Form 10-Q_3rd_Qtr_2006
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q

(Mark
One)
 
[X]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2006
 
OR
[ ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ______________ to ______________

Commission file number 1-12626
 
EASTMAN CHEMICAL COMPANY
(Exact name of registrant as specified in its charter)

Delaware
 
62-1539359
(State or other jurisdiction of
 
(I.R.S. employer
incorporation or organization)
 
identification no.)
     
200 South Wilcox Drive
   
Kingsport, Tennessee
 
37660
(Address of principal executive offices)
 
(Zip Code)
     
 
Registrant’s telephone number, including area code: (423) 229-2000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
YES [X] NO [ ]
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (check one);
Large accelerated filer [X] Accelerated filer [ ] Non-accelerated filer [ ]
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) YES [ ] NO [X]

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Class
Number of Shares Outstanding at September 30, 2006
Common Stock, par value $0.01 per share
 
82,285,145
(including rights to purchase shares of Common Stock or Participating Preferred Stock)
   

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EXHIBIT INDEX ON PAGE 51

 
 

 

TABLE OF CONTENTS

ITEM
 
PAGE

PART I. FINANCIAL INFORMATION

1.
 
Financial Statements
 
 
     
 
3
 
 
 
4
 
 
 
5
 
 
 
6
 
     
2.
 
 
27
 
     
3.
 
 
46
 
     
4.
 
 
47
 

PART II. OTHER INFORMATION

1.
 
 
48
 
     
1A.
48
 
     
2.
 
 
49
 
     
6.
 
 
49
 

SIGNATURES

 
 
5001
 


2

 

UNAUDITED CONSOLIDATED STATEMENTS OF EARNINGS,
COMPREHENSIVE INCOME AND RETAINED EARNINGS

   
Third Quarter
 
First Nine Months
(Dollars in millions, except per share amounts)
 
2006
 
2005
 
2006
 
2005
                 
Sales
$
1,966
$
1,816
$
5,698
$
5,330
Cost of sales
 
1,650
 
1,464
 
4,701
 
4,205
Gross profit
 
316
 
352
 
997
 
1,125
                 
Selling, general and administrative expenses
 
105
 
108
 
316
 
339
Research and development expenses
 
40
 
42
 
126
 
120
Asset impairments and restructuring charges, net
 
13
 
4
 
23
 
23
Other operating income
 
--
 
--
 
--
 
(2)
Operating earnings
 
158
 
198
 
532
 
645
                 
Interest expense, net
 
21
 
23
 
62
 
77
Income from equity investment in Genencor
 
--
 
--
 
--
 
(173)
Early debt extinguishment costs
 
--
 
--
 
--
 
46
Other (income) charges, net
 
1
 
(2)
 
(2)
 
(3)
Earnings before income taxes
 
136
 
177
 
472
 
698
Provision for income taxes
 
41
 
54
 
158
 
207
Net earnings
$
95
$
123
$
314
$
491
                 
Earnings per share
               
Basic
$
1.16
$
1.51
$
3.84
$
6.10
Diluted
$
1.15
$
1.50
$
3.79
$
6.01
                 
Comprehensive Income
               
Net earnings
$
95
$
123
$
314
$
491
Other comprehensive income (loss)
               
Change in cumulative translation adjustment
 
(8)
 
(5)
 
32
 
(84)
Change in unrealized gains (losses) on investments, net of tax
 
--
 
5
 
(1)
 
18
Change in unrealized gains (losses) on derivative instruments, net of tax
 
(6)
 
--
 
5
 
1
Total other comprehensive income (loss)
 
(14)
 
--
 
36
 
(65)
Comprehensive income
$
81
$
123
$
350
$
426
                 
Retained Earnings
               
Retained earnings at beginning of period
$
2,070
$
1,806
$
1,923
$
1,509
Net earnings
 
95
 
123
 
314
 
491
Cash dividends declared
 
(36)
 
(36)
 
(108)
 
(107)
Retained earnings at end of period
$
2,129
$
1,893
$
2,129
$
1,893



The accompanying notes are an integral part of these consolidated financial statements.

3

 

CONSOLIDATED STATEMENTS OF FINANCIAL POSITION

   
September 30,
 
December 31,
(Dollars in millions, except per share amounts)
 
2006
 
2005
   
(Unaudited)
   
Assets
     
 
Current assets
       
Cash and cash equivalents
$
430
$
524
Trade receivables, net of allowance of $16 and $20
 
758
 
575
Miscellaneous receivables
 
81
 
81
Inventories
 
702
 
671
Other current assets
 
56
 
73
Current assets held for sale
 
132
 
--
Total current assets
 
2,159
 
1,924
         
Properties
       
Properties and equipment at cost
 
8,763
 
9,597
Less: Accumulated depreciation
 
5,707
 
6,435
Net properties
 
3,056
 
3,162
         
Goodwill
 
313
 
312
Other noncurrent assets
 
358
 
375
Noncurrent assets held for sale
 
180
 
--
Total assets
$
6,066
$
5,773
         
Liabilities and Stockholders’ Equity
       
Current liabilities
       
Payables and other current liabilities
$
1,041
$
1,047
Borrowings due within one year
 
3
 
4
Current liabilities related to assets held for sale
 
15
 
--
Total current liabilities
 
1,059
 
1,051
         
Long-term borrowings
 
1,586
 
1,621
Deferred income tax liabilities
 
264
 
317
Post-employment obligations
 
1,058
 
1,017
Other long-term liabilities
 
151
 
155
Long-term liabilities related to assets held for sale
 
46
 
--
Total liabilities
 
4,164
 
4,161
         
Stockholders’ equity
       
Common stock ($0.01 par value - 350,000,000 shares authorized; shares
issued - 90,214,704 and 89,566,115 for 2006 and 2005, respectively)
 
1
 
1
Additional paid-in capital
 
368
 
320
Retained earnings
 
2,129
 
1,923
Accumulated other comprehensive loss
 
(164)
 
(200)
   
2,334
 
2,044
Less: Treasury stock at cost (8,036,330 shares for 2006 and 8,034,901 shares for 2005)
 
432
 
432
         
Total stockholders’ equity
 
1,902
 
1,612
         
Total liabilities and stockholders’ equity
$
6,066
$
5,773
         

The accompanying notes are an integral part of these consolidated financial statements.

4

 

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

   
First Nine Months
(Dollars in millions)
 
2006
 
2005
         
Cash flows from operating activities
       
Net earnings
$
314
$
491
 
       
Adjustments to reconcile net earnings to net cash provided by operating activities:
       
Income from equity investment in Genencor
 
--
 
(173)
Depreciation and amortization
 
226
 
229
Gain on sale of assets
 
(5)
 
--
Early debt extinguishment costs
 
--
 
46
Asset impairments
 
20
 
1
Provision for deferred income taxes
 
49
 
130
Changes in operating assets and liabilities:
       
(Increase) decrease in receivables
 
(189)
 
(35)
(Increase) decrease in inventories
 
(134)
 
(141)
Increase (decrease) in trade payables
 
50
 
(5)
Increase (decrease) in liabilities for employee benefits and incentive pay
 
(60)
 
(108)
Other items, net
 
(38)
 
(58)
         
Net cash provided by operating activities
 
233
 
377
         
Cash flows from investing activities
       
Proceeds from sale of equity investment in Genencor, net
 
--
 
417
Additions to properties and equipment
 
(279)
 
(224)
Proceeds from sale of assets and investments
 
12
 
50
Additions to capitalized software
 
(12)
 
(8)
Other items, net
 
--
 
(5)
         
Net cash provided by (used in) investing activities
 
(279)
 
230
         
Cash flows from financing activities
       
Net increase (decrease) in commercial paper, credit facility and other borrowings
 
33
 
(84)
Repayment of borrowings
 
--
 
(544)
Dividends paid to stockholders
 
(108)
 
(106)
Proceeds from stock option exercises and other items
 
25
 
91
         
Net cash provided by (used in) financing activities
 
(50)
 
(643)
         
Effect of exchange rate changes on cash and cash equivalents
 
2
 
(3)
         
Net change in cash and cash equivalents
 
(94)
 
(39)
         
Cash and cash equivalents at beginning of period
 
524
 
325
         
Cash and cash equivalents at end of period
$
430
$
286

The accompanying notes are an integral part of these consolidated financial statements.

5

 

ITEM
Page
   
7
7
7
8
8
9
9
10
11
11
12
14
14
15
16
16
17
21
23
24
26
 
6

 
 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
1.  

The accompanying unaudited consolidated financial statements have been prepared by Eastman Chemical Company (the "Company" or "Eastman") in accordance and consistent with the accounting policies stated in the Company's 2005 Annual Report on Form 10-K, except as described in Note 17 to the Company's unaudited financial statements in this Form 10-Q, and should be read in conjunction with the consolidated financial statements in Part II, Item 8 of the Company’s 2005 Annual Report on Form 10-K. In the opinion of the Company, all normal recurring adjustments necessary for a fair presentation have been included in the unaudited consolidated financial statements. The unaudited consolidated financial statements are prepared in conformity with accounting principles generally accepted ("GAAP") in the United States and, of necessity, include some amounts that are based upon management estimates and judgments. Future actual results could differ from such current estimates. The unaudited consolidated financial statements include assets, liabilities, revenues and expenses of all majority-owned subsidiaries and joint ventures. Eastman accounts for other joint ventures and investments in minority-owned companies where it exercises significant influence on the equity basis. Intercompany transactions and balances are eliminated in consolidation. The Company has reclassified certain 2005 amounts to conform to the 2006 presentation including the reclassification of segment sales and operating earnings. For additional information, see Note 18 to the Company's unaudited consolidated financial statements.  
 
2.  
 
 
September 30,
 
December 31,
(Dollars in millions)
2006
 
2005
       
At FIFO or average cost (approximates current cost)
     
Finished goods
$
672
$
664
Work in process
227
 
207
Raw materials and supplies
378
 
247
Total inventories
1,277
 
1,118
LIFO Reserve
(466)
 
(447)
Inventories before assets held for sale
 
811
 
671
Assets held for sale (1)
 
(109)
 
--
Total inventories
$
702
$
671

(1)  
For more information regarding assets held for sale, see Note 5 to the Company's unaudited consolidated financial statements. 

Inventories valued on the LIFO method were approximately 60% as of September 30, 2006 and 65% as of December 31, 2005 of total inventories.

3.  
 
