form10qsecondqtr.htm



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 June 30, 2007
 
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 June 30,  2007
Common Stock, par value $0.01 per share
 
84,045,690
     

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1


TABLE OF CONTENTS

ITEM
 
PAGE

PART I.  FINANCIAL INFORMATION

1.
Financial Statements
 
     
 
3
 
4
 
5
 
6
     
2.
21
     
3.
43
     
4.
43

PART II.  OTHER INFORMATION

1.
44
     
1A.
45
     
2.
45
     
4.
45
     
6.
46

SIGNATURES

 
47


2


UNAUDITED CONSOLIDATED STATEMENTS OF EARNINGS,
COMPREHENSIVE INCOME AND RETAINED EARNINGS

   
Second Quarter
 
First Six Months
 (Dollars in millions, except per share amounts)
 
2007
 
2006
 
2007
 
2006
                 
Sales
$
1,895
$
1,929
$
3,690
$
3,732
Cost of sales
 
1,575
 
1,579
 
3,077
 
3,051
Gross profit
 
 320
 
350
 
 613
 
681
                 
Selling, general and administrative expenses
 
113
 
113
 
214
 
211
Research and development expenses
 
37
 
44
 
73
 
86
Asset impairments and restructuring charges, net
 
2
 
3
 
23
 
10
Operating earnings
 
 168
 
190
 
 303
 
374
                 
Interest expense, net
 
15
 
21
 
33
 
41
Other (income) charges, net
 
(3)
 
(2)
 
(6)
 
(3)
Earnings before income taxes
 
 156
 
171
 
 276
 
336
Provision for income taxes
 
51
 
57
 
94
 
117
Net earnings
$
 105
$
114
$
 182
$
219
                 
Earnings per share
               
Basic
$
1.24
$
1.39
$
2.16
$
2.68
Diluted
$
1.22
$
1.37
$
2.13
$
2.64
                 
Comprehensive Income
               
Net earnings
$
105
$
114
$
  182
$
219
Other comprehensive income (loss)
               
Change in cumulative translation adjustment
 
13
 
23
 
9
 
40
Change in pension and other post employment benefits due to amortization, net of tax
 
(6)
 
--
 
(4)
 
--
Change in unrealized gains (losses) on investments, net of tax
 
2
 
8
 
1
 
11
Change in unrealized gains (losses) on derivative instruments, net of tax
 
(4)
 
(1)
 
3
 
(1)
Total other comprehensive income
 
   5
 
30
 
   9
 
50
Comprehensive income
$
 110
$
144
$
 191
$
269
                 
Retained Earnings
               
Retained earnings at beginning of period
$
2,234
$
1,992
$
2,186
$
1,923
Net earnings
 
 105
 
114
 
 182
 
219
Adoption of accounting standards
 
--
 
--
 
8
 
--
Cash dividends declared
 
(37)
 
(36)
 
(74)
 
(72)
Retained earnings at end of period
$
2,302
$
2,070
$
2,302
$
2,070



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

3


CONSOLIDATED STATEMENTS OF FINANCIAL POSITION

   
June 30,
 
December 31,
(Dollars in millions, except per share amounts)
 
2007
 
2006
   
(Unaudited)
   
Assets
       
Current assets
       
Cash and cash equivalents
$
891
$
939
Trade receivables, net of allowance of $12 and $16
 
747
 
682
Miscellaneous receivables
 
74
 
72
Inventories
 
700
 
682
Other current assets
 
89
 
47
Total current assets
 
2,501
 
2,422
         
Properties
       
Properties and equipment at cost
 
8,714
 
8,844
Less:  Accumulated depreciation
 
5,674
 
5,775
Net properties
 
3,040
 
3,069
         
Goodwill
 
315
 
314
Other noncurrent assets
 
384
 
368
Total assets
$
6,240
$
6,173
         
Liabilities and Stockholders’ Equity
       
Current liabilities
       
Payables and other current liabilities
$
1,028
$
1,056
Borrowings due within one year
 
72
 
3
Total current liabilities
 
1,100
 
1,059
         
Long-term borrowings
 
1,507
 
1,589
Deferred income tax liabilities
 
288
 
269
Post-employment obligations
 
996
 
1,084
Other long-term liabilities
 
179
 
143
Total liabilities
 
4,070
 
4,144
         
Stockholders’ equity
       
Common stock ($0.01 par value – 350,000,000 shares authorized; shares issued – 93,362,017 and 91,579,294 for 2007 and 2006, respectively)
 
1
 
1
Additional paid-in capital
 
549
 
448
Retained earnings
 
2,302
 
2,186
Accumulated other comprehensive loss
 
(165)
 
(174)
   
2,687
 
2,461
Less: Treasury stock at cost (9,399,001 shares for 2007 and 8,048,442 shares for 2006)
 
517
 
432
         
Total stockholders’ equity
 
2,170
 
2,029
         
Total liabilities and stockholders’ equity
$
6,240
$
6,173
         
The accompanying notes are an integral part of these consolidated financial statements.

