are likely to occur in the future. Our ability to pass increases in raw material prices through to our customers by increasing the prices of our products is an important factor in our business. The extent of our profitability depends, in part, on our ability to maintain the differential between our product prices and raw material prices, and we cannot guarantee that we will be able to maintain an appropriate differential at all times.

 

We may be required under U.S. GAAP accounting rules to write down the carrying value of our inventory when cobalt and other raw material prices decrease. In periods of raw material metal price declines or declines in the selling price of our finished products, inventory carrying values could exceed the amount we could realize on sale, resulting in a charge against inventory that could adversely affect our operating results.

 

WE MAY EXPERIENCE DIFFICULTIES INTEGRATING REM AND BORCHERS.

The integration of the operations of REM and Borchers involves consolidating products, operations and administrative functions. Achieving the anticipated benefits of the acquisitions will depend in part upon our ability to integrate the businesses in an efficient and effective manner. The integration of the businesses faces significant challenges, and we may be unable to accomplish the integration successfully.

 

In particular, the need to coordinate geographically dispersed organizations, the addition of lines of business in which we have not historically engaged and possible differences in corporate cultures and management philosophies may increase the difficulties of the integration. Additionally, we may incur substantial expense in our efforts to integrate general and administrative services and the key information processing systems of REM and Borchers into our pre-existing services and systems, and these efforts may not prove successful. The integration may take longer than planned and may be subject to unanticipated difficulties and expenses. The integration of these acquisitions will require the dedication of significant management resources and may temporarily divert management’s attention from operational matters. Employee uncertainty and lack of focus during the integration process may also disrupt our businesses. We may lose key personnel from the acquired organizations and employees in the acquired organizations may be resistant to change and may not adapt well to our corporate structure. The process of integrating operations could cause an interruption of, or loss of momentum in, the activities of one or more of our businesses.

 

Any inability of management to successfully integrate the operations of REM and Borchers with our other businesses could result in our not achieving the projected profitability and efficiencies of these transactions and could adversely affect our results of operations and financial condition.

 

In addition, there may be liabilities of the acquired companies that we failed to or were unable to discover during the due diligence investigation and for which we, as a successor owner, may be responsible. Indemnities and warranties obtained from the sellers may not fully cover the liabilities due to limitations in scope, amount or duration, financial limitations of the indemnitor or warrantor or other reasons.

 

WE ARE UNDERGOING A STRATEGIC TRANSFORMATION.

As a result of changes to our strategic direction, we are currently in a transformational period in which we have made and may continue to make changes that could be material to our business, financial condition and results of operations. These changes have included the sale of our Nickel business and the REM and Borchers acquisitions. It is impossible to predict what additional changes will occur and the impact they will have on our future results of operations.

WE INTEND TO CONTINUE TO SEEK ADDITIONAL ACQUISITIONS, WHICH COULD DIVERT MANAGEMENT’S ATTENTION, RESULT IN DIFFICULTIES INTEGRATING THE ACQUIRED OPERATIONS AND EXPOSE US TO UNANTICIPATED COSTS AND LIABILITIES.

Our strategy anticipates growth through future acquisitions. However, our ability to identify and consummate any future acquisitions on terms that are favorable to us may be limited by the number of attractive acquisition targets, internal demands on our resources and our ability to obtain financing. Our success in integrating newly acquired businesses will depend upon our ability to retain key personnel, avoid diversion of management’s attention from operational matters, and integrate general and administrative services and key information processing systems. In addition, future acquisitions could result in the incurrence of additional debt, costs and contingent liabilities. Integration of acquired operations may take longer, or be more costly or disruptive to our business, than originally anticipated. It is also possible that expected synergies from future acquisitions may not materialize. We may also incur costs and divert management attention with regard to potential acquisitions that are never consummated.

 

There may be liabilities of the acquired companies that we fail to or are unable to discover during the due diligence investigation and for which we, as a successor owner, may be responsible. Indemnities and warranties obtained from the seller may not fully cover the liabilities due to limitations in scope, amount or duration, financial limitations of the indemnitor or warrantor or other reasons.

 

THE RAPID INCREASE IN COBALT PRICES MAY CAUSE OUR CUSTOMERS TO LOOK FOR ALTERNATIVES TO COBALT IN THEIR PRODUCTS.

The average reference price for cobalt increased from an average of $12.43 per pound in the first quarter of 2006 to an average of $32.68 in the fourth quarter of 2007. If prices for cobalt are sustained at this level or continue to increase, new markets and application opportunities for cobalt may diminish as the use of cobalt becomes too costly for some manufacturers. In addition, manufacturers that currently use cobalt for their products may look for less expensive alternatives for cobalt in existing products and applications. If these events were to occur, our sales and operating results could decrease substantially, resulting in decreased profitability.

 

WE ARE EXPOSED TO FLUCTUATIONS IN FOREIGN EXCHANGE RATES, WHICH MAY ADVERSELY AFFECT OUR OPERATING RESULTS.

We have manufacturing and other facilities in North America, Europe, Asia-Pacific and Africa, and we market our products worldwide. Although most of our raw material purchases and product sales are transacted in U.S. dollars, liabilities for non-U.S. operating expenses and income taxes are denominated in local currencies. In addition, fluctuations in exchange rates may affect product demand and may adversely affect the profitability in U.S. dollars of products provided by us in foreign markets where payment for our products is made in the local currency. Accordingly, fluctuations in currency rates (particularly the Euro) may affect our operating results.

 

WE ARE SUBJECT TO STRINGENT ENVIRONMENTAL REGULATION AND MAY INCUR UNANTICIPATED COSTS OR LIABILITIES ARISING OUT OF ENVIRONMENTAL MATTERS.

We are subject to stringent laws and regulations relating to the storage, handling, disposal, emission and discharge of materials into the environment, and we have expended, and may be required to expend in the future, substantial funds for compliance with such laws and regulations. In addition, we may from time to time be subjected to claims for personal injury, property damages or natural resource damages made by third parties or regulators. Our annual environmental compliance costs were $8.0 million in 2007. In addition, we made capital expenditures of approximately $1.9 million in 2007 in connection with environmental compliance.

 

As of December 31, 2007, we had reserves of $4.9 million for environmental liabilities. However, given the many uncertainties involved in assessing liability for environmental claims, our current reserves may prove to be insufficient. We continually evaluate the adequacy of our reserves and adjust reserves when determined to be appropriate. In addition, our current reserves are based only on known sites and the known contamination on those sites. It is possible that additional remediation sites will be identified in the future or that unknown contamination at previously identified sites will be discovered. This could require us to make additional expenditures for environmental remediation or could result in exposure to claims in the future.

CHANGES IN ENVIRONMENTAL, HEALTH AND SAFETY REGULATORY REQUIREMENTS COULD AFFECT SALES OF THE COMPANY’S PRODUCTS.

New or revised governmental regulations relating to health, safety and the environment may affect demand for our products. The European Union’s REACH legislation, for example, could affect our ability to sell certain products. REACH establishes a new system to register and evaluate chemicals manufactured in, or imported to, the European Union and requires additional testing, documentation and risk assessments for the chemical industry. Such new or revised regulations may result in heightened concerns about the chemicals involved and in additional requirements being placed on the production, handling, or labeling of the chemicals and may increase the cost of producing them and/or limit the use of such chemicals or products containing such chemicals, which could lead to a decrease in demand. The regulations likely will require us to incur significant additional compliance costs.

 

IMPLEMENTATION OF AN ENTERPRISE RESOURCE PLANNING (“ERP”) PROJECT HAS THE POTENTIAL FOR BUSINESS INTERRUPTION AND ASSOCIATED ADVERSE IMPACT ON OPERATING RESULTS.

We have initiated a multi-year ERP project that is expected to be implemented worldwide to achieve increased efficiency and effectiveness in supply chain, financial processes and management reporting. During 2007, we began the implementation at several locations. We will continue to implement the ERP system in a phased approach through 2009. The implementation of the ERP system has the potential to disrupt our business by delaying the processing of key business transactions. In addition, the implementation of the ERP system may take longer than anticipated or be more costly than originally estimated.

 

WE MAY NOT BE ABLE TO RESPOND EFFECTIVELY TO TECHNOLOGICAL CHANGES IN OUR INDUSTRY OR IN OUR CUSTOMERS’ PRODUCTS.