The Company has a 50 percent interest in and serves as the operating partner in Primester, a joint venture which manufactures cellulose acetate at Eastman's Kingsport, Tennessee plant. This investment is accounted for under the equity method. During fourth quarter 2005, the Company provided a line of credit to the joint venture of up to $125 million, which Primester fully utilized to repay the principal amount of the joint venture's third-party borrowings, previously guaranteed by Eastman. The Company holds an interest-bearing note receivable. Eastman's investment in the joint venture was approximately $87 million and $86 million at September 30, 2006 and December 31, 2005, respectively, which was comprised of the recognized portion of the venture's accumulated deficits and the line of credit of $125 million. Such amount was included in other noncurrent assets.


7

 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
Eastman also owns a 50 percent interest in Nanjing Yangzi Eastman Chemical Ltd. ("Nanjing"), a company which manufactures Eastotac hydrocarbon tackifying resins for the adhesives market. This joint venture is accounted for under the equity method and is included in other noncurrent assets. At September 30, 2006 and December 31, 2005, the Company’s investment in Nanjing was approximately $5 million.
 
4.  

On April 21, 2005, the Company completed the sale of its preferred and common stock of Genencor International, Inc. ("Genencor") for cash proceeds of approximately $417 million, net of $2 million in fees. The book value of the investment prior to sale was $246 million, and the Company recorded a pre-tax gain on the sale of $171 million.

5.  

   
September 30,
(Dollars in millions)
 
2006
Current assets
   
Trade receivables, net
$
23
Inventories
 
109
Total current assets
 
132
     
Non-current assets
   
Properties and Equipment, net
 
174
Other non-current assets
 
6
Total non-current assets
 
180
Total assets
$
312
     
Current liabilities
   
Payables and other current liabilities, net
$
15
Total current liabilities
 
15
     
Long-term liabilities
   
Deferred income tax liabilities
 
40
Other long term liabilities
 
6
Total long-term liabilities
 
46
Total liabilities
$
61
     

For the third quarter 2006, the Company reclassified certain businesses and product lines and related assets as held for sale based on entry into two definitive agreements for the sale of those assets and recorded an impairment charge of $11 million to adjust the asset values to the sales amounts less cost to sell. These businesses and product lines are (i) the specialty organic chemicals product lines of the Performance Chemicals and Intermediates ("PCI") segment at the Batesville, Arkansas manufacturing facility and (ii) the Polyethylene and Epolene polymer businesses, related assets and the Company's ethylene pipeline in the Coatings, Adhesives, Specialty Polymers and Inks ("CASPI") and Performance Polymers segments.

The Company has concluded that the assets, businesses and product lines being sold should not be reported as discontinued operations per Statement of Financial Accounting Standards ("SFAS") No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," due to supply agreements between the Company and the buyers that will continue beyond the date of sale.


8

 
 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
6.  
 
   
September 30,
 
December 31,
(Dollars in millions)
 
2006
 
2005
         
Trade creditors
$
590
$
534
Accrued payrolls, vacation, and variable-incentive compensation
 
120
 
154
Accrued taxes
 
--
 
49
Post-employment obligations
 
65
 
134
Interest payable
 
26
 
31
Bank overdrafts
 
89
 
10
Other
 
166
 
135
Payables and other current liabilities before assets held for sale
 
1,056
 
1,047
Assets held for sale (1)
 
(15)
 
--
Total payables and other current liabilities
$
1,041
$
1,047

(1) For more information regarding assets held for sale, see Note 5 to the Company's unaudited consolidated financial statements. 

7.  

 
Third Quarter
 
First Nine Months
(Dollars in millions)
2006
 
2005
 
Change
 
2006
 
2005
 
Change
                       
Provision for income taxes
$
41
$
54
 
(24)%
$
158
$
207
 
(24)%
Effective tax rate
 
30 %
 
31 %
     
34 %
 
30 %
   

The third quarter and first nine months 2006 effective tax rate reflects the Company's expected annual tax rate on reported operating earnings before income tax, excluding discrete items, of approximately 34 percent. The third quarter 2006 effective tax rate was impacted by the reversal of foreign loss valuation allowances. The implementation of SFAS No. 123 Revised December 2004 ("SFAS No. 123 (R)"), "Share Based Payment", effective January 1, 2006, did not have a material effect on the Company's effective income tax rate in the third quarter and first nine months 2006. For additional information regarding SFAS No. 123 (R), see Note 17 to the Company's unaudited consolidated financial statements.

The third quarter 2005 effective tax rate reflects the Company's then expected annual tax rate on reported operating earnings before income tax, excluding discrete items, of approximately 30 percent and higher applicable tax rates related to the early extinguishment of debt costs and the gain on the sale of Genencor stock. The first nine months 2005 effective tax rate also reflects a net deferred tax benefit adjustment related to the expected utilization of capital loss carryforwards.

As described in Note 19 to the consolidated financial statements in Part II, Item 8 of the Company’s 2005 Annual Report on Form 10-K, the Company has significant foreign net operating loss carryforwards and related valuation allowances. Future tax provisions may be positively or negatively impacted to the extent that the realization of these carryforwards is greater or less than anticipated.

9

 
 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
8.  
 
   
September 30,
 
December 31,
(Dollars in millions)
 
2006
 
2005
         
Borrowings consisted of:
       
3 1/4% notes due 2008
$
72
$
72
7% notes due 2012
 
141
 
142
6.30% notes due 2018
 
182
 
185
7 1/4% debentures due 2024
 
497
 
497
7 5/8% debentures due 2024
 
200
 
200
7.60% debentures due 2027
 
297
 
297
Credit facility borrowings
 
182
 
214
Other
 
18
 
18
Total borrowings
 
1,589
 
1,625
Borrowings due within one year
 
(3)
 
(4)
Long-term borrowings
$
1,586
$
1,621

At September 30, 2006, the Company has credit facilities with various U.S. and non-U.S. banks totaling approximately $880 million as disclosed in Note 7 to the consolidated financial statements in Part II, Item 8 of the Company's 2005 Annual Report on Form 10-K. These credit facilities consist of a $700 million revolving credit facility (the "Credit Facility"), which was amended in April 2006 to extend the expiration date to April 2011, and a 144 million euro credit facility ("Euro Facility") which expires in December 2010. Borrowings under these credit facilities are subject to interest at varying spreads above quoted market rates. These credit facilities require facility fees on the total commitment that are based on Eastman's credit rating. In addition, these credit facilities contain a number of covenants and events of default, including the maintenance of certain financial ratios. The Company's combined credit facility borrowings at September 30, 2006 and December 31, 2005 were $182 million and $214 million at weighted average interest rates of 3.49 percent and 3.01 percent, respectively.

The Credit Facility provides liquidity support for commercial paper borrowings and general corporate purposes. Accordingly, any outstanding commercial paper borrowings reduce borrowings available under the Credit Facility. Since the Credit Facility expires in April 2011, any commercial paper borrowings supported by the Credit Facility are classified as long-term borrowings because the Company has the ability to refinance such borrowings on a long-term basis.

At September 30, 2006 and December 31, 2005, the Company had outstanding interest rate swaps associated with the entire outstanding principle of the 7% notes due in 2012 and $150 million of the outstanding principle of the 6.30% notes due in 2018. The average variable interest rate on the 7% notes was 7.89 percent and 7.22 percent for September 30, 2006 and December 31, 2005, respectively. The average variable interest rate on the 6.30% notes was 6.30 percent and 5.63 percent for September 30, 2006 and December 31, 2005, respectively.

10

 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
9.  

In the second quarter 2005, the Company completed the early repayment of $500 million of its outstanding long-term debt for $544 million in cash, which resulted in a charge of $46 million for early debt extinguishment costs including $2 million in unamortized bond issuance costs. The book value of the repaid debt was $500 million, as follows:

(dollars in millions)
 
Book Value
     
3 1/4% notes due 2008
$
178
6.30% notes due 2018
 
68
7% notes due 2012
 
254
Total
$
500

10.  

In the third quarter and first nine months 2006, asset impairments and restructuring charges totaled $13 million and $23 million, respectively. During the third quarter 2006, the Company classified the Batesville, Arkansas manufacturing facility as an asset group held for sale and recorded a related $11 million impairment charge to reduce the recorded book value of the assets to the contracted sales price. Other charges for the year relate primarily to previously closed manufacturing facilities. 

During the third quarter 2005, the Company recognized pre-tax restructuring charges of approximately $4 million, related primarily to Cendian Corporation's ("Cendian") shutdown of its business activities.
 
For the first nine months 2005, pre-tax restructuring charges totaled $23 million, primarily related to Cendian's shutdown of its business activities as well as the closure of other manufacturing facilities. Included in the $23 million are approximately $4 million in severance charges recognized within the PCI segment related to the severance of approximately 90 employees at the Company's Batesville, Arkansas manufacturing facility.
 
 

11

 
 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
Changes in Reserves for Asset Impairments, Restructuring Charges, and Severance Charges

The following table summarizes the beginning reserves, charges to and changes in estimates to the reserves as described above, and the cash and non-cash reductions to the reserves attributable to asset impairments and the cash payments for severance and site closure costs for the full year 2005 and the first nine months 2006:
 
 
(Dollars in millions)
 
Balance at
January 1, 2005
 
Provision/ Adjustments
 
Non-cash Reductions
 
Cash Reductions
 
Balance at
December 31, 2005
                     
Non-cash charges
$
--
$
12
$
(12)
$
--
$
--
Severance costs
 
26
 
3
 
--
 
(26)
 
3
Site closure and other restructuring costs
 
9
 
18
 
(1)
 
(19)
 
7
Total
$
35
$
33
$
(13)
$
(45)
$
10
                     
   
Balance at
January 1, 2006
 
Provision/ Adjustments
 
Non-cash Reductions
 
Cash Reductions
 
Balance at
September 30, 2006
                     
Non-cash charges
$
--
$
21
$
(21)
$
--
$
--
Severance costs
 
3
 
--
 
--
 
(1)
 
2
Site closure and other restructuring costs
 
7
 
2
 
--
 
--
 
9
Total
$
10
$
23
$
(21)
$
(1)
$
11

A majority of the remaining severance and site closure costs is expected to be applied to the reserves within one year.
 
11.  

DEFINED BENEFIT PENSION PLANS
 
Eastman maintains defined benefit plans that provide eligible employees with retirement benefits. Costs recognized for these benefits are recorded using estimated amounts, which may change as actual costs derived for the year are determined.
 