4


UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

   
First Six Months
(Dollars in millions)
 
2007
 
2006
         
Cash flows from operating activities
       
Net earnings
$
182
$
219
         
Adjustments to reconcile net earnings to net cash provided by (used in) operating activities:
       
Depreciation and amortization
 
169
 
150
Asset impairments
 
22
 
8
Provision (benefit) for deferred income taxes
 
(18)
 
29
Changes in operating assets and liabilities:
       
(Increase) decrease in receivables
 
(59)
 
(156)
(Increase) decrease in inventories
 
(18)
 
(49)
Increase (decrease) in trade payables
 
(63)
 
59
Increase (decrease) in liabilities for employee benefits and incentive pay
 
(121)
 
(74)
Other items, net
 
5
 
(23)
         
Net cash provided by operating activities
 
99
 
163
         
Cash flows from investing activities
       
Additions to properties and equipment
 
(198)
 
(169)
Proceeds from sale of assets and investments
 
43
 
11
Additions to capitalized software
 
(5)
 
(8)
Other items, net
 
14
 
(1)
         
Net cash (used in) investing activities
 
(146)
 
(167)
         
Cash flows from financing activities
       
Net increase (decrease) in commercial paper, credit facility and other borrowings
 
75
 
23
Dividends paid to stockholders
 
(75)
 
(72)
Treasury stock purchases
 
(86)
 
--
Proceeds from stock option exercises and other items
 
88
 
24
         
Net cash provided by (used in) financing activities
 
  2
 
(25)
         
Effect of exchange rate changes on cash and cash equivalents
 
(3)
 
2
         
Net change in cash and cash equivalents
 
( 48)
 
(27)
         
Cash and cash equivalents at beginning of period
 
939
 
524
         
Cash and cash equivalents at end of period
$
891
$
497

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

5

 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

ITEM
Page
   
Note 1.    Basis of Presentation
7
Note 2.    Inventories
7
7
8
Note 5.    Borrowings
8
9
11
Note 8.    Environmental Matters
12
Note 9.    Commitments
12
13
14
15
15
16
Note 15.  Legal Matters
19
19
Note 17.  Divestitures
20

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 2006 Annual Report on Form 10-K, except as described below.   The Company adopted the provisions of Financial Accounting Standards Board ("FASB") Interpretation No. 48, Accounting for Uncertainty in Income Taxes ("FIN 48"), on January 1, 2007.  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 generally accepted accounting principles ("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 2006 amounts to conform to the 2007 presentation including the reclassification of segment sales and operating earnings. For additional information, see Note 14 to the Company's unaudited consolidated financial statements.

2.  
 
 
June 30,
 
December 31,
(Dollars in millions)
2007
 
2006
       
At FIFO or average cost (approximates current cost)
     
Finished goods
$
635
$
660
Work in process
203
 
206
Raw materials and supplies
326
 
280
Total inventories
1,164
 
1,146
LIFO Reserve
(464)
 
(464)
Total inventories
$
700
$
682

Inventories valued on the LIFO method were approximately 70% as of June 30, 2007 and 65% as of December 31, 2006 of total inventories.

3.  
 
   
June 30,
 
December 31,
(Dollars in millions)
 
2007
 
2006
         
Trade creditors
$
530
$
581
Accrued payrolls, vacation, and variable-incentive compensation
 
97
 
126
Accrued taxes
 
58
 
59
Post-employment obligations
 
59
 
63
Interest payable
 
31
 
31
Bank overdrafts
 
93
 
11
Other
 
160
 
185
Total payables and other current liabilities
$
1,028
$
1,056

 
4.  
 