Our future business success will depend in part upon our ability to maintain and enhance our technological capabilities, develop and market products and applications that meet changing customer needs and successfully anticipate or respond to technological changes on a cost-effective and timely basis. Our inability to anticipate, respond to or utilize changing technologies could have an adverse effect on our business, financial condition or results of operations. Moreover, technological and other changes in our customers’ products or processes may render some of our specialty chemicals unnecessary, which would reduce the demand for those chemicals.

 

BECAUSE WE DEPEND ON SEVERAL LARGE CUSTOMERS FOR A SIGNIFICANT PORTION OF OUR REVENUES, OUR OPERATING RESULTS COULD BE ADVERSELY AFFECTED BY ANY DISRUPTION OF OUR RELATIONSHIP WITH THESE CUSTOMERS OR ANY MATERIAL ADVERSE CHANGE IN THEIR BUSINESSES.

We depend on several large customers for a significant portion of our business. In 2007, the top five customers accounted for 40% of net sales. Sales to Nichia Chemical Corporation represented approximately 23% of net sales in 2007. Any disruption in our relationships with our major customers, including any adverse modification of our agreements with them or the unwillingness or inability of them to perform their obligations under the agreements, would adversely affect our operating results. In addition, any material adverse change in the financial condition of any of our major customers would have similar adverse effects.

 

WE OPERATE IN VERY COMPETITIVE INDUSTRIES.

We have many competitors. Some of our principal competitors have greater financial and other resources and greater brand recognition than we have. Accordingly, these competitors may be better able to withstand changes in conditions within the industries in which we operate and may have significantly greater operating and financial flexibility than we do. As a result of the competitive environment in the markets in which we operate, we currently face and will continue to face pressure on the sales prices of our products from competitors and large customers. With these pricing pressures, we may experience future reductions in the profit margins on our sales, or may be unable to pass on future raw material price or operating cost increases to our customers, which also would reduce profit margins. In addition, we may encounter increased competition in the future, which could have a material

adverse effect on our business. Since we conduct our business mainly on a purchase order basis, with few long-term commitments from our customers, this competitive environment could give rise to a sudden loss of business.

 

INDUSTRY CONSOLIDATION MAY LEAD TO INCREASED COMPETITION AND MAY HARM OUR OPERATING RESULTS.

There has been a trend toward industry consolidation in our markets. We believe that industry consolidation may result in stronger competitors with greater financial and other resources that are better able to compete for customers. This could lead to more variability in operating results and could have a material adverse effect on our business, operating results, and financial condition.

 

FAILURE TO RETAIN AND RECRUIT KEY PERSONNEL WOULD HARM OUR ABILITY TO MEET KEY OBJECTIVES.

Our key personnel are critical to the management and direction of our businesses. Our future success depends, in large part, on our ability to retain key personnel and other capable management personnel. It is particularly important that we maintain our senior management group that is responsible for implementing our strategic transformation. If we were not able to attract and retain talented personnel and replace key personnel should the need arise, the inability could make it difficult to meet key objectives and disrupt the operations of our businesses.

 

CHANGES IN EFFECTIVE TAX RATES OR ADVERSE OUTCOMES RESULTING FROM EXAMINATION OF OUR INCOME TAX RETURNS COULD ADVERSELY AFFECT OUR RESULTS.

Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates, higher than anticipated in countries where we have higher statutory rates, or if we incur losses for which no corresponding tax benefit can be realized, by changes in the valuation of our deferred tax assets and liabilities, or by changes in tax laws, regulations, accounting principles or interpretations thereof. In addition, we are subject to examination of our income tax returns by the Internal Revenue Service and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. There can be no assurance that the outcomes from these examinations will not have an adverse effect on our operating results and financial condition.

 

INADEQUATELY PROTECTING OUR INTELLECTUAL PROPERTY RIGHTS MAY ALLOW OTHER COMPANIES TO COMPETE DIRECTLY AGAINST US, OR WE MIGHT BE FORCED TO DISCONTINUE SELLING CERTAIN PRODUCTS.

We rely on U.S. and foreign patents and trade secrets to protect our intellectual property. We attempt to protect and restrict access to our trade secrets and proprietary information, but it may be possible for a third party to obtain our information and develop similar technologies.

 

If a competitor infringes upon our patent or other intellectual property rights, enforcing those rights could be difficult, expensive and time-consuming, making the outcome uncertain. Even if we are successful, litigation to enforce our intellectual property rights or to defend our patents against challenge could be costly and could divert management’s attention.

 

OUR STOCK PRICE MAY CONTINUE TO BE VOLATILE.

Historically, our common stock has experienced substantial price volatility, particularly as a result of changes in metal prices, primarily unrefined cobalt, which is our primary raw material. In addition, the stock market has experienced and continues to experience significant price and volume volatility that has affected the market price of equity securities of many companies. This volatility has often been unrelated to the operating performance of those companies. These broad market fluctuations may adversely affect the market price of our common stock.

The Company has received no written comments regarding its periodic or current reports from the staff of the Securities and Exchange Commission that were issued 180 days or more preceding the end of its 2007 fiscal year and that remain unresolved.

 

The Company believes that its plants and facilities, which are of varying ages and of different construction types, have been satisfactorily maintained, are suitable for the Company’s operations and generally provide sufficient capacity to meet the Company’s production requirements. The depreciation lives of fixed assets do not exceed the lives of the leases.

 

The Company’s Kokkola, Finland production facility is situated on property owned by Boliden Kokkola Oy. The Company and Boliden Kokkola Oy share certain physical facilities, services and utilities under agreements with varying expiration dates.

 

Information regarding the Company’s primary offices, research and product development, and manufacturing and refining facilities, is set forth below:

 

 

 

The Company is a party to various legal and administrative proceedings incidental to its business. In the opinion of the Company, disposition of all suits and claims related to its ordinary course of business should not in the aggregate have a material adverse effect on the Company’s financial position or results of operations.

 

No matters were submitted to a vote of security holders during the fourth quarter of the Company’s 2007 fiscal year.

 

Executive Officers of the Registrant

The information under this item is being furnished pursuant to General Instruction G of Form 10-K.

 

There is set forth below the name, age, positions and offices held by each of the Company’s executive officers, as well as their business experience during the past five years. Years indicate the year the individual was named to the indicated position.

 

Joseph M. Scaminace — 54

 

 

Kenneth Haber — 57

 

 

Valerie Gentile Sachs — 52

 

 

Stephen D. Dunmead — 44

 

 

Gregory J. Griffith — 52

 

 

The Company’s common stock is traded on the New York Stock Exchange under the symbol “OMG”. As of December 31, 2007, the approximate number of record holders of the Company’s common stock was 1,417.

 

The high and low market prices for the Company’s common stock for each quarter during the past two years are presented in the table below:

 

 

 

 

Results for 2007 include a pretax and after-tax gain on the sale of the Nickel business of $77.0 million and $72.3 million, respectively. In addition, 2007 results also include a $21.7 million charge ($14.1 million after tax) related to the redemption of the Notes and income tax expense of $45.7 million related to repatriation of cash from overseas primarily as a result of the redemption of the Notes in March 2007.

 

Results for 2006 include a $12.2 million pre tax gain related to the common shares of Weda Bay Minerals, Inc. The net book value of the investment was zero due to a permanent impairment charge recorded in prior years. Results for 2006 also include a $3.2 million pre tax charge for the settlement of litigation related to the former chief executive officer’s termination. Income tax expense for 2006 includes $14.1 million to provide additional U.S. income taxes on $384.1 million of undistributed earnings of consolidated foreign subsidiaries in connection with the Company’s planned redemption of the Notes in March 2007.

 

Results for 2005 include $27.5 million of pre tax income related to the receipt of net insurance proceeds related to shareholder class action and derivative lawsuits, and $4.6 million of pre tax income related to the mark-to-market of 380,000 shares of common stock issued in connection with the shareholder derivative litigation, both partially offset by an $8.9 million charge related to the former chief executive officer’s termination.

 

Results for 2004 include a charge of $7.5 million for the shareholder derivative lawsuits.

 

Results for 2003 include the sale of the Company’s Precious Metals Group (PMG) for cash proceeds of approximately $814 million, which resulted in a gain on sale of $145.9 million ($131.7 million after tax). Results for PMG are included in discontinued operations. In 2003, cost of products sold includes restructuring charges of $5.8 million. Selling, general and administrative expenses include restructuring charges of $14.2 million and a charge of $84.5 million related to the shareholder class action and derivative lawsuits. In addition, discontinued operations include $5.6 million of restructuring charges.