Below is a summary of the components of net periodic benefit cost recognized for Eastman's significant defined benefit pension plans:
 
Summary of Components of Net Periodic Benefit Costs
       
   
Third Quarter
 
First Nine Months
(Dollars in millions)
 
2006
 
2005
 
2006
 
2005
                 
Service cost
$
11
$
11
$
33
$
32
Interest cost
 
21
 
20
 
61
 
59
Expected return on assets
 
(21)
 
(21)
 
(65)
 
(59)
Amortization of:
               
Prior service credit
 
(3)
 
(2)
 
(7)
 
(8)
Actuarial loss
 
9
 
9
 
28
 
27
Net periodic benefit cost
$
17
$
17
$
50
$
51

In July 2006, the Company announced plans to change the U.S. defined benefit plans such that employees hired on or after January 1, 2007 will not be eligible for those plans. This change will not impact net periodic benefit cost in 2006 and will begin to impact the financial statements in first quarter 2007.

12

 
 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
As of September 30, 2006, the Company has contributed $75 million to its U.S. defined benefit plans during 2006.

DEFINED CONTRIBUTION PLANS

The Company sponsors a defined contribution employee stock ownership plan (the "ESOP"), a qualified plan under Section 401(a) of the Internal Revenue Code, which is a component of the Eastman Investment Plan and Employee Stock Ownership Plan ("EIP/ESOP"). Eastman anticipates that it will make annual contributions for substantially all U.S. employees equal to five percent of eligible compensation to the ESOP, or for employees who have five or more prior ESOP contributions, to either the Eastman Stock Fund or other investment funds within the EIP. Employees may diversify to other investment funds within the EIP from the ESOP at any time without restrictions.

In July 2006, the Company amended its EIP/ESOP to provide a company match of 50 percent of the first 7 percent of an employee's compensation contributed to the plan for employees who are hired on or after January 1, 2007. Employees who are hired on or after January 1, 2007, will also be eligible for the 5 percent contribution to the ESOP as described above.

POSTRETIREMENT WELFARE PLANS

Eastman provides life insurance and health care benefits for eligible retirees, and health care benefits for retirees' eligible survivors. Similar benefits are also provided to retirees of Holston Defense Corporation ("HDC"), a wholly-owned subsidiary of the Company that, prior to January 1, 1999, operated a government-owned ammunition plant. HDC’s contract with the Department of the Army ("DOA") provided for reimbursement of allowable costs incurred by HDC, including certain postretirement welfare costs, for as long as HDC operated the plant. After the contract was terminated at the end of 1998, the Army did not contribute further to these costs. The Company continues to accrue and pay for the costs related to HDC retirees, and has pursued extraordinary relief from the DOA for reimbursement of these and other previously expensed employee benefit costs. In October 2006, HDC received notification that the request for extraordinary contractual relief to provide funding for post-retirement benefits had been approved by the DOA, and HDC expects the decision to be effective during the fourth quarter 2006. The Company will begin recognizing the impact of any reimbursement in the period settled by recording an unrecognized gain which will be amortized into earnings over a period of time.

In general, Eastman provides those benefits to retirees eligible under the Company's U.S. pension plans. A few of the Company's non-U.S. operations have supplemental health benefit plans for certain retirees, the cost of which is not significant to the Company. Costs recognized for these benefits are recorded using estimated amounts, which may change as actual costs derived for the year are determined. Below is a summary of the components of net periodic benefit cost recognized for the Company’s U.S. plans:

Summary of Components of Net Periodic Benefit Costs
       
   
Third Quarter
 
First Nine Months
(Dollars in millions)
 
2006
 
2005
 
2006
 
2005
                 
Service cost
$
2
$
2
$
6
$
6
Interest cost
 
10
 
11
 
31
 
32
Amortization of:
               
Prior service credit
 
(5)
 
(6)
 
(17)
 
(17)
Actuarial loss
 
3
 
5
 
11
 
15
Net periodic benefit cost
$
10
$
12
$
31
$
36

In July 2006, the Company announced plans to change its U.S. life insurance and health care benefit plans such that employees hired on or after January 1, 2007 will have access to post-retirement health care benefits only, while Eastman will not provide a company contribution toward the premium cost of post-retirement benefits for those employees. This change will begin to impact the financial statements in first quarter 2007.
 
13

 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
12.  

Certain Eastman manufacturing sites generate hazardous and nonhazardous wastes, the treatment, storage, transportation, and disposal of which are regulated by various governmental agencies. In connection with the cleanup of various hazardous waste sites, the Company, along with many other entities, has been designated a potentially responsible party ("PRP") by the U.S. Environmental Protection Agency under the Comprehensive Environmental Response, Compensation and Liability Act, which potentially subjects PRPs to joint and several liability for such cleanup costs. In addition, the Company will be required to incur costs for environmental remediation and closure and postclosure under the federal Resource Conservation and Recovery Act. Reserves for environmental contingencies have been established in accordance with Eastman’s policies described in Note 1 to the consolidated financial statements in Part II, Item 8 of the Company's 2005 Annual Report on Form 10-K. Because of expected sharing of costs, the availability of legal defenses, and the Company’s preliminary assessment of actions that may be required, management does not believe that the Company's liability for these environmental matters, individually or in the aggregate, will be material to the Company’s consolidated financial position, results of operations or cash flows. The Company’s reserve for environmental contingencies was $51 million at September 30, 2006 and December 31, 2005, representing the minimum or best estimate for remediation costs and the best estimate accrued to date over the facilities’ estimated useful lives for asset retirement obligation costs. Estimated future environmental expenditures for remediation costs range from the minimum or best estimate of $21 million to the maximum of $42 million at September 30, 2006 and at December 31, 2005.

13.  

Purchasing Obligations and Lease Commitments

At September 30, 2006, the Company had various purchase obligations totaling approximately $2.1 billion over a period of approximately 15 years for materials, supplies, and energy incident to the ordinary conduct of business. The Company also had various lease commitments for property and equipment under cancelable, non-cancelable, and month-to-month operating leases totaling approximately $200 million over a period of several years. Of the total lease commitments, approximately 15 percent relate to machinery and equipment, including computer and communications equipment and production equipment; approximately 45 percent relate to real property, including office space, storage facilities and land; and approximately 40 percent relate to vehicles, primarily railcars.

Accounts Receivable Securitization Program

In 1999, the Company entered into an agreement that allows the Company to sell certain domestic accounts receivable under a planned continuous sale program to a third party. The agreement permits the sale of undivided interests in domestic trade accounts receivable. Receivables sold to the third party totaled $200 million at September 30, 2006 and December 31, 2005. Undivided interests in designated receivable pools were sold to the purchaser with recourse limited to the purchased interest in the receivable pools. Average monthly proceeds from collections reinvested in the continuous sale program were approximately $334 million and $314 million in the third quarter 2006 and 2005, respectively, and $323 million and $283 million for the first nine months of 2006 and 2005, respectively.
 
Guarantees

Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"), clarifies the requirements of SFAS No. 5, “Accounting for Contingencies,” relating to the guarantor’s accounting for, and disclosure of, the issuance of certain types of guarantees. If certain operating leases are terminated by the Company, it guarantees a portion of the residual value loss, if any, incurred by the lessors in disposing of the related assets. Under these operating leases, the residual value guarantees at September 30, 2006 totaled $98 million and consisted primarily of leases for railcars, aircraft, and other equipment. The Company believes, based on current facts and circumstances, that a material payment pursuant to such guarantees is remote. Leases with guarantee amounts totaling $3 million, $27 million, and $68 million will expire in 2006, 2008, and 2012, respectively.

14

 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
Variable Interest Entities

The Company has evaluated material relationships and has concluded that the legal entities involved with these material relationships are not Variable Interest Entities ("VIEs") or, in the case of Primester, a joint venture that manufactures cellulose acetate at its Kingsport, Tennessee plant, the Company is not the primary beneficiary of the VIE. As such, in accordance with Interpretation No. 46R "Consolidation of Variable Interest Entities" ("FIN 46R"), the Company is not required to consolidate these entities. In addition, the Company has evaluated long-term purchase obligations with two entities that may be VIEs at September 30, 2006. These potential VIEs are joint ventures from which the Company has purchased raw materials and utilities for several years and purchases approximately $70 million of raw materials and utilities on an annual basis. The Company has no equity interest in these entities and has confirmed that one party to each of these joint ventures does consolidate the potential VIE. However, due to competitive and other reasons, the Company has not been able to obtain the necessary financial information to determine whether the entities are VIEs, and if one or both are VIEs, whether or not the Company is the primary beneficiary.

14.  

Hedging Programs

Financial instruments held as part of the hedging programs discussed below are recorded at fair value based upon comparable market transactions as quoted by brokers.

The Company is exposed to market risk, such as changes in currency exchange rates, raw material and energy costs and interest rates. The Company uses various derivative financial instruments pursuant to the Company's hedging policies to mitigate these market risk factors and their effect on the cash flows of the underlying transactions. Designation is performed on a specific exposure basis to support hedge accounting. The changes in fair value of these hedging instruments are offset in part or in whole by corresponding changes in the cash flows of the underlying exposures being hedged. The Company does not hold or issue derivative financial instruments for trading purposes. For further information, see Note 9 to the consolidated financial statements in Part II, Item 8 of the Company's 2005 Annual Report on Form 10-K.

At September 30, 2006, mark-to-market gains from raw material, currency and certain interest rate hedges that were included in accumulated other comprehensive loss totaled approximately $2 million. If realized, approximately $1 million in losses will be reclassified into earnings during the next 12 months. The mark-to-market gains or losses on non-qualifying, excluded and ineffective portions of hedges are immediately recognized in cost of sales or other income and charges. Such amounts did not have a material impact on earnings during the third quarter and first nine months 2006.

15

 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
15.  

A reconciliation of the changes in stockholders’ equity for the first nine months 2006 is provided below:

 
 
 
(Dollars in millions)
Common Stock at Par Value
$
Paid-in Capital
$
Retained Earnings
$
Accumulated Other Comprehensive Income (Loss)
$
Treasury Stock at Cost
$
Total Stockholders' Equity
$
Balance at December 31, 2005
1
320
1,923
(200)
(432)
1,612
             
Net Earnings
--
--
314
--
--
314
Cash Dividends Declared
--
--
(108)
--
--
(108)
Other Comprehensive Income
--
--
--
36
--
36
Stock Option Exercises and Other Items (1)
--
48
--
--
--
48
Balance at September 30, 2006
1
368
2,129
(164)
(432)
1,902

(1) The tax benefits relating to the difference between the amounts deductible for federal income taxes over the amounts charged to income for book purposes have been credited to paid-in capital.