 
Second Quarter
First Six Months
(Dollars in millions)
2007
 
2006
 
2007
 
2006
 
             
Provision for income taxes
$
51
$
57
$
94
$
117
Effective tax rate
 
32.7 %
 
33.5 %
 
34.0 %
 
34.9 %
 
The second quarter and first six months 2007 effective tax rates reflect the Company's expected tax rate on reported operating earnings before income tax, excluding discrete items, of approximately 34 percent.  The second quarter and first six months 2006 effective tax rates reflect the Company's expected tax rate on reported operating earnings before income tax, excluding discrete items, of approximately 35 percent.

The Company adopted the provisions of FIN 48 on January 1, 2007.  As a result of the implementation of FIN 48 and reliance on the FASB Staff Position No. FIN 48-a, "Definition of Settlement in FASB Interpretation No. 48," the Company recognized an approximately $3 million decrease in the liability for unrecognized tax benefits, which was accounted for as a $8 million increase to the January 1, 2007 balance of retained earnings and a $5 million decrease in long-term deferred tax liabilities. After the above decrease, the liability for unrecognized tax benefits was approximately $31 million, of which $26 million would, if recognized, impact the Company's effective tax rate.

Interest and penalties, net, related to unrecognized tax benefits are recorded as a component of income tax expense.  As of January 1, 2007 the company had accrued approximately $3 million for interest, net of tax benefit and had no accrual for tax penalties.  During the second quarter 2007, the Company recognized an immaterial amount of interest associated with unrecognized tax benefits.

The Company or one of its subsidiaries files tax returns in the U.S. federal jurisdiction, and various states and foreign jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 2001. It is reasonably possible that within the next 12 months the Company will recognize approximately $2 million of unrecognized tax benefits as a result of the expiration of relevant statutes of limitations.

5.  
 
   
June 30,
 
December 31,
(Dollars in millions)
 
2007
 
2006
         
Borrowings consisted of:
       
3 1/4% notes due 2008
$
72
$
72
7% notes due 2012
 
139
 
141
6.30% notes due 2018
 
176
 
182
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
 
183
 
185
Other
 
15
 
18
Total borrowings
 
1,579
 
1,592
Borrowings due within one year
 
(72)
 
(3)
Long-term borrowings
$
1,507
$
1,589


8

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS      

 
At June 30, 2007, the Company has credit facilities with various U.S. and non-U.S. banks totaling approximately $883 million. These credit facilities consist of a $700 million revolving credit facility (the "Credit Facility"), expiring in April 2012, and a 135 million euro credit facility which expires in December 2011.  Both of these credit facilities have options for a one year extension. 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 June 30, 2007 and December 31, 2006 were $183 million and $185 million at weighted average interest rates of 4.29 percent and 4.00 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 2012, 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 June 30, 2007 and December 31, 2006, the Company had outstanding interest rate swaps associated with the entire outstanding principal of the 7% notes due in 2012 and $150 million of the outstanding principal of the 6.30% notes due in 2018.  The average variable interest rate on the 7% notes was 7.91 percent and 7.89 percent for June 30, 2007 and December 31, 2006, respectively.  The average variable interest rate on the 6.30% notes was 6.31 percent and 6.30 percent for June 30, 2007 and December 31, 2006, respectively.

6.  

In the second quarter and first six months 2007, asset impairments and restructuring charges totaled $2 million and $23 million, respectively, related primarily to the impairment of assets of the San Roque, Spain polyethylene terephthalate ("PET") manufacturing facility which was sold in second quarter 2007.  The Company impaired the assets of this facility in first quarter 2007 to adjust the asset values to the sales price less cost to sell.  This impairment was partially offset by the reversal of the $5 million severance accrual related to the fourth quarter 2006 shut down of the cyclohexane dimethanol ("CHDM") manufacturing facility, located adjacent to the PET manufacturing facility. The employees included in the CHDM severance accrual were employed by the purchaser of the San Roque, Spain PET manufacturing facility, relieving the Company of the severance obligation.  These charges were reflected in the Performance Polymers and the Specialty Plastics ("SP") segments.