 

Management’s discussion and analysis of financial condition and results of operations should be read in conjunction with the consolidated financial statements and the notes thereto appearing elsewhere in this Annual Report.

 

Overview

The Company is a diversified global developer, producer and marketer of value-added specialty chemicals and advanced materials that are essential to complex chemical and industrial processes. The Company believes it is the world’s largest refiner of cobalt and producer of cobalt-based specialty products and the largest producer of electroless nickel plating chemistry for memory disk applications.

 

The Company is executing a deliberate and aggressive growth strategy to grow its value-added Specialties businesses through continued product innovation, as well as tactical and strategic acquisitions. The strategy is part of a transformational process to leverage the Company’s core strengths in developing and producing value-added specialty products for dynamic markets while reducing the impact of metal price volatility on financial results. The strategy is designed to allow the Company to deliver sustainable and profitable volume growth in order to drive consistent financial performance and enhance the Company’s ability to continue to build long-term shareholder value. During 2007, the Company completed three important transactions in connection with this long-term strategy:

 

 

The REM and Borchers acquisitions represent an important step in the Company’s effort to transform itself into a diversified, market-facing global provider of specialty chemicals and advanced materials. These events are discussed further under “2007 Events” below.

As a result of the acquisition of REM, beginning January 1, 2008, the Company reorganized its management structure and external reporting around two reportable segments: Specialty Chemicals and Advanced Materials. However, the Company operated only one business segment throughout 2007: Specialties. Since the REM acquisition was completed on December 31, 2007, the Company’s results of operations for 2007 do not include the results of the REM businesses. The assets and liabilities of REM are included in the Company’s consolidated balance sheet at December 31, 2007. Unless indicated otherwise, this Management’s Discussion and Analysis of Financial Condition and Results of Operations relates solely to the Company’s Specialties business and does not include REM.

 

The Specialties business produces products using unrefined cobalt and other metals including nickel, copper, zinc, manganese and calcium. The Company’s products are essential components in numerous complex chemical and industrial processes, and are used in many end markets, such as rechargeable batteries, coatings, custom catalysts, liquid detergents, lubricants and fuel additives, plastic stabilizers, polyester promoters, adhesion promoters for rubber tires, colorants, petroleum additives, magnetic media, metal finishing agents, cemented carbides for mining and machine tools, diamond tools used in construction, stainless steel, alloy and plating applications. The Company’s products are sold in various forms such as solutions, crystals, cathodes and powders.

 

The Company’s Specialties business is critically connected to both the price and availability of raw materials. The primary raw material used by the Company is unrefined cobalt. Cobalt raw materials include ore, concentrate, slag and scrap. The Company attempts to mitigate changes in availability by maintaining adequate inventory levels and long-term supply relationships with a variety of suppliers. The cost of the Company’s raw materials fluctuates due to actual or perceived changes in supply and demand of raw materials, changes in cobalt reference price and changes in availability from suppliers. Fluctuations in the prices of cobalt have been significant in the past and the Company believes that cobalt price fluctuations are likely to continue in the future. The Company attempts to pass through to its customer’s increases in raw material prices by increasing the prices of its products. The Company’s profitability is largely dependent on the Company’s ability to maintain the differential between its product prices and product costs. Certain sales contracts and raw material purchase contracts contain variable pricing that adjusts based on changes in the price of cobalt. During periods of rapidly changing metal prices, however, there may be price lags that can impact the short-term profitability and cash flow from operations of the Company both positively and negatively. Reductions in the price of raw materials or declines in the selling prices of the Company’s finished goods could also result in the Company’s inventory carrying value being written down to a lower market value.

 

The Company has manufacturing and other facilities in North America, Europe, Africa and Asia-Pacific, and markets its products worldwide. Although most of the Company’s raw material purchases and product sales are based on the U.S. dollar, prices of certain raw materials, non-U.S. operating expenses and income taxes are denominated in local currencies. As such, the results of operations are subject to the variability that arises from exchange rate movements (particularly the Euro). In addition, fluctuations in exchange rates may affect product demand and profitability in U.S. dollars of products provided by the Company in foreign markets in cases where payments for its products are made in local currency. Accordingly, fluctuations in currency prices affect the Company’s operating results.

 

2007 Events

REM Acquisition:  On December 31, 2007, the Company acquired the Electronics businesses of Rockwood Specialties Group, Inc., which consist of its PCB business, its UPC business, and its Compugraphics business. The businesses supply customers with chemicals used in the manufacture of semiconductors and printed circuit boards as well as photo-imaging masks primarily for semiconductor and photovoltaic manufacturers. REM employs approximately 700 people, has locations in the United States, the United Kingdom, France, Taiwan, Singapore and China and had combined sales of approximately $200 million in 2007. The purchase price was approximately $315.6 million in cash, subject to customary post-closing adjustments. The Company has incurred fees as of December 31, 2007 of approximately $4.9 million associated with this transaction.

 

Borchers Acquisition:  On October 1, 2007, the Company acquired Borchers GmbH, a European-based specialty coatings additive supplier, with locations in France and Germany, for approximately $20.7 million, net of cash

acquired. The Company has incurred fees as of December 31, 2007 of approximately $1.2 million associated with this transaction. Borchers had sales in the first nine months of 2007 of approximately $42 million.

 

Sale of the Nickel business:  On March 1, 2007, the Company completed the sale of its Nickel business to Norilsk. The Nickel business consisted of the Harjavalta, Finland nickel refinery, the Cawse, Australia nickel mine and intermediate refining facility, a 20% equity interest in MPI Nickel Pty. Ltd. and an 11% ownership interest in Talvivaara Mining Company, Ltd. The Company received cash proceeds of $490.0 million for the Nickel business, net of transaction costs, including a final purchase price adjustment primarily related to working capital for the net assets sold. In connection with the sale of the Nickel business, the Company entered into five-year supply agreements with Norilsk for cobalt and nickel raw materials. The Nickel business has been reclassified to discontinued operations for all periods presented.

 

Redemption of Senior Subordinated Notes:  On March 7, 2007, the Company redeemed the entire $400.0 million of its outstanding 9.25% Senior Subordinated Notes due 2011 at a redemption price of 104.625% of the principal amount, or $418.5 million, plus accrued interest of $8.4 million.

 

Overall operating results for 2007, 2006 and 2005

Set forth below is a summary of the Statements of Consolidated Income for the years ended December 31,

 

 

The Specialties segment is made up of three business units that represent product line groupings around end markets: Advanced Organics, Inorganics and Electronic Chemicals. Advanced Organics offers products for the tire, coatings and inks, additives and chemical markets. Inorganics serves the battery, powder metallurgy, ceramics and chemicals markets. Electronic Chemicals develops products for the electronic packaging, memory disk, general metal finishing and printed circuit board finishing markets. The Specialties business also includes certain other operations, primarily the DRC smelter operations, which are not classified into one of these groupings. Additional product information is contained in Item 1 of this Form 10-K.

 

2007 operating results compared to 2006

The following table reflects the sales for the product line groupings in the Specialties segment for the year ended December 31,

 

 

The following table reflects the volumes in the Specialties segment for the year ended December 31,

 

 

 

 

The following table summarizes the percentage of sales dollars by region for the year ended December 31:

 

 

The following table summarizes the percentage of sales dollars by end market:

 

 

The following table summarizes the average quarterly reference price of low grade (formerly referred to as 99.3%) cobalt:

 

 

Net sales increased $361.4 million to $1,021.5 million in 2007 from $660.1 million in 2006, primarily due to increased product selling prices ($291.0 million). The increase in product selling prices was primarily caused by the increase in the average cobalt reference price during 2007 compared with 2006. The resale of cobalt metal resulted in a $72.8 million increase to net sales in 2007 compared with 2006, and increased volume, primarily in the inorganics and electronic chemical product line groupings, contributed an additional $27.0 million. The acquisition of Borchers in October 2007 contributed an additional $12.7 million. These increases were partially offset by a $9.5 million decrease related to copper by-product sales and a $9.1 million unfavorable shift in product mix. The decrease in copper by-product sales was primarily due to a decrease in copper by-product volume partially offset by an increase in copper price. In connection with the sale of the Nickel business to Norilsk, the Company entered into two-year agency and distribution agreements for certain specialty nickel salts products. Under the contracts, the Company now acts as a distributor of these products on behalf of Norilsk and records the related commission revenue on a net basis. Prior to March 1, 2007, the Company, through its Specialties business, was the primary obligor for these sales and recorded the revenue on a gross basis. This change resulted in a $23.5 million decrease in net sales in 2007 compared with 2006.