 
 
 
 
(Dollars in millions)
 
 
Cumulative Translation Adjustment
 
 
Unfunded Minimum Pension Liability
 
 
Unrealized Gains (Losses) on Derivative Instruments
 
Unrealized Gains (Losses) on Investments
 
 
Accumulated Other Comprehensive Income (Loss)
                     
Balance at December 31, 2004
$
155
$
(248)
$
(8)
$
(2)
$
(103)
Period change
 
(94)
 
(7)
 
3
 
1
 
(97)
Balance at December 31, 2005
 
61
 
(255)
 
(5)
 
(1)
 
(200)
Period change
 
32
 
--
 
5
 
(1)
 
36
Balance at September 30, 2006
$
93
$
(255)
$
--
$
(2)
$
(164)

Except for cumulative translation adjustment, amounts of other comprehensive loss are presented net of applicable taxes. Because cumulative translation adjustment is considered a component of permanently invested unremitted earnings of subsidiaries outside the United States, no taxes are provided on such amounts.

16.  

 
Third Quarter
 
First Nine Months
 
2006
 
2005
 
2006
 
2005
               
Shares used for earnings per share calculation:
             
Basic
82.1
 
81.3
 
81.8
 
80.5
Diluted
83.1
 
82.0
 
82.8
 
81.7

In the third quarter and first nine months 2006, common shares underlying options to purchase 2,193,779 shares of common stock at a range of prices from $52.18 to $63.25 were excluded from the computation of diluted earnings per share because the option exercise prices were greater than the average market price of the common shares during those periods.
 
In the third quarter and first nine months 2005, common shares underlying options to purchase 1,210,088 shares of common stock at a range of prices from $52.19 to $67.50 and 854,187 shares of common stock at a range of prices from $56.50 to $67.50, respectively, were excluded from the computation of diluted earnings per share because the option exercise prices were greater than the average market price of the common shares during those periods.
 

16

 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
The Company declared cash dividends of $0.44 per share in the third quarters 2006 and 2005 and $1.32 per share in the first nine months 2006 and 2005.
 
17.  

On January 1, 2006, the Company adopted SFAS No. 123 (R). SFAS No. 123 (R) replaces SFAS No. 123, "Accounting for Stock-Based Compensation" and supersedes Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees" and amends SFAS No. 95, "Statement of Cash Flows". Prior to adoption, the Company implemented the disclosure-only requirements of SFAS No. 123 and continued to implement the requirements of APB No. 25 for financial statement reporting. Additional information regarding SFAS No. 123 (R), SFAS No. 123 and APB No. 25 may be found in Note 23 to the consolidated financial statements in Part II, Item 8 of the Company's 2005 Annual Report on Form 10-K.

The Company adopted SFAS No. 123 (R) using the "modified prospective" method that requires compensation expense of all employee and non-employee director share-based compensation awards be recognized in the financial statements based upon their fair value over the requisite service or vesting period: a) based upon the requirements of SFAS No. 123 (R) for all new awards granted after the effective date and b) based upon the requirements of SFAS No. 123 for all awards granted prior to the effective date of SFAS No. 123 (R) that remain unvested on the effective date. Under the requirements of APB No. 25, the Company was required to recognize compensation cost for such awards unless the employee or non-employee director paid an amount to acquire the awarded shares at least equal to the quoted market price of the stock at the measurement date (typically the date of grant). This requirement resulted in compensation expense recognition and reporting in the financial statements for most share-based awards (unrestricted stock awards, restricted stock awards, long-term performance stock awards and stock appreciation rights) except for stock options, substantially all of which were awarded at the closing market price of the Company's common stock on the date of grant. Effective with adoption of SFAS No. 123 (R), compensation expense related to stock option awards are recognized in the financial statements at their fair value.
 
The Company is authorized by the Board of Directors under the 2002 Omnibus Long-Term Compensation Plan and 2002 Director Long-Term Compensation Plan to provide grants to employees and non-employee members of the Board of Directors. Additional information regarding compensation plans may be found in Note 15 to the consolidated financial statements in Part II, Item 8 of the Company's 2005 Annual Report on Form 10-K. It has been the Company's practice to issue new shares rather than treasury shares for equity awards that require payment by the issuance of common stock and to withhold or accept back shares awarded necessary to cover the income taxes of employee participants. Shares of non-employee directors are not withheld or acquired for the withholding of their income taxes. Shares of unrestricted common stock owned by specified senior management level employees are accepted by the Company to pay for the exercise price of stock option exercises in accordance with the terms and conditions of the awards.
 

17

 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
In accordance with implementation requirements of SFAS No. 123 (R) under the modified prospective method, the Company did not restate prior fiscal periods and is required to continue the same disclosure-only requirements of SFAS No. 123 for comparative purposes until all periods reported are comparable on the same basis. The following table illustrates the effect on net earnings and earnings per share as formerly provided under SFAS No. 123:
 
 
Third Quarter
 
First Nine Months
(Dollars and shares in millions, except per share amounts)
2006
 
Proforma 2005
 
2006
 
Proforma 2005
               
Net earnings, as reported
$
95
$
123
$
314
$
491
                 
Add: Stock-based employee compensation expense
               
included in net earnings, as reported
 
2
 
--
 
9
 
7
                 
Deduct: Total additional stock-based employee compensation cost, net of tax, that would have been included in net earnings under fair value method
 
2
 
1
 
9
 
10
                 
Pro forma net earnings
$
95
$
122
$
314
$
488
                   
Basic earnings per share
As reported
$
1.16
$
1.51
$
3.84
$
6.10
 
Pro forma
$
N.A.
$
1.50
$
N.A.
$
6.06
                   
Diluted earnings per share
As reported
$
1.15
$
1.50
$
3.79
$
6.01
 
Pro forma
$
N.A.
$
1.49
$
N.A.
$
5.99

In the third quarter and first nine months 2006, approximately $4 million and $15 million, respectively, of compensation expense before tax was recognized in selling, general and administrative expense in the earnings statement for all share-based awards of which approximately $2 million and $6 million related to stock options in the third quarter and the first nine months 2006, respectively. The impact on third quarter 2006 net earnings of $2 million is net of a $2 million credit to deferred tax expense for recognition of deferred tax assets. The impact on the first nine months 2006 net earnings of $9 million is net of a $6 million credit to deferred tax expense for recognition of deferred tax assets.
 
The impact on the financial statements of implementing SFAS No. 123 (R) is the recognition of compensation expense for all stock options granted.


18

 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
Stock Option Awards

Option awards are granted to non-employee directors on an annual basis and to employees who meet certain eligibility requirements. A single large volume option grant is usually awarded to eligible employees in the fourth quarter of each year, if and when granted by the Compensation and Management Development Committee of the Board of Directors, and occasional individual grants are awarded to eligible employees throughout the year. Option awards have an exercise price equal to the closing price of the Company's stock on the date of grant. The term of options is ten years with vesting periods that vary up to three years. Vesting usually occurs ratably or at the end of the vesting period. The fair value of options cannot be determined by market value as they are not traded in an open market. Accordingly, a financial pricing model is utilized to determine fair value. The Company utilizes the Black Scholes Merton ("BSM") model which relies on certain assumptions to estimate an option's fair value. These weighted average assumptions relevant to options granted in the third quarter and first nine months 2006 and the same periods for 2005 are identified in the table below:

 
 
Assumptions
Third Quarter 2006
 
Third Quarter 2005
 
First Nine Months 2006
 
First Nine Months 2005
               
Exercise Price
$52.18
 
--
 
$56.25
 
$56.52
Expected term years
5.00
 
--
 
4.41
 
6.00
Expected volatility rate
22.58%
 
--
 
22.51%
 
27.90%
Expected dividend yield
3.37%
 
--
 
3.13%
 
3.70%
Average risk-free interest rate
4.99%
 
--
 
5.02%
 
3.50%
Expected forfeiture rate
0.75%
 
--
 
0.75%
 
Actual

In the third quarter and first nine months 2006, the Company granted 3,200 and 110,838 options, respectively. The Company did not grant any options during the third quarter 2005 and granted 64,788 options during the first nine months 2005.

Prior to adoption of SFAS No. 123 (R), the Company calculated the expected term of stock options using a standard formula prescribed in accounting literature which indicated a six year expected term. Effective with the fourth quarter 2005 large annual option award, the Company analyzed historical pre-vesting and post-vesting cancellations, forfeitures, expirations and exercise transactions of large annual grants to determine the expected term. The Company expects to analyze historical transactions preceding the large annual option grant to ensure that all assumptions based upon internal data reflect the most reasonable expectations for fair value analysis.

The volatility rate is derived from actual Company common stock volatility over the same time period as the expected term. The Company uses a weekly high closing stock price based upon daily closing prices in the week. The volatility rate is derived by mathematical formula utilizing the weekly high closing price data.

The expected dividend yield is derived by mathematical formula which uses the expected Company annual dividends over the expected term divided by the fair market value of the Company's common stock at the grant date.

The average risk-free interest rate is derived from United States Department of Treasury published interest rates of daily yield curves for the same time period as the expected term.


19

 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
Prior to adoption of SFAS No. 123 (R), the Company did not estimate forfeitures and recognized them as they occurred for proforma disclosure of share-based compensation expense. With adoption of SFAS No. 123 (R), estimated forfeitures must be considered in recording share-based compensation expense. While not actually utilized by the BSM model to determine the fair value amount of a share-based payment award, it is a factor that must be estimated, monitored and reviewed over the life of share-based compensation awards to record the most probable expected compensation expense related to the award. Estimated forfeiture rates vary with each type of award affected by several factors, one of which is the varying composition and characteristics of the award participants. Estimated forfeitures for the Company's share-based awards range from 0.75 percent to 10.0 percent with the estimated forfeitures for options at 0.75 percent.