In the second quarter and first six months 2006, asset impairments and restructuring charges totaled $3 million and $10 million, respectively, relating primarily to previously closed manufacturing facilities.
9

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 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 2006 and the first six months 2007:
 
 
(Dollars in millions)
 
Balance at
January 1, 2006
 
Provision/ Adjustments
 
Non-cash Reductions
 
Cash Reductions
 
Balance at
December 31, 2006
                     
Non-cash charges
$
--
$
62
$
(62)
$
--
$
--
Severance costs
 
3
 
32
 
--
 
(1)
 
34
Site closure and other  restructuring costs
 
7
 
7
 
--
 
--
 
14
Total
$
10
$
101
$
(62)
$
(1)
$
48
                     
   
Balance at
January 1, 2007
 
Provision/ Adjustments
 
Non-cash Reductions
 
Cash Reductions
 
Balance at
June 30, 2007
                     
Non-cash charges
$
--
$
22
$
(22)
$
--
$
--
Severance costs
 
34
 
(5)
 
--
 
(8)
 
21
Site closure and other  restructuring costs
 
14
 
6
 
--
 
(5)
 
15
Total
$
48
$
  23
$
(22)
$
(13)
$
36

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

10

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS      

 
7.  
PENSION AND OTHER POST-EMPLOYMENT BENEFITS

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
       
   
Second Quarter
 
First Six Months
(Dollars in millions)
 
2007
 
2006
 
2007
 
2006
                 
Service cost
$
13
$
11
$
24
$
22
Interest cost
 
24
 
20
 
45
 
40
Expected return on assets
 
(27)
 
(23)
 
(52)
 
(44)
Amortization of:
               
Prior service credit
 
(2)
 
(2)
 
(4)
 
(4)
Actuarial loss
 
8
 
10
 
17
 
19
Net periodic benefit cost
$
16
$
16
$
30
$
33

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 did not impact net periodic benefit cost in 2006 and had minimal impact on the financial statements in the first six months 2007.

The Company contributed $100 million to its U.S. defined benefit plans during first quarter 2007.

POSTRETIREMENT WELFARE PLANS

Eastman provides life insurance and health care benefits for eligible retirees, and health care benefits for retirees' eligible survivors.  In general, Eastman provides those benefits to retirees eligible under the Company's U.S. defined benefit 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. postretirement welfare plans:


Summary of Components of Net Periodic Benefit Costs
       
   
Second Quarter
 
First Six Months
(Dollars in millions)
 
2007
 
2006
 
2007
 
2006
                 
Service cost
$
2
$
2
$
4
$
4
Interest cost
 
10
 
10
 
21
 
21
Expected return on assets
 
--
     
(1)
   
Amortization of:
               
Prior service credit
 
(5)
 
(6)
 
(11)
 
(12)
Actuarial loss
 
3
 
4
 
6
 
8
Net periodic benefit cost
$
10
$
10
$
19
$
21


11

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS      

 
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 ammunitions plant.  HDC’s contract with the Department of 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 DOA did not contribute further to these costs.  The Company pursued extraordinary relief from the DOA and was granted an award in the amount of $95 million effective in the fourth quarter 2006.  This award was for reimbursement of the described costs and other previously expensed post-retirement benefit costs.  The Company began recognizing the impact of the reimbursement in fourth quarter 2006 by recording an unrecognized gain and amortizing the gain into earnings over a period of time.

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 had minimal impact on the financial statements in the first six months 2007.

8.  

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 responsible for 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, "Significant Accounting Policies" in the Company's 2006 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 $47 million at June 30, 2007 and December 31, 2006, 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 $18 million to the maximum of $31 million at June 30, 2007 and the minimum or best estimate of $18 million to the maximum of $32 million at December 31, 2006.

9.  

Purchase Obligations and Lease Commitments

At June 30, 2007, the Company had various purchase obligations totaling approximately $2.2 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 10 percent relate to machinery and equipment, including computer and communications equipment and production equipment; approximately 55 percent relate to real property, including office space, storage facilities and land; and approximately 35 percent relate to vehicles, primarily railcars.


12

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS      

 
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 June 30, 2007 and December 31, 2006.  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 $312 million and $317 million in the second quarter 2007 and 2006, respectively, and $302 million and $319 million for the first six months of 2007 and 2006, respectively.
 
Guarantees

FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"), clarifies the requirements of Statement of Financial Accounting Standards ("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 June 30, 2007 totaled $141 million and consisted primarily of leases for railcars, aircraft, and other equipment.  Leases with guarantee amounts totaling $2 million, $27 million, and $112 million will expire in 2007, 2008, and 2012, respectively.  The Company believes, based on current facts and circumstances, that the likelihood of a material payment pursuant to such guarantees is remote.