 

Gross profit increased to $313.2 million in 2007, compared with $184.7 million in 2006, and as a percentage of net sales increased to 30.7% from 28.0%. Gross profit in 2007 was higher due to the impact of both the higher cobalt reference price and the sale into a higher price environment of finished products that were manufactured using cobalt raw material that was purchased at lower prices ($121.7 million), increased volume ($11.7 million) and a $6.7 million unrealized gain on cobalt forward purchase contracts (see discussion of these contracts below). These increases were partially offset by a decrease in profit associated with lower copper by-product sales ($16.1 million).

The increase in gross profit as a percentage of sales (30.7% in 2007, 28.0% in 2006) was primarily due to the positive factors discussed above, partially offset by the low margins on the resale of cobalt metal.

 

During 2007, the Company entered into cobalt forward purchase contracts to establish a fixed margin and mitigate the risk of price volatility related to the anticipated sale during the second quarter of 2008 of cobalt-containing finished products that are priced based on a formula that includes a fixed cobalt price component. These forward purchase contracts have not been designated as hedging instruments under SFAS No. 133, “Accounting for Derivative and Hedging Activities.” Accordingly, these contracts are adjusted to fair value at the end of each reporting period, with the gain or loss recorded in cost of products sold. The adjustment to fair value had no cash impact in 2007 as the contracts will be net settled with the counterparty in 2008. As noted above, the Company recorded a $6.7 million gain in 2007 related to these contracts. These contracts will continue to be marked to fair value until settlement, resulting in additional gains or losses based on changes in the cobalt reference price.

 

Selling, general and administrative (“SG&A”) expenses were $117.0 million in 2007 compared with $109.4 million in 2006. The increase was primarily due to increased selling expenses as a result of the increase in sales. SG&A expense in 2007 also includes $3.5 million in legal fees incurred by Specialties for a lawsuit the Company filed related to the unauthorized use by a third-party of proprietary information; and $3.1 million of SG&A expense related to Plaschem Specialty Products Pte Ltd. (“Plaschem”), which was acquired on March 21, 2006, and Borchers, which was acquired on October 1, 2007. Included in SG&A are corporate expenses in 2007 of $35.8 million compared with $40.1 million in 2006. Corporate expenses consist of unallocated corporate overhead, including legal, finance, human resources, information technology, strategic development and corporate governance activities, as well as share-based compensation. The decrease in corporate expenses was primarily due to a $3.2 million charge for the settlement of litigation related to the former chief executive officer’s termination in 2006 and a $2.9 million decrease in corporate legal and other professional fees, partially offset by a $3.0 million increase in employee incentive and share-based compensation expense.

 

Operating profit for 2007 increased to $196.2 million from $75.3 million in 2006 due to the factors impacting gross profit and SG&A expenses discussed above.

 

Other income (expense), net for 2007 was to $2.0 million of income compared with $14.8 million of expense in 2006. The following table summarizes the components of Other income (expense), net:

 

 

The Company redeemed all $400.0 million of its outstanding Notes on March 7, 2007, at a redemption price of 104.625% of the principal amount, or $418.5 million, plus accrued interest of $8.4 million. The loss on redemption of the Notes was $21.7 million, which includes the premium of $18.5 million plus related deferred financing costs of $5.7 million less a deferred net gain on terminated interest rate swaps of $2.5 million. The loss on redemption of the Notes was offset by a $30.8 million decrease in interest expense due to the redemption of the Notes. Increased interest income in 2007 was primarily due to increased interest earned on the higher average cash balance throughout 2007 and $1.2 million of interest earned on the working capital adjustment related to the Norilsk transaction. In addition, 2007 also includes $4.5 million of interest income related to the notes receivable from the 25% minority shareholder in its joint venture in the DRC (See Note 1 to the Consolidated Financial Statements in

this Form 10-K). The $12.2 million gain included in 2006 was related to the sale of the Company’s investment in Weda Bay (See Note 5 to the Consolidated Financial Statements in this Form 10-K).

 

Income tax expense in 2007 was $76.3 million on pre-tax income of $198.3 million, or 38.5%, compared with income tax expense in 2006 of $30.6 million on pre-tax income of $60.5 million, or 50.5%. Income tax expense in 2007 includes $45.7 million of expense for the repatriation of foreign earnings in the first quarter of 2007, partially offset by a $7.6 million income tax benefit related to the $21.7 million loss on redemption of the Notes. Excluding these discrete items, the effective income tax rate would have been 17.3% in 2007. This rate is lower than the U.S. statutory rate (35%) due primarily to income earned in foreign tax jurisdictions with lower statutory tax rates than the U.S., a tax holiday in Malaysia and the recognition of tax benefits for domestic losses in 2007. During the fourth quarter of 2007, the Company was informed by the DRC taxing authority that its tax holiday had expired, resulting in $9.8 million of expense related to income earned in the DRC. In both years, the strengthening Euro compared with the US dollar positively impacted the effective tax rate, as the Company’s statutory tax liability in Finland is calculated and payable in Euros but is remeasured to the US dollar functional currency for preparation of the consolidated financial statements. The 2006 effective tax rate is discussed below under “2006 operating results compared to 2005”.

 

Minority partners’ share of income relates to the Company’s 55%-owned smelter joint venture in the DRC. The increase in the minority partner’s income in 2007 compared with 2006 is primarily due to higher cobalt prices.

 

Income from continuing operations was $111.5 million in 2007 compared with $23.6 million in 2006 due primarily to the aforementioned factors.

 

Income from discontinued operations for 2007 and 2006 was primarily related to the operations of the Nickel business. Total income from discontinued operations for 2007 also included the $72.3 million gain on the sale of the Nickel business. Also included in income from discontinued operations in 2006 was $5.8 million of income from the discontinued operations of the Company’s former Precious Metals Group (“PMG”) primarily due to the reversal of a $4.6 million tax contingency accrual and a $2.4 million gain on the sale of a former PMG building that had been fully depreciated, both partially offset by foreign exchange losses of $1.8 million from remeasuring Euro-denominated liabilities to U.S. dollars.

 

Net income in 2006 includes $0.3 million of income related to the cumulative effect of a change in accounting principle for the adoption of SFAS No. 123R, “Share-Based Payments.” See further discussion of the adoption of SFAS No. 123R in Note 2 to the Consolidated Financial Statements in this Form 10-K.

 

Net income was $246.9 million, or $8.15 per diluted share, in 2007 compared with $216.1 million, or $7.31 per diluted share, in 2006, due primarily to the aforementioned factors.

 

2006 operating results compared to 2005

The following table reflects the sales for the product line groupings in the Specialties segment for the year ended December 31,

 

The following table summarizes the percentage of sales dollars by region for the year ended December 31:

 

 

The following table summarizes the percentage of sales dollars by end market:

 

 

The following table summarizes the average quarterly reference price of low grade (formerly 99.3%) cobalt:

 

 

Net sales increased $42.6 million, or 6.9%, to $660.1 million for the year ended December 31, 2006, compared with $617.5 million for the year ended December 31, 2005. The increase in net sales was primarily due to increased copper by-product sales ($40.6 million), sales related to the March 2006 acquisition of Plaschem ($10.8 million) and a favorable shift in product mix ($5.2 million). The increase in copper by-product sales was due to the increase in the average copper price in 2006 compared with 2005 and an increase in copper by-product volume. These increases were partially offset by lower product selling prices ($18.9 million) caused primarily by lower cobalt reference prices in the first half of 2006 compared with 2005.

 

Gross profit increased to $184.7 million in 2006 compared with $101.0 million in 2005. Margins increased to 28.0% from 16.4% primarily due to the sale of cobalt finished goods manufactured using lower cost raw materials that were purchased before the increase in cobalt metal prices which occurred throughout 2006 ($31.2 million). Also impacting gross profit were increased copper by-product sales ($23.9 million) and a favorable shift in product mix ($10.9 million). In addition, 2005 included the $9.4 million negative impact related to the scheduled maintenance shut-down of the smelter in the DRC.