The following tables provide a reconciliation of option activity for the first nine months 2006 and 2005:

Stock Options
Number of Shares
 
Weighted Average Exercise Price
Weighted Average Remaining Contractual Life (years)
 
Aggregate Intrinsic Value(1)
Outstanding at 12/31/2005
6,616,803
$
48.26
     
Grants
110,838
$
56.25
     
Exercises
(542,506)
$
44.82
 
$
5,938,424
Cancelled/Forfeited/Expired
(228,226)
$
55.65
     
Outstanding at 9/30/2006
5,956,909
$
48.44
5.6
$
37,167,411
Exercisable at 9/30/2006
4,173,751
$
47.12
4.3
$
32,447,135
             
Outstanding at 12/31/2004
8,155,148
$
46.86
     
Grants
64,788
$
56.52
     
Exercises
(2,159,797)
$
43.27
 
$
32,982,186
Cancelled/Forfeited/Expired
(469,135)
$
63.65
     
Outstanding at 9/30/2005
5,591,004
$
46.93
5.4
$
15,808,530
Exercisable at 9/30/2005
4,628,774
$
47.24
4.8
$
13,758,499

(1) Intrinsic value is the amount by which the market price of the stock or the market price at the exercise date underlying the option exceeds the exercise price of the option.

A total of 1,783,158 options are unvested at September 30, 2006 for which $12 million in compensation expense will be recognized over 3 years. A total of 962,230 options were unvested at September 30, 2005. Cash proceeds from the exercise of options in the first nine months 2006 total approximately $23 million with a related tax benefit of approximately $2 million.

Other Share-Based Compensation Awards

In addition to stock option awards, the Company has long-term performance stock awards, restricted stock awards and stock appreciation rights. The long-term performance awards are based upon return on capital and total shareholder return. The recognized compensation cost before tax for these other share-based awards in the third quarter and first nine months 2006, is approximately $2 million and $9 million, respectively. The unrecognized compensation cost before tax for these same awards total approximately $18 million at September 30, 2006 and will be recognized through 2009.

20

 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
18.  

The Company's products and operations are managed and reported in five reportable operating segments, consisting of the CASPI segment, the Fibers segment, the PCI segment, the Performance Polymers segment and the Specialty Plastics ("SP") segment. The Company's segments were previously aligned in a divisional structure that provided for goods and services to be transferred between divisions at predetermined prices that may have been in excess of cost, which resulted in the recognition of intersegment sales revenue and operating earnings. Such interdivisional transactions were eliminated in the Company's consolidated financial statements. In first quarter 2006, the Company realigned its organizational structure to support its growth strategy and to better reflect the integrated nature of the Company's assets. A result of the realigned organizational structure is that goods and services are transferred among the segments at cost. As part of this change, the Company's segment results have been restated to eliminate the impact of interdivisional sales revenue and operating earnings. For additional information concerning the Company's segments' businesses and products, refer to Note 21 to the consolidated financial statements in Part II, Item 8 of the Company's 2005 Annual Report on Form 10-K and the Form 8-K filed on April 20, 2006.

In the first quarter of 2006, management determined that the Developing Businesses ("DB") segment is not of continuing significance for financial reporting purposes. As a result, revenues and costs previously included in the DB segment and research and development expenses not identifiable to an operating segment are not included in segment operating results for either of the periods presented and are shown in the tables below as "other" revenues and operating losses.

   
Third Quarter
(Dollars in millions)
 
2006
 
2005
Sales by Segment
       
CASPI
$
367
$
333
Fibers
 
228
 
228
PCI
 
457
 
428
Performance Polymers
 
707
 
646
SP
 
207
 
179
Total Sales by Segment
 
1,966
 
1,814
Other
 
--
 
2
         
Total Sales
$
1,966
$
1,816
         

   
First Nine Months
(Dollars in millions)
 
2006
 
2005
Sales by Segment
       
CASPI
$
1,078
$
977
Fibers
 
696
 
633
PCI
 
1,321
 
1,214
Performance Polymers
 
2,007
 
1,944
SP
 
596
 
536
Total Sales by Segment
 
5,698
 
5,304
Other
 
--
 
26
         
Total Sales
$
5,698
$
5,330
         


21

 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
   
Third Quarter
(Dollars in millions)
 
2006
 
2005 
         
Operating Earnings (Loss) (1)
       
CASPI (1)
$
53
$
63
Fibers
 
55
 
60
PCI (1)
 
25
 
40
Performance Polymers
 
17
 
32
SP
 
18
 
17
Total Operating Earnings by Segment
 
168
 
212
Other (1)
 
(10)
 
(14)
         
Total Operating Earnings
$
158
$
198

(1)  
Operating earnings (loss) for the following segments include asset impairments and restructuring charges: CASPI includes $1 million in third quarter 2005 for previously closed manufacturing facilities; PCI includes $11 million in third quarter 2006 for the expected divestiture of the Arkansas facility and Other includes $4 million for Cendian's shutdown of its business activities.

   
First Nine Months
(Dollars in millions)
 
2006
 
2005 
         
Operating Earnings (Loss) (1)
       
CASPI (2)
$
176
$
194
Fibers
 
182
 
155
PCI (2)
 
113
 
128
Performance Polymers
 
46
 
166
SP
 
50
 
59
Total Operating Earnings by Segment
 
567
 
702
Other (2)
 
(35)
 
(57)
         
Total Operating Earnings
$
532
$
645

(2)  
Operating earnings (loss) for the following segments include asset impairments and restructuring charges: CASPI includes $8 million and $3 million in the first nine months 2006 and 2005, respectively, for previously closed manufacturing facilities; PCI includes $11 million and $4 million in the first nine months 2006 and 2005, respectively, for the expected divestiture of the Arkansas facility and Other includes $4 million and $16 million for the first nine months 2006 and 2005, respectively for Cendian's shutdown of its business activities.

22

 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
   
September 30,
 
December 31,
(Dollars in millions)
 
2006
 
2005
         
Assets by Segment
       
CASPI 
$
1,509
$
1,393
Fibers
 
612
 
675
PCI
 
1,541
 
1,589
Performance Polymers
 
1,318
 
1,416
SP
 
772
 
689
Total Assets by Segment Before Assets Held for Sale
 
5,752
 
5,762
Other
 
2
 
11
Assets Held for Sale (3)
 
312
 
--
         
Total Assets
$
6,066
$
5,773
         

(3)  
For more information regarding assets held for sale, see Note 5 to the Company's unaudited consolidated financial statements. 
 
 
19.  

General

From time to time, the Company and its operations are parties to, or targets of, lawsuits, claims, investigations and proceedings, including product liability, personal injury, asbestos, patent and intellectual property, commercial, contract, environmental, antitrust, health and safety, and employment matters, which are being handled and defended in the ordinary course of business. While the Company is unable to predict the outcome of these matters, it does not believe, based upon currently available facts, that the ultimate resolution of any such pending matters, including the sorbates litigation and the asbestos litigation (described below), will have a material adverse effect on its overall financial condition, results of operations or cash flows. However, adverse developments could negatively impact earnings or cash flows in a particular future period.

Sorbates Litigation

Two civil cases relating to sorbates remain. In each case, the Company prevailed at the trial court, and in each case, the plaintiff has appealed the trial court's decision. The Company intends to vigorously defend its position at the appellate court level in both cases.
 
Asbestos Litigation 

Over the years, Eastman has been named as a defendant, along with numerous other defendants, in lawsuits in various state courts in which plaintiffs have alleged injury due to exposure to asbestos at Eastman’s manufacturing sites and sought unspecified monetary damages and other relief. Historically, these cases have been dismissed or settled without a material effect on Eastman’s financial condition, results of operations, or cash flows.

In certain recently filed cases, plaintiffs allege exposure to asbestos-containing products allegedly made by Eastman. Based on its investigation to date, the Company has information that it manufactured limited amounts of an asbestos-containing plastic product between the mid-1960’s and the early 1970’s. The Company’s investigation has found no evidence that any of the plaintiffs worked with or around any such product alleged to have been manufactured by the Company. The Company intends to defend vigorously all such claims or to settle them on acceptable terms.

The Company has finalized an agreement with an insurer that issued primary general liability insurance to certain predecessors of the Company prior to the mid-1970's, pursuant to which that insurer will provide coverage for a portion of certain of the Company's defense costs and payments of settlements or judgments in connection with asbestos-related lawsuits.

23

 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
Evaluation of the allegations and claims made in recent asbestos-related lawsuits continue to be reviewed by the Company. Based on such evaluation to date, the Company continues to believe that the ultimate resolution of the approximately 1,000 pending asbestos claims will not have a material impact on the Company’s financial condition, results of operations, or cash flows, although these matters could result in the Company being subject to monetary damages, costs or expenses, and charges against earnings in particular periods. To date, costs incurred by the Company related to the recent asbestos-related lawsuits have not been material.

20.  

In February 2006, the Financial Accounting Standards Board ("FASB") issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments,” an amendment of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," and SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities." SFAS No. 155 simplifies accounting for certain hybrid instruments under SFAS No. 133 by permitting fair value remeasurement for financial instruments containing an embedded derivative that otherwise would require bifurcation. SFAS No. 155 eliminates both the previous restriction under SFAS No. 140 on passive derivative instruments that a qualifying special-purpose entity may hold and SFAS No. 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets,” which provides that beneficial interests are not subject to the provisions of SFAS No. 133. SFAS No. 155 also establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, and clarifies that concentrations of credit risk in the form of subordination are not imbedded derivatives. SFAS No. 155 is effective for all financial instruments acquired, issued, or subject to a remeasurement event occurring after the beginning of an entity’s fiscal year that begins after September 15, 2006. The Company has evaluated the effect of SFAS No. 155 and determined that it does not expect a material impact from the adoption to its consolidated financial position, liquidity, or results from operations.

In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets,” an amendment of SFAS No. 140. SFAS No. 156 permits entities to choose to either subsequently measure servicing rights at fair value and report changes in fair value in earnings or amortize servicing rights in proportion to and over the estimated net servicing income or loss and assess to rights for impairment or the need for an increased obligation. SFAS No. 156 also clarifies when a servicer should separately recognize servicing assets and liabilities; requires all separately recognized assets and liabilities to be initially measured at fair value, if practicable; permits a one-time reclassification of available-for-sales securities to trading securities by an entity with recognized servicing rights and requires additional disclosures for all separately recognized servicing assets and liabilities. SFAS No. 156 is effective as of the beginning of an entity’s fiscal year that begins after September 15, 2006. The Company has evaluated the effect of SFAS No. 156 and determined that it does not expect a material impact from the adoption to its consolidated financial position, liquidity, or results from operations.