Variable Interest Entities

The Company has evaluated material relationships including the guarantees related to the third-party borrowings of joint ventures and has concluded that the entities are not Variable Interest Entities (“VIEs”) or, in the case of Primester, a joint venture that manufactures cellulose acetate at the Company's 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 June 30, 2007.  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.

10.  

Hedging Programs

Financial instruments held as part of the hedging programs described 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 2006 Annual Report on Form 10-K.


13

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS      

 
At June 30, 2007, mark-to-market gains from raw material and energy, currency and certain interest rate hedges that were included in accumulated other comprehensive loss totaled approximately $3 million.  If realized, approximately $4 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 second quarter of 2007.

11.  

A reconciliation of the changes in stockholders’ equity for the first six months 2007 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, 2006
1
448
2,186
(174)
(432)
2,029
             
Net Earnings
 --
 --
182
 --
 --
182
Effect of FIN 48 Adoption
--
--
8
--
--
8
Cash Dividends Declared (1)
 --
 --
(74)
 --
 --
(74)
Other Comprehensive Income
 --
 --
 --
9
 --
9
Stock Option Exercises and Other Items (2)(3)
 --
  101
 --
 --
1
102
Stock Repurchases
--
--
--
--
(86)
(86)
Balance at June 30, 2007
 1
549
2,302
(165)
 (517)
 2,170

 
(1) Includes cash dividends paid and dividends declared but unpaid.
 
(2)   The tax benefits relating to the difference between the amounts deductible for federal income taxes over the amounts charged to income for financial reporting purposes have been credited to paid-in capital.
 
 (3) Includes the fair value of equity share-based awards recognized under SFAS No. 123 Revised December 2004 ("SFAS No. 123(R)"), "Share-Based Payment".

ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

 
 
 
 
(Dollars in millions)
 
 
Cumulative Translation Adjustment
 
 
Unfunded
Additional
Minimum Pension Liability
 
Unrecognized Loss and Prior Service Cost,  net of taxes
 
Unrealized Gains (Losses) on Cash Flow Hedges
 
 
Unrealized Losses on Investments
 
 
Accumulated Other Comprehensive Income (Loss)
 
Balance at December 31, 2005
61
 (255)
--
(5)
(1)
(200)
Period change
60
48
--
(1)
--
107
Pre-SFAS No. 158 (1) balance at December 31, 2006
121
(207)
--
(6)
(1)
(93)
Adjustments to apply SFAS No. 158
--
207
(288)
--
--
(81)
Balance at December 31, 2006
121
--
(288)
(6)
(1)
(174)
Period change
9
--
(4)
3
1
9
Balance at June 30, 2007
130
--
(292)
(3)
--
(165)

 
(1)   SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans" ("SFAS No. 158").

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.

14

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS      

 
12.  

 
Second Quarter
 
First Six Months
 
2007
 
2006
 
2007
 
2006
               
Shares used for earnings per share calculation:
             
Basic
84.2
 
81.9
 
84.1
 
81.7
Diluted
85.5
 
83.0
 
85.3
 
82.7

In the second quarter and first six months 2007, common shares underlying options to purchase 158,434 shares of common stock at a range of prices from $66.31 to $66.71 and 159,093 shares of common stock at a range of prices from $63.25 to $66.71, 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.
 
In the second quarter and first six months 2006, common shares underlying options to purchase 942,771 shares of common stock at a range of prices from $53.94 to $63.25 and 2,348,486 shares of common stock at a range of prices from $52.63 to $63.25, 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.
 
The Company declared cash dividends of $0.44 per share in the second quarters 2007 and 2006 and $0.88 per share in the first six months 2007 and 2006.
 
13.  

In the second quarter and first six months 2007, approximately $7 million and $13 million, respectively, of compensation expense before tax was recognized in selling, general and administrative expense in the earnings statement for all share-based awards. The impact on second quarter 2007 net earnings of $4 million is net of a $3 million credit to deferred tax expense for recognition of deferred tax assets.  The impact on the first six months 2007 net earnings of $8 million is net of a $5 million credit to deferred tax expense for recognition of deferred tax assets.

In the second quarter and first six months 2006, approximately $6 million and $11 million, respectively, of compensation expense before tax was recognized in selling, general and administrative expense in the earnings statement for all share-based awards. The impact on second quarter 2006 net earnings of $4 million is net of a $2 million credit to deferred tax expense for recognition of deferred tax assets.  The impact on the first six months 2006 net earnings of $7 million is net of a $4 million credit to deferred tax expense for recognition of deferred tax assets.