 

SG&A expenses increased to $109.4 million in 2006 compared with $75.9 million in 2005. SG&A expenses in 2006 include $4.7 million of increased employee incentive compensation expense triggered by increased profitability in 2006, a $3.2 million charge for the settlement of litigation related to the former chief executive officer’s termination, a $1.7 million increase in share-based compensation, environmental charges of $4.2 million and an additional $1.0 million reserve against the note receivable from one of our joint venture partners in the DRC. SG&A expenses in 2005 included $27.5 million of income related to the receipt of net insurance proceeds related to the shareholder class action litigation, $4.6 million of income related to the mark-to-market of 380,000 shares of common stock issued in connection with the shareholder derivative litigation and income of $2.5 million related to the collection of a note receivable that had been fully reserved in 2002. In addition, 2005 included an $8.9 million charge related to the former chief executive officer’s departure, a $4.2 million charge to establish a reserve against the notes receivable from one of our joint venture partners in the DRC and environmental charges of $2.8 million.

Other expense, net decreased $28.1 million to $14.8 million in 2006 compared with $42.9 million in 2005. The decrease was primarily due to a $12.2 million gain in 2006 related to the sale of the Company’s investment in Weda Bay (See Note 5 to the Consolidated Financial Statements in this Form 10-K) and a $6.7 million increase in interest income in 2006 compared with 2005 due to the higher average cash balance. In addition, other expense, net was also impacted by foreign exchange gains of $3.7 million in 2006 compared with a foreign exchange loss of $4.6 million in 2005.

 

Income tax expense in 2006 was $30.6 million on pre-tax income of $60.5 million, compared with income tax expense in 2005 of $1.7 million on a pre-tax loss of $17.8 million. The 2006 effective rate is higher than the statutory rate in the United States (35%) due primarily to additional U.S. income taxes on $384.1 million of undistributed earnings of consolidated foreign subsidiaries as of December 31, 2006. The taxes provided on such earnings were partially offset by the reversal of the valuation allowance against certain operating loss carryforwards. Previously, the Company’s intent was for such earnings to be reinvested by the subsidiaries indefinitely. However, due primarily to the redemption of the Notes in March 2007, the Company repatriated such undistributed earnings to the United States during 2007. The effective tax rate was also negatively impacted by losses in the United States with no corresponding tax benefit. These increases to the effective tax rate were partially offset by income earned in tax jurisdictions with lower statutory tax rates (primarily Finland at 26%) and a tax “holiday” in Malaysia. Also in 2006, the strengthening Euro compared with the US dollar positively impacted the effective tax rate, as the Company’s statutory tax liability in Finland is calculated and payable in Euros but is remeasured to the US dollar functional currency for preparation of the consolidated financial statements. The 2005 expense results primarily from profitability of the Company’s Kokkola, Finland operations and no tax benefit from losses in the US. In addition, the effective income tax rate in 2005 was negatively impacted by the weakening Euro compared with the US dollar.

 

Minority interest share of (income) loss relates to the Company’s 55%-owned smelter joint venture in the DRC. The minority partner’s income in 2006 reflects production and shipments throughout the year, whereas the losses in 2005 were attributable to the scheduled extended maintenance shut-down of the GTL smelter from January through May 2005.

 

Income from discontinued operations for 2006 was $192.2 million, of which $186.4 million relates to the Nickel business and $5.8 million relates to retained liabilities of PMG, which was sold in 2003. Income from discontinued operations for 2005 was $49.0 million, of which $39.6 million relates to the Nickel business and $9.4 million relates to PMG.

 

Income included in discontinued operations related to the Nickel business increased to $186.4 million in 2006 compared with $39.6 million in 2005. The increase was primarily due to a higher average nickel price ($116.9 million), the impact of favorable raw material pricing ($44.3 million) and favorable nickel hedging transactions ($28.3 million). Favorable raw material pricing was primarily due to the rapid increase in nickel price and the resulting impact of selling inventory purchased at lower prices. These increases were partially offset by a $35.1 million increase in income tax expense due to the increased earnings.

 

The Company recorded income from the discontinued operations of PMG of $5.8 million in 2006 primarily due to the reversal of a $4.6 million tax contingency accrual and a $2.4 million gain on the sale of a former PMG building that had been fully depreciated, both offset by foreign exchange losses of $1.8 million from remeasuring Euro-denominated liabilities to U.S. dollars. The Company recorded income from non-Nickel discontinued operations of $9.4 million in 2005 primarily due to the reversal of a $5.5 million tax contingency accrual, a $1.6 million tax refund related to PMG, and foreign exchange gains of $1.6 million from remeasuring Euro-denominated liabilities to U.S. dollars.

 

Net income in 2006 includes $0.3 million of income related to the cumulative effect of a change in accounting principle for the adoption of SFAS No. 123R, “Share-Based Payments.” See further discussion of the adoption of SFAS No. 123R in Note 2 to the Consolidated Financial Statements in this Form 10-K. Net income in 2005 includes $2.3 million of income related to the cumulative effect of a change in accounting principle for the adoption of FASB Interpretation (“FIN”) No. 47, “Accounting for Conditional Asset Retirement Obligations.” The

adoption of FIN No. 47 only impacted the Company’s Cawse mine which is included in discontinued operations in the consolidated financial statements for all periods presented.

 

Net income was $216.1 million, or $7.31 per diluted share, in 2006 compared with $38.9 million, or $1.36 per diluted share, in 2005, due primarily to the aforementioned factors.

 

Liquidity and Capital Resources

Cash Flow Summary

The Company’s cash flows from operating, investing and financing activities, as reflected in the Statements of Consolidated Cash Flows, are summarized and discussed in the following tables (in millions) and related narrative:

 

 

The $54.0 million decrease in net cash provided by operating activities was primarily due to a $165.7 million increase in inventories during 2007 compared with a $27.6 million increase in inventories during 2006 and a $38.4 million increase in accounts receivable during 2007 compared with a $3.9 million increase in accounts receivable during 2006. These items were partially offset by a $92.2 million increase in accounts payable during 2007 compared with a $39.3 million increase in 2006. These increases in inventories, accounts receivable and accounts payable in 2007, which excludes amounts acquired in business combinations, were primarily due to higher cobalt metal prices in 2007 compared with 2006. Also impacting net cash provided by operating activities was the positive cash flow impact of income from continuing operations of $111.5 million in 2007 compared with income from continuing operations of $23.6 million in 2006. In addition, 2007 includes a $21.7 million charge related to the redemption of the Notes while 2006 includes a $12.2 million gain on the sale of the Company’s investment in Weda Bay. The $21.7 million charge related to the redemption of the Notes consisted of a cash premium of $18.5 million and non-cash charges totaling $3.2 million. The $18.5 million cash premium payment is included as a component of financing activities. The receipt of the Weda Bay proceeds is included as a component of investing activities

 

Net cash provided by investing activities increased $153.2 million in 2007 compared with 2006 primarily due to the $490.0 million of net proceeds related to the sale of the Nickel business partially offset by the cash outflow for acquisitions in 2007 ($337.0 million, net of cash acquired). Net cash provided by investing activities in 2007 also includes $7.6 million of proceeds from the repayment of a loan made to a former Nickel joint venture partner. Investing activities in 2006 include proceeds of $12.2 million from the sale of the Company’s investment in Weda Bay, a $5.4 million payment for the Plaschem acquisition and a $6.9 million loan to a former Nickel joint venture partner.

Net cash used in financing activities increased $401.0 million in 2007 compared with 2006 primarily due to the $418.5 million payment to redeem the Notes.

 

 

The $102.4 million increase in net cash provided by operating activities was primarily due to the positive cash flow impact of income from continuing operations before accounting changes of $23.6 million in 2006 compared with a loss of $12.4 million in 2005; a $74.0 million payment in 2005 related to settlement of the shareholder litigation; an increase in accounts payable during the 2006 period compared to 2005 which resulted in a cash flow change of $62.9 million; and the change in accrued income taxes during 2006 compared to 2005 ($15.2 million). These positive factors were partially offset by the negative cash flow impact of an increase in inventories during 2006 compared with a decrease in inventories during 2005 ($95.0 million). The increase in inventories in 2006 was due primarily to higher cobalt metal prices at December 31, 2006 compared to a year ago, and corresponded with the increase in accounts payable in 2006. The increase in accrued income taxes in 2006 was due to higher earnings compared to a year ago.