In July 2006, the FASB issued Interpretation No. 48 ("FIN 48"), "Accounting for Uncertainty in Income Taxes—an Interpretation of SFAS 109 "Accounting for Income Taxes". FIN 48 prescribes a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that a company has taken or expects to take on a tax return. Under FIN 48, the financial statements will reflect expected future tax consequences of such positions presuming the taxing authorities' full knowledge of the position and all relevant facts, but without considering time values. FIN 48 also revises disclosure requirements and introduces a prescriptive, annual, tabular roll-forward of the unrecognized tax benefits. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the effect FIN 48 will have on its consolidated financial position, liquidity, or results of operations.

24

 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," which addresses the measurement of fair value by companies when they are required to use a fair value measure for recognition or disclosure purposes under GAAP. SFAS No. 157 provides a common definition of fair value to be used throughout GAAP which is intended to make the measurement of fair value more consistent and comparable and improve disclosures about those measures. SFAS No. 157 will be effective for an entity's financial statements issued for fiscal years beginning after November 15, 2007. The Company is currently evaluating the effect SFAS No. 157 will have on its consolidated financial position, liquidity, or results of operations.

In September 2006, the FASB issued SFAS No. 158, "Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106, and 132(R)". One objective of this standard is to make it easier for investors, employees, retirees and other parties to understand and assess an employer’s financial position and its ability to fulfill the obligations under its benefit plans. SFAS No. 158 requires employers to fully recognize in their financial statements the obligations associated with single-employer defined benefit pension plans, retiree healthcare plans, and other postretirement plans. SFAS No. 158 requires an employer to fully recognize in its statement of financial position the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. This Statement also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions. SFAS No. 158 requires an entity to recognize as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost pursuant to SFAS No. 87. This Statement requires an entity to disclose in the notes to financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits, and transition asset or obligation. The Company is required to initially recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures for fiscal years ending after December 15, 2006. Based on the funded status of Eastman's pension and postretirement benefit plans in the December 31, 2005 Annual Report on Form 10-K, the adoption of SFAS No. 158 will result in a $128 million reduction to stockholders' equity.
 
In September 2006, the Securities and Exchange Commission ("SEC") published Staff Accounting Bulletin No. 108 ("SAB 108") which expresses the SEC staff's views regarding the process to be applied in considering the effects of prior years' misstatements when quantifying misstatements in the current year's financial statements. Registrants must quantify the impact on the current year's financial statements of correcting all misstatements, including the carryover and reversing effects of prior years' misstatements, as well as the effects of errors arising in the current year. If material to the current year's income statement, correction of existing accumulated balance sheet misstatements (i.e., from immaterial errors in prior years) should be accomplished by correcting the financial statements of affected previous years. However, in such case, previously filed reports would not require amendment; rather, corrections should be made the next time such prior years' statements are filed with the SEC. The Company does not expect to change its current practice regarding accounting for misstatements and does not expect the need for restatement of prior periods as a result of SAB 108.

In September 2006, the FASB issued Staff Position No. AUG AIR-1 ("FSP No. AUG AIR-1") which addresses the accounting for planned major maintenance activities. FSP No. AUG AIR-1 amends certain provisions in the American Institute of Certified Public Accountants ("AICPA") Industry Audit Guide and APB Opinion No. 28, "Interim Financial Reporting". Four alternative methods of accounting for planned major maintenance activities were permitted: direct expense, built-in overhaul, deferral, and accrual ("accrue-in-advance"). This FSP prohibits the use of the accrue-in-advance method of accounting for planned major maintenance activities because it results in the recognition of a liability in a period prior to the occurrence of the transaction or event obligating the entity. FSP No. AUG AIR-1 is effective for an entity's financial statements issued for fiscal years beginning after December 15, 2006. The Company does not utilize the accrue-in-advance method of accounting and therefore expects this FSP to have no impact on its consolidated financial position, liquidity, or results of operations.

25

 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
21.  
 
In October 2006, the Company announced a definitive agreement for the sale of its polyethylene businesses for a purchase price of $255 million in cash at closing. The sale will include Eastman's polyethylene and Epolene polymer businesses, related assets, and the Company's ethylene pipeline. Subject to regulatory approval and satisfaction of customary conditions, the sale is expected to be completed in fourth quarter 2006. Results from the polyethylene product lines are reported in the Performance Polymers segment and results from the Epolene polymer businesses are reported in the CASPI Segment.

In October 2006, the Company decided to cease production of cyclohexane dimethanol ("CHDM") modified polymers, intermediate products primarily used internally, in San Roque, Spain to gain operational efficiencies at other facilities, which will result in asset impairment and restructuring charges in the fourth quarter 2006 of approximately $25 million.




26

 

 
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

ITEM
Page
   
27
   
28
   
29
   
32
   
37
   
38
   
41
   
43
   
44
   

This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company's audited consolidated financial statements, including related notes, and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in the Company's 2005 Annual Report on Form 10-K, and the Company's unaudited consolidated financial statements, including related notes, included elsewhere in this report. All references to earnings per share contained in this report are diluted earnings per share unless otherwise noted.

CRITICAL ACCOUNTING POLICIES

In preparing the consolidated financial statements in conformity with accounting principles generally accepted ("GAAP") in the United States, Eastman Chemical Company's (the "Company" or "Eastman") management must make decisions which impact the reported amounts and the related disclosures. Such decisions include the selection of the appropriate accounting principles to be applied and assumptions on which to base estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, the Company evaluates its estimates, including those related to allowances for doubtful accounts, impaired assets, environmental costs, U.S. pension and other post-employment benefits, litigation and contingent liabilities, and income taxes. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The Company’s management believes the critical accounting policies listed and described in Part II, Item 7 of the Company's 2005 Annual Report on Form 10-K are the most important to the fair presentation of the Company’s financial condition and results. These policies require management’s more significant judgments and estimates in the preparation of the Company’s consolidated financial statements.


27

 
MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
OVERVIEW

Sales revenue in third quarter 2006 was $2.0 billion, an 8 percent increase over third quarter 2005. Sales revenue in the first nine months 2006 was $5.7 billion, a 7 percent increase over the first nine months 2005. Operating earnings were $158 million in third quarter 2006, a $40 million decrease from third quarter 2005. Operating earnings were $532 million in the first nine months 2006, a $113 million decrease from first nine months 2005. Despite higher raw material and energy costs, especially for paraxylene in the Performance Polymers and Specialty Plastics ("SP") segments and for propane in all segments except Fibers, these results reflect strong earnings from a broad base of businesses. Third quarter and first nine months 2006 results were negatively impacted by $13 million and $23 million, respectively, in asset impairments and restructuring charges compared to $4 million and $23 million for the comparable periods in 2005.

First nine months 2006 results were negatively impacted by approximately $15 million of costs, net of insurance, associated with operational disruptions at the Company's Longview, Texas, manufacturing facility, primarily in the first quarter 2006. The Company expects no further impact on results in the fourth quarter 2006 from these events.

Net earnings for the third quarter 2006 and first nine months 2006 were $95 million and $314 million, respectively, versus the third quarter and first nine months 2005 net earnings of $123 million and $491 million, respectively. Included in 2005 results were a $171 million gain on the sale of the Company's equity investment in Genencor International, Inc. ("Genencor") and early debt retirement costs of $46 million.

The Company generated $233 million in cash from operating activities in the first nine months 2006, a decrease of $144 million compared to the first nine months 2005 due to the prior year's higher net earnings and the current year's increase in working capital, partially offset by lower pension contributions in the current year.

The Company continues to evaluate its portfolio, which could lead to further restructuring, divestiture, or consolidation of product lines. As previously announced, the Company has entered into definitive agreements for the sale of its Batesville, Arkansas manufacturing facility and related assets and the specialty organic chemicals product lines in the Performance Chemicals and Intermediates ("PCI") segment and for the sale of its polyethylene and Epolene polymer businesses and related assets of the Performance Polymers and Coatings, Adhesives, Specialty Polymers, and Inks ("CASPI") segments located at the Longview, Texas site, and the Company's ethylene pipeline. These sales are for a cash purchase price of $330 million at closing. Subject to regulatory approval and satisfaction of customary conditions, both divestitures are expected to be completed in fourth quarter 2006. For the first nine months of 2006, sales revenue of $667 million and operating earnings of $50 million were attributed to the product lines being divested.

With the continuing successful implementation of the Company's turnaround strategy, as evidenced by strong operating results and a strengthened financial profile, the Company believes that it is positioned for profitable growth. This growth will be focused in markets in which the Company has expertise and deep understanding, and where it can leverage the technological innovation it has built over the past 85 years.

28

 
MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
 
RESULTS OF OPERATIONS
 
 
Third Quarter
 
 
Volume Effect
 
 
 
Price Effect
 
 
Product
Mix Effect
 
Exchange
Rate
Effect
(Dollars in millions)
2006
 
2005
 
Change
 
                           
Sales
$
1,966
$
1,816
 
8 %
 
-- %
 
9 %
 
(1) %
 
-- %

 
First Nine Months
 
 
Volume Effect
 
 
 
Price Effect
 
 
Product
Mix Effect
 
Exchange
Rate
Effect
(Dollars in millions)
2006
 
2005
 
Change
 
                           
Sales
$
5,698
$
5,330
 
7 %
 
1 %
 
7 %
 
(1) %
 
-- %

Sales revenue for the third quarter and the first nine months 2006 increased $150 million and $368 million over the third quarter and the first nine months 2005, respectively. The increase was primarily due to higher selling prices in response to both higher raw material and energy costs and continued strong economic conditions.

 
Third Quarter
 
First Nine Months
(Dollars in millions)
2006
 
2005
 
Change
 
2006
 
2005
 
Change
                       
Gross Profit
$
316
$
352
 
(10) %
$
997
$
1,125
 
(11) %
As a percentage of sales
 
16%
 
19 %
     
17 %
 
21 %
   

Gross profit and gross profit as a percentage of sales for third quarter 2006 decreased compared to the third quarter 2005 due to increased raw material and energy costs and operational disruptions that were partially offset by higher selling prices.

Gross profit and gross profit as a percentage of sales for first nine months 2006 decreased compared to the first nine months 2005 primarily due to reduced gross margins in the Performance Polymers segment.