Stockholders approved the 2007 Omnibus Long-Term Compensation Plan at the annual stockholders' meeting held on May 3, 2007.  This new plan, effective with the date of approval, replaces the 2002 Omnibus Long-Term Compensation Plan.  Additional information regarding share-based compensation may be found in Note 15 to the consolidated financial statements in Part II, Item 8 of the Company's 2006 Annual Report on Form 10-K.




15

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS      
14.  

The Company's products and operations are managed and reported in five reportable operating segments, consisting of the Coatings, Adhesives, Specialty Polymers and Inks ("CASPI") segment, the Fibers segment, the Performance Chemicals and Intermediates ("PCI") segment, the Performance Polymers segment and the SP segment.  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 2006 Annual Report on Form 10-K.

Revenues, research and development, other expenses and assets 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, operating losses and assets.

In fourth quarter 2006, certain product lines were transferred from the PCI segment to the Performance Polymers segment.  Accordingly, the 2006 amounts for sales and operating earnings have been adjusted to retrospectively apply these changes to all periods presented.

   
Second Quarter
(Dollars in millions)
 
2007
 
2006
Sales by Segment
       
CASPI
$
376
$
362
Fibers
 
239
 
238
PCI
 
552
 
431
Performance Polymers
 
513
 
696
SP
 
215
 
202
Total Sales by Segment
 
1,895
 
1,929
Other
 
--
 
--
         
Total Sales
$
1,895
$
1,929
         

   
First Six Months
(Dollars in millions)
 
2007
 
2006
Sales by Segment
       
CASPI
$
721
$
711
Fibers
 
473
 
468
PCI
 
1,050
 
823
Performance Polymers
 
1,019
 
1,341
SP
 
427
 
389
Total Sales by Segment
 
3,690
 
3,732
Other
 
--
 
--
         
Total Sales
$
3,690
$
3,732
         

16

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS      

   
Second quarter
(Dollars in millions)
 
2007
 
2006
         
Operating Earnings (Loss)
       
CASPI (1)
$
66
$
68
Fibers
 
51
 
61
PCI (1)
 
57
 
45
Performance Polymers (1)
 
(13)
 
14
SP(1)
 
18
 
14
Total Operating Earnings (Loss) by Segment
 
 179
 
202
Other
 
(11)
 
(12)
         
Total Operating Earnings (Loss)
$
 168
$
190

(1)  
Operating earnings (loss) for the following segments include asset impairments and restructuring charges:  CASPI includes $1 million in second quarter 2006 relating primarily to the divestiture of previously closed manufacturing facilities; Performance Polymers includes $1 million in the second quarter of 2007 relating primarily to the impairment of the San Roque, Spain PET facility; and SP includes $1 million in second quarter 2007 relating primarily to the San Roque, Spain CHDM facility.  Operating earnings (loss) for the second quarter 2007 in the PCI, Performance Polymers and SP segments also include $7 million, $6 million and $1 million, respectively, in accelerated depreciation costs related to cracking units at the Company's Longview, Texas facility and polymer assets in Columbia, South Carolina.

   
First Six Months
(Dollars in millions)
 
2007
 
2006
         
Operating Earnings (Loss)
       
CASPI (1)
$
131
$
123
Fibers
 
110
 
127
PCI (1)
 
111
 
86
Performance Polymers (1)
 
(64)
 
31
SP(1)
 
36
 
32
Total Operating Earnings (Loss) by Segment
 
324
 
399
Other
 
(21)
 
(25)
         
Total Operating Earnings (Loss)
$
303
$
374

(1)  
Operating earnings (loss) for the following segments include asset impairments and restructuring charges:  CASPI includes $8 million in first six months 2006 relating primarily to the divestiture of previously closed manufacturing facilities; Performance Polymers includes $22 million in the first six months 2007 relating primarily to the impairment of the San Roque, Spain PET facility; and SP includes $1 million in first six months 2007 relating primarily to the San Roque, Spain CHDM facility.  Operating earnings (loss) for the first six months 2007 in the PCI, Performance Polymers and SP segments also include $14 million, $13 million and $1 million, respectively, in accelerated depreciation costs related to cracking units at the Company's Longview, Texas facility and polymer assets in Columbia, South Carolina.