 

Higher cash used in investing activities in 2006 was due primarily to the acquisition of Plaschem in March 2006 ($5.4 million, net of cash acquired) and loans to non-consolidated joint ventures in 2006 of $6.9 million, compared with proceeds from the collection of notes receivable of $5.5 million in 2005. Investing activities in 2006 also include proceeds of $12.2 million from the sale of the Company’s investment in Weda Bay. Capital expenditures were $14.5 million in 2006 compared with $13.4 million in 2005

 

In 2006, financing activities include proceeds from the exercise of stock options of $11.6 million, compared with $0.1 million in 2005. The cash inflow from the exercise of stock options in 2006 was offset by the repayment of the $17.3 million note payable with a Finnish bank.

 

Debt and Other Financing Activities

On March 7, 2007, the Company redeemed the entire $400.0 million of its outstanding Notes at a redemption price of 104.625% of the principal amount, or $418.5 million, plus accrued interest of $8.4 million. The premium amount of $18.5 million plus related deferred financing costs of $5.7 million less the deferred net gain on terminated interest rate swaps of $2.5 million is included in the Loss on redemption of Notes in the Statements of Consolidated Income.

 

The Company has a Revolving Credit Agreement (the “Revolver”) with availability of up to $100.0 million, including up to the equivalent of $25.0 million in Euros or other foreign currencies. The Revolver includes an “accordion” feature under which the Company may increase the availability by $50.0 million to a maximum of $150.0 million subject to certain conditions. Obligations under the Revolver are guaranteed by each of the Company’s U.S. subsidiaries and are secured by a lien on the assets of the Company and such subsidiaries. The Revolver provides for interest-only payments during its term, with principal due at maturity. The Company has the option to specify that interest be calculated based either on LIBOR, plus a calculated margin amount, or a base rate. The applicable margin for the LIBOR rate ranges from 0.50% to 1.00%. The Revolver also requires the payment of a fee of 0.125% to 0.25% per annum on the unused commitment. The margin and unused commitment fees are subject to quarterly adjustment based on a certain debt-to-adjusted-earnings ratio. The Revolver matures on

December 20, 2010 and contains various affirmative and negative covenants. At December 31, 2007, there were no borrowings outstanding under the Revolver and the Company was in compliance with all covenants.

 

The Company has two term loans outstanding that expire in 2008 and 2019 and require monthly principal and interest payments. The balance of these term loans was $1.3 million at December 31, 2007 and $1.4 million at December 31, 2006. At December 31, 2007 and December 31, 2006, the Company also had a $0.3 million short-term note payable.

 

The Company believes that it will have sufficient cash provided by operations and available from its credit facility to provide for its working capital, debt service, acquisition and capital expenditure requirements during 2008.

 

The Company did not pay cash dividends in 2007, 2006 or 2005. The Company intends to continue to retain earnings for use in the operation and expansion of the business and therefore does not anticipate paying cash dividends in 2008.

 

Capital Expenditures

Capital expenditures in 2007 were $19.4 million, related primarily to ongoing projects to maintain current operating levels and were funded through cash flows from operations. The Company expects to incur capital spending of approximately $53.0 million in 2008, (including items relating to the REM businesses), for projects to expand capacity, maintain and improve throughput with outlays for sustaining operations, and for expenditures related to environmental, health and safety compliance, and also for other fixed asset additions at existing facilities.

 

During 2005, the Company initiated a multi-year Enterprise Resource Planning (“ERP”) project that is expected to be implemented worldwide to achieve increased efficiency and effectiveness in supply chain, financial processes and management reporting. The new ERP system will replace or complement existing legacy systems and standardize the global business processes across the enterprise. The system implementation began in the first quarter of 2007, and the Company will continue to implement the ERP system at additional locations in a phased approach through 2009.

 

Contractual Obligations

The Company has entered into contracts with various third parties in the normal course of business that will require future payments. The following table summarizes the Company’s contractual cash obligations and their expected maturities at December 31, 2007 (in thousands).

 

 

 

 

Pension funding and postretirement benefit payments can vary significantly each year due to changes in legislation and the Company’s significant assumptions. As a result, pension funding and post-retirement benefit payments have not been included in the table above. The Company expects to contribute approximately $0.8 million related to its SCM pension plan in 2008. Pension benefit payments are made from assets of the pension plan. The Company expects to make payments related to its other postretirement benefit plans of approximately $0.5 million annually over the next ten years. Benefit payments beyond that time cannot currently be estimated. The Company also has an unfunded obligation to its former chief executive officer in settlement of an unfunded supplemental executive

retirement plan. The Company expects to make annual benefit payments of approximately $0.7 million related to the former chief executive officer.

 

Off Balance Sheet Arrangements

The Company has not entered into any off balance sheet financing arrangements, other than operating leases, which are disclosed in the contractual obligations table and Note 17 to the consolidated financial statements included in Item 8 of this Annual Report.

 

Critical Accounting Policies

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires the Company’s management to make estimates and assumptions in certain circumstances that affect amounts reported in the accompanying consolidated financial statements. In preparing these financial statements, management has made their best estimates and judgments of certain amounts included in the financial statements related to the critical accounting policies described below. The application of these critical accounting policies involves the exercise of judgment and use of assumptions as to future uncertainties and, as a result, actual results could differ from these estimates. In addition, other companies may utilize different estimates, which may impact the comparability of the Company’s results of operations to similar businesses.

 

Revenue Recognition — Revenues are recognized when the revenue is realized or realizable, and has been earned, in accordance with the U.S. Securities and Exchange Commission’s Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements.” The majority of the Company’s sales are related to sales of product. Revenue for product sales is recognized when persuasive evidence of an arrangement exists, unaffiliated customers take title and assume risk of loss, the sales price is fixed or determinable and collection of the related receivable is reasonably assured. Revenue recognition generally occurs upon shipment of product or usage of consignment inventory. Freight costs and any directly related associated costs of transporting finished product to customers are recorded as Cost of products sold.

 

Inventories — The Company’s inventories are stated at the lower of cost or market and valued using the first-in, first-out (FIFO) method. The cost of the Company’s raw materials fluctuates due to actual or perceived changes in supply and demand of raw materials, changes in cobalt reference/market prices and changes in availability from suppliers. In periods of raw material metal price declines or declines in the selling prices of the Company’s finished products, inventory carrying values may exceed the amount the Company could realize on sale, resulting in a lower of cost or market charge. The Company evaluates on a monthly basis the need for a lower of cost or market adjustment to inventories based on the end-of-the-month market price.

 

Long-Lived Assets — Goodwill must be reviewed at least annually for impairment, in accordance with a specified methodology. Further, goodwill, intangibles and other long-lived assets are assessed for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. The Company generally invests in long-lived assets to secure raw material feedstocks, produce new products, or increase production capacity or capability. Because market conditions may change, future cash flows may be difficult to forecast. Furthermore, the assets and related businesses may be in different stages of development. If the Company determined that the future undiscounted cash flows from these investments were not expected to exceed the carrying value of the investments, the Company would record an impairment charge. However, determining future cash flows is subject to estimates and different estimates could yield different results. Additionally, other changes in the estimates and assumptions, including the discount rate and expected long-term growth rate, which drive the valuation techniques employed to estimate the future cash flows of the these investments, could change and, therefore, impact the analysis of impairment in the future.

 

Income Taxes — Deferred income taxes are provided to recognize the effect of temporary differences between financial and tax reporting. Deferred income taxes are not provided for undistributed earnings of foreign consolidated subsidiaries, to the extent such earnings are determined to be reinvested for an indefinite period of time. The Company has significant operations outside the United States, where most of its pre-tax earnings are derived, and in jurisdictions where the statutory tax rate is lower than in the United States. The Company’s tax

assets, liabilities, and tax expense are supported by its best estimates and assumptions of its global cash requirements, planned dividend repatriations, and expectations of future earnings. When the Company determines that it is more likely than not that deferred tax assets will not be realized, a valuation allowance is established.

 

Prior to December 31, 2006, the Company had recorded a valuation allowance against its U.S. net deferred tax assets, primarily related to net operating loss carryforwards, because it was more likely than not that those deferred tax assets would not be realized. However, the Company now believes that it is more likely than not that the net deferred tax asset related to temporary differences that reverse in 2008 and 2009 will be realized. Because there has been no fundamental change in the Company’s U.S. operations, it is more likely than not that deferred tax assets related to state and local net operating loss carryforwards and temporary differences that will reverse beyond 2009 will not be realized, and therefore the Company has recorded a valuation allowance against those deferred tax assets.