 
Third Quarter
 
First Nine Months
(Dollars in millions)
2006
 
2005
 
Change
 
2006
 
2005
 
Change
                       
Selling, General and
                     
Administrative Expenses
$
105
$
108
 
(3) %
$
316
$
339
 
(7) %
Research and Development
                       
Expenses
 
40
 
42
 
(5) %
 
126
 
120
 
5 %
 
$
145
$
150
 
(3) %
$
442
$
459
 
(4) %
As a percentage of sales
 
7 %
 
8 %
     
8 %
 
9 %
   

Selling, general and administrative ("SG&A") expenses for third quarter 2006 decreased compared to third quarter 2005 primarily due to lower incentive compensation expense. SG&A expenses in the first nine months 2006 decreased compared to the first nine months 2005 due to lower incentive compensation expense in the first nine months 2006 and to Cendian Corporation's ("Cendian") shutdown of its business activities in the first quarter of 2005. SG&A expenses include compensation expense under Statement of Financial Accounting Standards ("SFAS") No. 123 Revised December 2004 ("SFAS No. 123 (R)"), "Share-Based Payment". For more information concerning SFAS No. 123 (R), see Note 17 to the Company's unaudited consolidated financial statements.

29

 
MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
 
Research and development ("R&D") expenses decreased $2 million in third quarter 2006 compared to third quarter 2005 primarily due to lower expenses in the Performance Polymers segment. R&D expenses increased $6 million in the first nine months 2006 compared to the first nine months 2005 primarily due to increased spending on growth initiatives, particularly in the SP segment. The Company expects that R&D expenses will be approximately 3 percent of revenue in 2006.

Asset Impairments and Restructuring Charges, Net

Asset impairments and restructuring charges totaled $13 million and $23 million for the third quarter and first nine months 2006 compared to $4 million and $23 million in third quarter and first nine months 2005, respectively. The Company continues to review its portfolio of products and businesses, which could result in further restructuring, divestiture, and consolidation. For more information regarding asset impairments and restructuring charges, see Note 10 to the Company's unaudited consolidated financial statements.

Other Operating Income

Other operating income for the first nine months 2005 reflects a gain of $2 million related to the 2004 divestiture of certain businesses and product lines within the CASPI segment.

Interest Expense, Net

 
Third Quarter
 
First Nine Months
(Dollars in millions)
2006
 
2005
 
Change
 
2006
 
2005
 
Change
                       
Gross interest costs
$
28
$
27
   
$
84
$
91
   
Less: Capitalized interest
 
2
 
1
     
5
 
3
   
Interest expense
 
26
 
26
 
-- %
 
79
 
88
 
(10) %
Interest income
 
5
 
3
     
17
 
11
   
Interest expense, net
$
21
$
23
 
(9) %
$
62
$
77
 
(19) %
                       

Gross interest costs for the third quarter 2006 were higher compared to the third quarter 2005 due to higher average borrowings and higher average interest rates.

Gross interest costs for the first nine months 2006 were lower compared to the first nine months 2005 due to lower average borrowings that more than offset higher average interest rates.

For 2006, the Company expects net interest expense to decrease compared to 2005 due to anticipated lower average borrowings, increased capitalized interest and higher interest income.

Income from Equity Investment in Genencor

Income from equity investment in Genencor includes the Company's portion of earnings from its equity investment in Genencor for the first six months 2005. In the second quarter 2005, the Company completed the sale of its equity interest in Genencor for net cash proceeds of approximately $417 million. The book value of the investment prior to sale was $246 million resulting in a pre-tax gain on the sale of $171 million.


30

 
MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
 
Early Debt Extinguishment Costs

In the second quarter 2005, the Company completed the early repayment of $500 million of its outstanding long-term debt for $544 million in cash and recorded a charge of $46 million for early debt extinguishment costs including $2 million in unamortized bond issuance costs. The book value of the repaid debt was $500 million.

Other (Income) Charges, Net

 
Third Quarter
 
First Nine Months
(Dollars in millions)
2006
 
2005
 
Change
 
2006
 
2005
 
Change
                       
Other (income)
$
(3)
$
(2)
$
(1)
$
(10)
$
(8)
$
(2)
Other charges
 
4
 
--
 
4
 
8
 
5
 
3
Other (income) charges, net
$
1
$
(2)
$
3
$
(2)
$
(3)
$
1

Included in other income are the Company’s portion of earnings from its equity investments, gains on the sale of certain technology business venture investments, royalty income, and net gains on foreign exchange transactions. Included in other charges are net losses on foreign exchange transactions, the Company’s portion of losses from its equity investments, write-downs to fair value of certain technology business venture investments due to other than temporary declines in value, and fees on securitized receivables.

Provision for Income Taxes

 
Third Quarter
 
First Nine Months
(Dollars in millions)
2006
 
2005
 
Change
 
2006
 
2005
 
Change
                       
Provision for income taxes
$
41
$
54
 
(24)%
$
158
$
207
 
(24)%
Effective tax rate
 
30%
 
31%
     
34%
 
30%
   

The third quarter and first nine months 2006 effective tax rate reflects the Company's expected annual tax rate on reported operating earnings before income tax, excluding discrete items, of approximately 34 percent. The third quarter 2006 effective tax rate was impacted by the reversal of foreign loss valuation allowances. The increase in the effective tax rate for the first nine months 2006 over the first nine months 2005 is primarily attributable to lower foreign earnings in favorable tax jurisdictions and to a decrease in tax deductions for charitable donations. The implementation of SFAS No. 123 (R), effective January 1, 2006, did not have a material effect on the Company's effective income tax rate in the third quarter and first nine months 2006. For additional information regarding SFAS No. 123 (R), see Note 17 to the Company's unaudited consolidated financial statements.

The third quarter 2005 effective tax rate reflects the Company's then expected annual tax rate on reported operating earnings before income tax, excluding discrete items, of approximately 30 percent and higher applicable tax rates related to the early extinguishment of debt costs and the gain on the sale of Genencor stock. The first nine months 2005 effective tax rate also reflects a net deferred tax benefit adjustment related to the expected utilization of capital loss carryforwards.

As described in Note 19 to the consolidated financial statements in Part II, Item 8 of the Company’s 2005 Annual Report on Form 10-K, the Company has significant foreign net operating loss carryforwards and related valuation allowances. Future tax provisions may be positively or negatively impacted to the extent that the realization of these carryforwards is greater or less than anticipated.


31

 
MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
 
SUMMARY BY OPERATING SEGMENT 

The Company's products and operations are managed and reported in five reportable operating segments, consisting of the CASPI segment, the Fibers segment, the PCI segment, the Performance Polymers segment and the SP segment. The Company's segments were previously aligned in a divisional structure that provided for goods and services to be transferred between divisions at predetermined prices that may have been in excess of cost, which resulted in the recognition of intersegment sales revenue and operating earnings. Such interdivisional transactions were eliminated in the Company's consolidated financial statements. In first quarter 2006, the Company realigned its organizational structure to support its growth strategy and to better reflect the integrated nature of the Company's assets. A result of the realigned organizational structure is that goods and services are transferred among the segments at cost. As part of this change, the Company's segment results have been restated to eliminate the impact of interdivisional sales revenue and operating earnings. For additional information concerning the segments' businesses and products, see Note 21 to the consolidated financial statements in Part II, Item 8 of the Company's 2005 Annual Report on Form 10-K and the Form 8-K filed on April 20, 2006.

In the first quarter of 2006, management determined that the Developing Businesses ("DB") segment is not of continuing significance for financial reporting purposes. As a result, revenues and costs previously included in the DB segment and research and development expenditures not identifiable to an operating segment are not included in segment operating results for either of the periods presented and are shown in Note 18 to the Company's unaudited consolidated financial statements as "other" revenues and operating losses.

During third quarter 2006, the Company entered into a definitive agreement for the sale of its Batesville, Arkansas manufacturing facility and related assets and specialty organic chemicals product lines in the PCI segment. In October 2006, the Company announced a definitive agreement for the sale of its polyethylene and Epolene polymer businesses and related assets located at the Longview, Texas site and the Company's ethylene pipeline. The polyethylene assets and product lines are in the Performance Polymers segment, while the Epolene assets and product lines are in the CASPI segment. Subject to regulatory approval and satisfaction of customary conditions, both divestitures are expected to be completed in fourth quarter 2006.

CASPI Segment
 
Third Quarter
 
First Nine Months
         
Change
         
Change
(Dollars in millions)
2006
 
2005
 
$
 
%
 
2006
 
2005
 
$
 
%
                               
Sales
$
367
$
333
$
34
 
10 %
$
1,078
$
977
$
101
 
10 %
 
Volume effect
       
(2)
 
(1)%
         
5
 
-- %
 
Price effect
       
34
 
10 %
         
96
 
10 %
 
Product mix effect
       
--
 
-- %
         
6
 
1 %
 
Exchange rate effect
       
2
 
1 %
         
(6)
 
(1)%
                               
Operating earnings
53
 
63
 
(10)
 
(16)%
 
176
 
194
 
(18)
 
(9)%
                               
Asset impairments and
                             
restructuring charges, net
--
 
1
 
(1)
     
8
 
3
 
5
   
                               
Other operating income
--
 
--
 
--
     
--
 
(2)
 
2
   


32

 
MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

For the third quarter and first nine months 2006 compared to the third quarter and first nine months 2005, sales revenue increased $34 million and $101 million, respectively, due to an increase in selling prices in response to higher raw material and energy costs.

Operating earnings decreased $10 million, particularly for cyclical commodity and for adhesives product lines, for the third quarter 2006 compared to the third quarter 2005 due to an increase in raw materials and energy costs which was partially offset by an increase in selling prices.

Operating earnings decreased $18 million for the first nine months 2006 compared to the first nine months 2005, primarily due to increased raw material and energy costs and increased asset impairments and restructuring charges which more than offset an increase in selling prices. Asset impairments and restructuring charges of $8 million for the first nine months 2006 and $3 million for the first nine months 2005, related primarily to previously closed manufacturing facilities.

In October 2006, the Company announced a definitive agreement for the sale of the CASPI segment's Epolene polymer businesses and related assets. Subject to regulatory approval and satisfaction of customary conditions, the divestiture is expected to be completed in fourth quarter 2006. CASPI sales revenue and operating earnings attributed to the assets held for sale were $53 million and $1 million, respectively, for the first nine months of 2006.