17

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS      


   
June 30,
 
December 31,
(Dollars in millions)
 
2007
 
2006
         
Assets by Segment (1)
       
CASPI
$
1,110
$
1,078
Fibers
 
660
 
651
PCI
 
1,103
 
926
Performance Polymers
 
1,319
 
1,480
SP
 
600
 
599
Total Assets by Segment
 
4,792
 
4,734
Other
 
9
 
13
Corporate Assets
 
1,439
 
1,426
         
Total Assets
$
6,240
$
6,173

(1)  
Assets managed by segments include accounts receivable, inventory, fixed assets and goodwill.



18

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS      

 
 
 15.  LEGAL MATTERS
 
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

Over time, the Company has been named in several putative class action lawsuits filed on behalf of purchasers of sorbates and products containing sorbates, claiming those purchasers paid more for sorbates and for products containing sorbates than they would have paid in the absence of the defendants’ price-fixing. Two civil cases relating to sorbates remain.  In each case, the Company prevailed at the trial court, and in each case, the plaintiff appealed the trial court's decision.  In one case, the appellate court affirmed the trial court's dismissal of all claims, except the plaintiff's claim for civil penalties.  In the other case, the court of appeals overturned the trial court's decision and ruled that the plaintiff could amend and re-file its complaint with the trial court.  The Company appealed this decision to the state supreme court, which declined to review the decision.  Accordingly, the plaintiff filed its Second Amended Complaint on July 9, 2007.  In each case the Company intends to continue to vigorously defend its position.

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.  More recently, certain plaintiffs have claimed exposure to an asbestos-containing plastic, which Eastman manufactured in limited amounts between the mid-1960’s and the early 1970’s.

To date, the Company has obtained dismissals or settlements of its asbestos-related lawsuits with no material effect on its financial condition, results of operations or cash flows, and over the past several years, has substantially reduced its number of pending asbestos-related claims.  The Company has also obtained insurance coverage that applies to a portion of certain of the Company’s defense costs and payments of settlements or judgments in connection with asbestos-related lawsuits.

Based on an ongoing evaluation, the Company believes that the resolution of its 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.

16.  

In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," ("SFAS No. 157") 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.


19

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS      

 
In February, 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115" ("SFAS No. 159").  SFAS No. 159 permits companies to choose to measure many financial instruments and certain other items at fair value at specified election dates.  Upon adoption, an entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date.  Most of the provisions apply only to entities that elect the fair value option.  However, the amendment to SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," applies to all entities with available for sale and trading securities.  SFAS No. 159 will be effective as of the beginning of an entity's first fiscal year that begins after November 15, 2007.  The Company is currently evaluating the effect SFAS No. 159 will have on its consolidated financial position, liquidity, or results of operations.

17.  

Certain Businesses and Product Lines and Related Assets in Performance Polymers Segments
 
On April 30, 2007, the Company sold its San Roque, Spain PET manufacturing facility in the Performance Polymer's segment for net proceeds of approximately $43 million.  The Company also retained approximately $12 million of accounts receivable related to this manufacturing site.  The final purchase price is subject to change based upon working capital and other adjustments.  The Company will continue to produce certain intermediate products for the buyer under ongoing supply agreements with indefinite terms.  In addition, the Company indemnified the buyer against certain liabilities primarily related to taxes, legal matters, environmental matters, and other representations and warranties.  During the first six months, the Company has recorded an impairment charge and site closure costs of $21 million related to the San Roque PET site.  Changes in estimates will be reflected in future periods.


20



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

ITEM
Page
   
21
   
22
   
22
   
24
   
27
   
34
   
35
   
38
   
39
   
40
   

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 2006 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 generally accepted accounting principles ("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, impairment of 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 2006 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.


21

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS               

PRESENTATION OF NON-GAAP FINANCIAL MEASURES

This Management's Discussion and Analysis includes the following non-GAAP financial measures and accompanying reconciliations to the most directly comparable GAAP financial measures:
·  
Company and segment sales excluding contract ethylene sales under a transition agreement related to the polyethylene ("PE") product lines divested in fourth quarter 2006;
·  
Company gross profit, operating earnings and net earnings excluding accelerated depreciation costs and asset impairments and restructuring charges; and
·  
Segment operating earnings excluding accelerated depreciation costs and asset impairments and restructuring charges.