 

Share-Based Compensation  — The computation of the expense associated with share-based compensation requires the use of a valuation model. The Company currently uses a Black-Scholes option pricing model to calculate the fair value of its stock options. The Black-Scholes model requires the use of subjective assumptions, including estimating the expected term of stock options and expected stock price volatility. Changes in the assumptions to reflect future stock price volatility and actual forfeiture experience could result in a change in the assumptions used to value awards in the future and may result in a material change to the fair value calculation of share-based awards. The fair value of share-based compensation awards less estimated forfeitures is amortized over the vesting period.

 

The fair value of time-based and performance-based restricted stock grants is calculated based upon the market value of an unrestricted share of the Company’s common stock at the date of grant. The performance-based restricted stock vests solely upon the Company’s achievement of specific measurable criteria over a three-year performance period. A recipient of performance-based restricted stock may earn a total award ranging from 0% to 100% of the initial grant. No payout will occur unless the Company equals or exceeds certain threshold performance objectives. The amount of compensation expense recognized is based upon current performance projections for the three-year period and the percentage of the requisite service that has been rendered.

 

Recently Issued Accounting Standards

Accounting Standards adopted in 2007:

FIN No. 48:  In July 2006, the Financial Accounting Standards Board (“FASB”) issued FIN No. 48. FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” FIN No. 48 prescribes a recognition threshold and measurement attributable for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures and transitions. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. The Company adopted FIN No. 48 on January 1, 2007. The transition provisions require that the effect of applying the provisions of FIN No. 48 be reported as an adjustment to the opening balance of retained earnings in the year of adoption. The effect of adoption was a $0.5 million reduction to retained earnings at January 1, 2007.

 

EITF No. 06-3:  In June 2006, the FASB ratified the consensus of Emerging Issues Task Force (“EITF”) No. 06-03, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (that is, gross versus net presentation).” EITF No. 06-03 indicates that the income statement presentation of taxes within the scope of the Issue on either a gross basis or a net basis is an accounting policy decision that should be disclosed pursuant to APB No. 22. The Company has historically accounted for such taxes on a net basis and therefore the adoption of EITF No. 06-03 in the first quarter of 2007 had no impact on the Company’s results of operations and financial position.

 

Accounting Standards Not Yet Adopted

SFAS No. 160:  In December 2007, the FASB issued SFAS No. 160 (“SFAS No. 160”), “Noncontrolling Interests in Consolidated Financial Statements, an amendment of Accounting Research Bulletin No. 51”). SFAS No. 160

requires (i) that noncontrolling (minority) interests be reported as a component of shareholders’ equity, (ii) that net income attributable to the parent and to the noncontrolling interest be separately identified in the consolidated statement of operations, (iii) that changes in a parent’s ownership interest while the parent retains its controlling interest be accounted for as equity transactions, (iv) that any retained noncontrolling equity investment upon the deconsolidation of a subsidiary be initially measured at fair value, and (v) that sufficient disclosures are provided that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS No. 160 is effective for annual periods beginning after December 15, 2008 and should be applied prospectively. However, the presentation and disclosure requirements of the statement shall be applied retrospectively for all periods presented. The Company has not determined the effect, if any; the adoption of SFAS No. 160 will have on its results of operations, financial position and related disclosure.

 

SFAS No. 159:  On February 15, 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — Including an Amendment of FASB Statement No. 115” (“SFAS No. 159”). SFAS No. 159 permits entities to choose to measure many financial assets and liabilities and certain other items at fair value that are not currently required to be measured at fair value. An entity will report unrealized gains and losses on items for which the fair value option has been elected in the consolidated statements of income at each subsequent reporting date. The fair value option may be applied on an instrument-by-instrument basis, with several exceptions, such as those investments accounted for by the equity method, and once elected, the option is irrevocable unless a new election date occurs. The fair value option can be applied only to entire instruments and not to portions thereof. The pronouncement also establishes presentation and disclosure requirements to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The Company has not determined the effect, if any, the adoption of this statement will have on its results of operations, financial position and related disclosures.

 

SFAS No. 157:  In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This statement clarifies the definition of fair value, establishes a framework for measuring fair value, and expands the disclosures on fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 for financial assets and liabilities, as well as for any other assets and liabilities that are carried at fair value on a recurring basis, and should be applied prospectively. The adoption of the provisions of SFAS No. 157 related to financial assets and liabilities and other assets and liabilities that are carried at fair value on a recurring basis is not anticipated to materially impact the Company’s results of operations or financial position. The FASB provided for a one-year deferral of the provisions of SFAS No. 157 for non-financial assets and liabilities that are recognized or disclosed at fair value in the consolidated financial statements on a non-recurring basis. The Company has not determined the effect, if any; the adoption of the provisions of SFAS No. 157 for non-financial assets and liabilities will have on its results of operations, financial position and related disclosures.

 

SFAS No. 141R:  In December 2007, the FASB issued SFAS No. 141 (revised 2007) (“SFAS No. 141R”), “Business Combinations”. SFAS No. 141R will change how business acquisitions are accounted for and will impact financial statements both on the acquisition date and in subsequent periods. SFAS No. 141R establishes principles and requirements for how an acquirer recognizes and measures the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree and the goodwill acquired. SFAS 141R requires restructuring and acquisition-related costs to be recognized separately from the acquisition and establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. SFAS No. 141R is effective for fiscal years beginning after December 15, 2008. SFAS No. 141R must be applied prospectively to business combinations for which the acquisition date is on or after the adoption date. Early adoption is not permitted. The Company has not determined the effect, if any; the adoption of SFAS No. 141R will have on its results of operations or financial position.

 

EITF No. 06-4:  In June 2006, the EITF reached a consensus on EITF No. 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements,” which requires the application of the provisions of SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions” to endorsement split-dollar life insurance arrangements. SFAS No. 106 would require the Company to recognize a liability for the discounted future benefit obligation that the Company will have

to pay upon the death of the underlying insured employee. An endorsement-type arrangement generally exists when the Company owns and controls all incidents of ownership of the underlying policies. EITF No. 06-4 is effective for fiscal years beginning after December 15, 2007. The Company may have certain policies subject to the provisions of this new pronouncement and is currently determining the effect the adoption of EITF No. 06-4 will have on its financial statements.

 

Effects of Foreign Currency

The Company has manufacturing and other facilities in North America, Europe, Africa and Asia-Pacific, and markets its products worldwide. Although most of the Company’s raw material purchases and product sales are based on the U.S. dollar, prices of certain raw materials, non-U.S. operating expenses and income taxes are denominated in local currencies. As such, the results of operations are subject to the variability that arises from exchange rate movements (particularly the Euro). In addition, fluctuations in exchange rates may affect product demand and profitability in U.S. dollars of products provided by the Company in foreign markets in cases where payments for its products are made in local currency. Accordingly, fluctuations in currency prices affect the Company’s operating results.

 

Environmental Matters

The Company is subject to a wide variety of environmental laws and regulations in the United States and in foreign countries as a result of its operations and use of certain substances that are, or have been, used, produced or discharged by its plants. In addition, soil and/or groundwater contamination presently exists and may in the future be discovered at levels that require remediation under environmental laws at properties now or previously owned, operated or used by the Company.

 

The European Union’s REACH legislation establishes a new system to register and evaluate chemicals manufactured in, or imported to, the European Union and will require additional testing, documentation and risk assessments for the chemical industry. Due to the ongoing development and understanding of facts and remedial options and due to the possibility of unanticipated regulatory developments, the amount and timing of future environmental expenditures could vary significantly. Although it is difficult to quantify the potential impact of compliance with or liability under environmental protection laws, based on presently available information, the Company believes that its ultimate aggregate cost of environmental remediation as well as liability under environmental protection laws will not result in a material adverse effect upon its financial condition or results of operations.

 

See Item I of this Annual Report on Form 10-K for further discussion of these matters.

 

Cautionary Statement for “Safe Harbor” Purposes Under the Private Securities Litigation Reform Act of 1995

The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements made by or on behalf of the Company. This report contains statements that the Company believes may be “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are not historical facts and generally can be identified by use of statements that include words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “foresee” or other words or phrases of similar import. Similarly, statements that describe the Company’s objectives, plans or goals also are forward-looking statements. These forward-looking statements are subject to risks and uncertainties that are difficult to predict, may be beyond the Company’s control and could cause actual results to differ materially from those currently anticipated. The Company undertakes no obligation to publicly revise these forward-looking statements to reflect events or circumstances that arise after the date hereof. Significant factors affecting these expectations are set forth under Item 1A — Risk Factors in this Annual Report on Form 10-K.