Fibers Segment
 
Third Quarter
 
First Nine Months
         
Change
         
Change
(Dollars in millions)
2006
 
2005
 
$
 
%
 
2006
 
2005
 
$
 
%
                               
Sales
$
228
$
228
$
--
 
-- %
$
696
$
633
$
63
 
10 %
 
Volume effect
       
(6)
 
(3) %
         
37
 
6 %
 
Price effect
       
12
 
6 %
         
51
 
8 %
 
Product mix effect
       
(6)
 
(3) %
         
(24)
 
(4) %
 
Exchange rate effect
       
--
 
-- %
         
(1)
 
-- %
                               
Operating earnings
55
 
60
 
(5)
 
(8) %
 
182
 
155
 
27
 
17 %

Sales revenue remained constant for the third quarter 2006 compared to the third quarter 2005 primarily due to higher selling prices which were offset by lower sales volume and an unfavorable shift in product mix. The higher selling prices were in response to higher raw material and energy costs as well as continued strong demand for and limited supply of acetate yarn and acetyl chemical products. The lower sales volume was primarily a result of reduced operating rates due to operational disruptions.

Sales revenue increased $63 million for the first nine months 2006 compared to the first nine months 2005 primarily due to higher selling prices and higher sales volume that were partially offset by an unfavorable shift in product mix. The higher selling prices were in response to higher raw material and energy costs as well as continued strong demand for and limited supply of acetate yarn and acetyl chemical products. The increased sales volume was due to strong demand for acetyl chemical products attributed to strengthened global acetate tow demand.

Operating earnings for the third quarter 2006 compared to the third quarter 2005 decreased $5 million due to lower sales volume and higher raw materials and energy costs more than offsetting higher selling prices.

Operating earnings for the first nine months 2006 compared to the first nine months 2005 increased $27 million as higher selling prices and increased sales volume more than offset higher raw material and energy costs.


33

 
MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
 
The Company believes that acetate tow has modest growth potential in future years and has been evaluating growth options in Europe and Asia. In the third quarter 2006, the Company announced plans to add capacity and expand production of Estron acetate tow in Europe at its Workington, England facility to ensure continued supply of customers' acetate tow needs. The Company continues to evaluate options for growth in Asia.

PCI Segment
 
Third Quarter
 
First Nine Months
         
Change
         
Change
(Dollars in millions)
2006
 
2005
 
$
 
%
 
2006
 
2005
 
$
 
%
                               
Sales
$
457
$
428
$
29
 
7 %
$
1,321
$
1,214
$
107
 
9 %
 
Volume effect
       
(1)
 
-- %
         
(5)
 
-- %
 
Price effect
       
32
 
8 %
         
113
 
9 %
 
Product mix effect
       
(3)
 
(1)%
         
1
 
-- %
 
Exchange rate effect
       
1
 
-- %
         
(2)
 
-- %
                               
Operating earnings
25
 
40
 
(15)
 
(38)%
 
113
 
128
 
(15)
 
(12)%
                               
Asset impairments and
                             
restructuring charges, net
11
 
--
 
11
     
11
 
4
 
7
   

Sales revenue for the third quarter and first nine months 2006 compared to the third quarter and first nine months 2005 increased $29 million and $107 million, respectively, primarily due to higher selling prices, particularly in the intermediates product lines, in response to increases in raw material and energy costs.

Operating earnings decreased $15 million for the third quarter and first nine months 2006 compared to the third quarter and first nine months 2005, respectively. The third quarter 2006 operating earnings included asset impairments and restructuring charges of $11 million related to the expected divestiture of the PCI segment's Arkansas facility, assets and product lines. The third quarter 2005 operating earnings included $10 million of operating earnings from the achievement of certain milestones under an acetyls technology licensing agreement.

In third quarter 2006, the Company announced a definitive agreement for the sale of the PCI segment's Batesville, Arkansas manufacturing facility and related assets and specialty organic chemicals product lines. Subject to regulatory approval and satisfaction of customary conditions, this divestiture is expected to be completed in fourth quarter 2006. PCI sales revenue and operating results attributed to the assets held for sale were $97 million and $3 million, respectively, for the first nine months of 2006.

34

 
MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
 
Performance Polymers Segment
 
Third Quarter
   
Change
(Dollars in millions)
2006
 
2005
 
$
 
%
               
Total sales
$
707
$
646
$
61
 
10 %
Sales - assets held for sale
169
 
164
 
5
 
3 %
Sales - continuing product lines
538
 
482
 
56
 
12 %
                 
 
Volume effect
       
(22)
 
(3) %
 
Price effect
       
77
 
12 %
 
Product mix effect
       
(2)
 
-- %
 
Exchange rate effect
       
8
 
1 %
               
Total operating earnings
17
 
32
 
(15)
 
(47) %
Operating earnings - assets held for sale (1) 
15
 
11
 
4
 
36 %
Operating earnings - continuing product lines
2
 
21
 
(19)
 
(90) %
               

 
First Nine Months
   
Change
(Dollars in millions)
2006
 
2005
 
$
 
%
               
Total sales
$
2,007
$
1,944
$
63
 
3 %
Sales - assets held for sale
517
 
442
 
75
 
17 %
Sales - continuing product lines
1,490
 
1,502
 
(12)
 
(1) %
                 
 
Volume effect
       
--
 
-- %
 
Price effect
       
58
 
3 %
 
Product mix effect
       
11
 
-- %
 
Exchange rate effect
       
(6)
 
-- %
               
Total operating earnings
46
 
166
 
(120)
 
(72) %
Operating earnings - assets held for sale (1) 
52
 
56
 
(4)
 
(7) %
Operating earnings - continuing product lines
(6)
 
110
 
(116)
 
>(100) %
               
(1) Includes allocated costs consistent with the Company’s historical practices, some of which may remain and could be reallocated to the remainder of the segment and other segments.

In October 2006, the Company announced a definitive agreement for the sale of the Performance Polymer segment's polyethylene businesses and related assets located at the Longview, Texas site and the Company's ethylene pipeline. Subject to regulatory approval and satisfaction of customary conditions, the divestiture is expected to be completed in fourth quarter 2006.

Sales revenue increased $61 million in third quarter 2006 compared to third quarter 2005 primarily due to higher selling prices in all product lines in response to higher raw material and energy costs, partially offset by lower sales volume, particularly for PET polymers in North America due to sustained levels of Asian imports and for polyethylene due to operational disruptions. Excluding the product lines being divested, sales revenue increased $56 million.

Sales revenue increased $63 million in first nine months 2006 compared to first nine months 2005 primarily due to higher selling prices in polyethylene. Excluding the product lines being divested, sales revenue decreased $12 million.


35

 
MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
 
Operating earnings decreased $15 million in third quarter 2006 compared to third quarter 2005 primarily due to higher raw material costs and lower sales volume, particularly for PET polymers in North America, more than offsetting higher selling prices. Excluding product lines expected to be divested in fourth quarter, operating earnings decreased $19 million.

Operating earnings decreased $120 million in the first nine months 2006 compared to the first nine months 2005 primarily due to higher raw material and energy costs and lower selling prices for PET polymers globally. Excluding the product lines being divested, operating earnings decreased $116 million.

In early March, 2005, the Company broke ground on the first commercial scale PET polymers plant based upon Eastman's IntegRex technology. The plant will be a 350,000 metric ton facility and the Company continues to expect to begin production in fourth quarter 2006. Research and development efforts continue to enhance IntegRex technology in parallel with construction of the first IntegRex manufacturing facility. The Company is evaluating the possible construction of a full IntegRex facility in North America utilizing these further refinements to IntegRex technology.

The Company is continuing to evaluate its strategic and operational options related to certain PET assets to improve profitability of the segment.

SP Segment
 
Third Quarter
 
First Nine Months
         
Change
         
Change
(Dollars in millions)
2006
 
2005
 
$
 
%
 
2006
 
2005
 
$
 
%
                               
Sales
$
207
$
179
$
28
 
16 %
$
596
$
536
$
60
 
11 %
 
Volume effect
       
26
 
15 %
         
47
 
9 %
 
Price effect
       
7
 
4 %
         
27
 
5 %
 
Product mix effect
       
(5)
 
(3) %
         
(9)
 
(2) %
 
Exchange rate effect
       
--
 
-- %
         
(5)
 
(1) %
                               
Operating earnings
18
 
17
 
1
 
6 %
 
50
 
59
 
(9)
 
(15)%

Sales revenue for the third quarter and first nine months 2006 compared to the third quarter and first nine months 2005 increased $28 million and $60 million, respectively, due to increased sales volume. The higher sales volume was primarily attributed to continued market development efforts, particularly in copolyester product lines. Selling prices increased to offset higher raw material and energy costs with increases limited by competitive industry dynamics.

Operating earnings for third quarter 2006 increased $1 million compared with third quarter 2005 due to increased sales volume and higher selling prices which more than offset higher raw material and energy costs.
 
Operating earnings for the first nine months 2006 declined $9 million compared with the first nine months 2005 primarily due to higher raw material and energy costs and increased expenditures related to growth initiatives more than offsetting increased sales volume and higher selling prices.

Eastman continues to be a market leading supplier of cyclohexane dimethanol ("CHDM") modified polymers. In October 2006, the Company decided to cease production of CHDM, an intermediate product primarily used internally, in San Roque, Spain to gain operational efficiencies at other facilities, which will result in asset impairment and restructuring charges in the fourth quarter 2006.


36

 
MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

SUMMARY BY CUSTOMER LOCATION

Sales Revenue

 
Third Quarter
               
 
 
(Dollars in millions)
 
 
 
2006
 
 
 
2005
 
 
 
Change
 
Volume Effect
 
Price Effect
 
Product
Mix Effect
 
Exchange
Rate
Effect
                             
United States and Canada
$
1,111
$
1,052
 
6 %
 
(3) %
 
9 %
 
-- %
 
-- %
Europe, Middle East, and Africa
 
371
 
332
 
12 %
 
2 %
 
9 %
 
(3) %
 
4 %
Asia Pacific
 
243
 
235
 
3 %
 
(3) %
 
9 %
 
(3) %
 
-- %
Latin America
 
241
 
197
 
22 %
 
14 %
 
6 %
 
2 %
 
-- %
 
$
1,966
$
1,816
 
8 %
 
-- %
 
9 %
 
(1) %
 
-- %

Sales revenue in the United States and Canada increased for third quarter 2006 compared to third quarter 2005 primarily due to higher selling prices, particularly in the Performance Polymers segment, which had a $47 million positive impact on sales revenue. The higher selling prices were primarily in response to increases in raw material and energy costs.

Sales revenue in Europe, Middle East and Africa increased for third quarter 2006 compared to third quarter 2005 primarily due to higher selling prices, particularly in the Performance Polymers segment. The higher selling prices were primarily in response to increases in raw material and energy costs.