Quantitative and Qualitative Disclosures About Market Risk

The Company, as a result of its global operating and financing activities, is exposed to changes in commodity prices, interest rates and foreign currency exchange rates which may adversely affect its results of operations and financial position. In seeking to minimize the risks and/or costs associated with such activities, the Company manages exposures to changes in commodity prices, interest rates and, at times, foreign currency exchange rates through its regular operating and financing activities, which include the use of derivative instruments.

 

The primary raw material used by the Company in manufacturing its products is cobalt. There are a limited number of supply sources for cobalt. Production problems or political or civil instability in supplier countries, primarily the DRC, Australia, Finland and Russia, have affected and may continue to affect the supply and market price of cobalt. In particular, political and civil instability in the DRC may affect the availability of raw materials from that country. Although the Company has never experienced a significant shortage of cobalt raw material, production problems and political and civil instability in certain supplier countries may in the future affect the supply and market price of cobalt raw materials.

 

The cost of the Company’s raw materials fluctuates due to actual or perceived changes in supply and demand, changes in cobalt reference prices and changes in availability from suppliers. The Company attempts to mitigate changes in availability by maintaining adequate inventory levels and long-term supply relationships with a variety of producers. Fluctuations in the prices of cobalt have been significant in the past and the Company believes that cobalt price fluctuations are likely to continue in the future. The Company attempts to pass through to its customers increases in raw material prices by increasing the prices of its products. The Company’s profitability is largely dependent on the Company’s ability to maintain the differential between its product prices and product costs. Certain sales contracts and raw material purchase contracts contain variable pricing that adjusts based on changes in the price of cobalt. During periods of rapidly changing metal prices, however, there may be price lags that can impact the short-term profitability and cash flow from operations of the Company both positively and negatively. Reductions in the price of raw materials or declines in the selling prices of the Company’s finished goods could also result in the Company’s inventory carrying value being written down to a lower market value.

 

The Company is exposed to interest rate risk primarily through its borrowing activities. If needed, the Company predominantly utilizes U.S. dollar-denominated borrowings to fund its working capital and investment needs. There is an inherent rollover risk for borrowings as they mature and are renewed at current market rates. The extent of this risk is not quantifiable or predictable because of the variability of future interest rates and business financing requirements (see Note 9 to the consolidated financial statements contained in Item 8 of this Annual Report).

 

The Company enters into derivative instruments and hedging activities to manage, where possible and economically efficient, commodity price risk and interest rate risk related to borrowings. All derivatives are reflected at their fair value in the Consolidated Balance Sheets. Changes in the fair values of derivatives not designated in a hedging relationship are recognized in earnings each period.

 

The Company, from time to time, employs derivative instruments in connection with certain purchases and sales of inventory in order to establish a fixed margin and mitigate the risk of price volatility. Some customers request fixed pricing and the Company may use a derivative to mitigate price risk. While this hedging may limit the Company’s ability to participate in gains from favorable commodity price fluctuations, it eliminates the risk of loss from adverse commodity price fluctuation.

 

During 2007, the Company entered into cobalt forward purchase contracts to establish a fixed margin and mitigate the risk of price volatility related to the anticipated sale during the second quarter of 2008 of cobalt-containing finished products that are priced based on a formula which includes a fixed cobalt price component. These forward purchase contracts have not been designated as hedging instruments under SFAS No. 133. Accordingly, these contracts are adjusted to fair value as of the end of each reporting period, with the gain or loss recorded in cost of sales in the statements of consolidated income. Fair value is estimated based on the expected future cash flows discounted to present value. Future cash flows are estimated using a theoretical forward price when quoted forward prices are not available. These adjustments to fair value had no cash impact in 2007 as the contracts will be net

settled with the counterparty in 2008. The Company recorded a $6.7 million gain in 2007 related to these contracts. These contracts will continue to be marked to fair value until settlement, resulting in additional gains or losses based on changes in the cobalt reference price.

 

By using derivative instruments to hedge exposures to changes in commodity prices and interest rates, the Company exposes itself to credit risk and market risk.

 

Credit risk is the failure of the counterparty to perform under the terms of the derivative contract. When the fair value of a derivative contract is positive, the counterparty owes the Company, which creates credit risk for the Company. When the fair value of a derivative contract is negative, the Company owes the counterparty and the Company does not possess credit risk. To mitigate credit risk, it is the Company’s policy to execute such instruments with creditworthy banks and not enter into derivative instruments for speculative purposes. There were no counterparty defaults during the years ended December 31, 2007, 2006 and 2005.

 

Market risk is the change in value of a derivative instrument that results from a change in commodity prices or interest rates. The market risk associated with commodity prices and interests is managed by establishing and monitoring parameters that limit the types and degree of market risk that may be undertaken.

 

During 2007, the Company invested $2.0 million in Quantumsphere, Inc. (“QSI”) through the purchase of 615,385 shares of common stock and warrants to purchase an additional 307,692 shares of common stock. The Company and QSI, a privately-held company, have agreed to co-develop new applications for the clean-energy and portable power sectors based upon QSI’s proprietary technology. This type of investment has an inherent risk as the technologies or products under development are generally early stage and may never materialize into a commercial opportunity. The carrying amount of this investment approximated fair value as of December 31, 2007.

 

In addition to the United States, the Company has manufacturing and other facilities in Africa, Canada, Europe and Asia-Pacific, and markets its products worldwide. Although most of the Company’s raw material purchases and product sales are based on the U.S. dollar, prices of certain raw materials, non-U.S. operating expenses and income taxes are denominated in local currencies. As such, the results of operations are subject to the variability that arises from exchange rate movements (particularly the Euro). In addition, fluctuations in exchange rates may affect product demand and profitability in U.S. dollars of products provided by the Company in foreign markets in cases where payments for its products are made in local currency. Accordingly, fluctuations in currency prices affect the Company’s operations. The Company does not currently hedge against the risk of exchange rate fluctuation.

 

 

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders of OM Group, Inc.

 

We have audited the accompanying consolidated balance sheets of OM Group, Inc. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedule listed in the index at Item 15. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

 

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

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of OM Group, Inc. and subsidiaries at December 31, 2007 and 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

 

As discussed in Notes 2, 7 and 15 to the consolidated financial statements, the Company adopted Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109,” as of January 1, 2007, Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans an amendment of FASB Statements No. 87, 88, 106 and 132(R),” as of December 31, 2006, Statement of Financial Accounting Standards No. 123R, “Share-Based Payment,” and Emerging Issues Task Force No. 04-6, “Accounting for Stripping Costs Incurred during Production in the Mining Industry,” as of January 1, 2006 and Financial Accounting Standards Board Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations,” as of October 1, 2005.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), OM Group, Inc.’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 26, 2008 expressed an adverse opinion on the effectiveness of internal control over financial reporting as of December 31, 2007.

 

/s/ ERNST & YOUNG LLP

 

 

Cleveland, Ohio

February 26, 2008

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders of OM Group, Inc.

 

We have audited OM Group, Inc.’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). OM Group, Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

As indicated in the accompanying Management’s Report on Internal Control over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of the Electronics businesses of Rockwood Specialties Group, Inc. and Borchers GmbH (both acquired in 2007), which are included in the 2007 consolidated financial statements of OM Group, Inc. and together constituted 28% and 34% of total assets and net assets, respectively, as of December 31, 2007 and 1% and less than 1% of revenues and net income, respectively, for the year then ended. Our audit of internal control over financial reporting of OM Group, Inc. also did not include an evaluation of the internal control over financial reporting of the Electronics businesses of Rockwood Specialties Group, Inc. and Borchers GmbH.

 

A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. The following material weakness has been identified and included in management’s assessment.

 

 

This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2007 consolidated financial statements, and this report does not affect our report dated February 26, 2008, on those consolidated financial statements.

 

In our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, OM Group, Inc. has not maintained effective internal control over financial reporting as of December 31, 2007, based on the COSO criteria.

 

/s/ ERNST & YOUNG LLP

 

 

Cleveland, Ohio

February 26, 2008

OM Group, Inc. and Subsidiaries

 

Consolidated Balance Sheets

 

 

See accompanying notes to consolidated financial statements.

OM Group, Inc. and Subsidiaries

 

Statements of Consolidated Income