Eastman's management believes that sales from contract ethylene sales under the transition agreement related to the previous divestiture of the PE product lines do not reflect the continuing and expected future business of the Performance Chemicals and Intermediates ("PCI") segment.  In addition, management believes that corporate and segment earnings should be considered both with and without accelerated depreciation costs and asset impairments and restructuring charges for evaluation and analysis of ongoing business results.   However, management believes that these items are indicative of results of continuous efforts to reduce costs and of actions to improve the profitability of the Company.  Management believes that investors can better evaluate and analyze historical and future business trends if they also consider the reported corporate and segment results, respectively, without the identified items. Management utilizes corporate and segment results including and excluding the identified items in the measures it uses to evaluate business performance and in determining certain performance-based compensation.  These measures, excluding the identified items, are not recognized in accordance with GAAP and should not be viewed as alternatives to the GAAP measures of performance.

In addition, the Company has chosen separately to present on a GAAP basis in this Management's Discussion and Analysis certain financial measures for the Company and certain segments with and without sales, costs, and charges attributable to recently divested product lines.

OVERVIEW

The Company generated sales revenue of $1.9 billion for the second quarter 2007 and second quarter 2006, and $3.7 billion for the first six months 2007 and first six months 2006.  Excluding the sales from divested product lines and contract ethylene sales, sales revenue increased by 6 percent and 8 percent, respectively.

Operating earnings were $168 million in second quarter 2007, a $22 million decrease compared with second quarter 2006, and $303 million in the first six months 2007, a $71 million decrease compared with the first six months 2006.  As a result of strategic decisions related to the Performance Polymers and PCI segments, operating earnings in second quarter and first six months 2007 were negatively impacted by $14 million and $28 million, respectively, of accelerated depreciation costs, as well as $2 million and $23 million, respectively, in asset impairment and restructuring charges. Operating earnings in second quarter and first six months 2006 were negatively impacted by $3 million and $10 million, respectively, in asset impairment and restructuring charges.  Excluding accelerated depreciation costs and asset impairments and restructuring charges from second quarter and first six months 2007 and 2006, operating earnings were $184 million in second quarter 2007 compared with $193 million in second quarter 2006 and $354 million in first six months 2007 compared with $384 million in first six months 2006.  The Company's broad base of businesses continues to have strong results, with the declines primarily due to lower operating results in the Performance Polymers and Fibers segments.

Net earnings for second quarter 2007 were $105 million compared to second quarter 2006 net earnings of $114 million.  Net earnings for first six months 2007 were $182 million compared to first six months 2006 net earnings of $219 million. Excluding accelerated depreciation costs and asset impairment and restructuring charges, net earnings were $114 million and $116 million, for second quarter 2007 and 2006, respectively and $216 million and $228 million for first six months 2007 and 2006, respectively.

22

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS               

The Company generated $99 million in cash from operating activities during the first six months 2007 compared to $163 million from operating activities in the first six months 2006.  The difference was due primarily to contributions to its U.S. defined benefit pension plans.  The Company contributed $100 million and $50 million to its U.S. defined benefit pension plans in the first six months 2007 and 2006, respectively.  The Company does not plan to make additional contributions to its U.S. defined benefit pension plans in 2007.  Priorities for use of available cash include paying the quarterly cash dividend, funding targeted growth initiatives and repurchasing shares.  In the second quarter and first six months 2007, the Company repurchased shares under the authorized repurchase plan totaling $53 million and $86 million, respectively.
 
In addition to achieving the above results, Eastman continued to progress on its overall growth objectives including the announcement on July 27, 2007, of two industrial gasification projects in the U.S. Gulf Coast and actions to improve the performance of its Performance Polymers segment.

The gasification projects demonstrate significant progress in leveraging Eastman's technology and operational expertise to ensure future growth.  These projects are an important part of the efforts to achieve a low cost position and add to the Company's earnings growth.  The Beaumont, Texas project is expected to be on-line in 2011 and will produce low-cost intermediate chemicals, such as methanol, hydrogen and ammonia.  The Company will be an investor, developer, service provider and customer for this project.  The Faustina project is expected to be on-line in 2010 and will produce anhydrous ammonia for agriculture, methanol, sulfur and industrial-grade carbon dioxide.  The Company will be an investor, service provider and customer for this project.

The actions in the Performance Polymers segment include the start-up of the Company's new 350 thousand metric tons polyethylene terephthalate ("PET") facility using IntegRex technology in Columbia, South Carolina, which was fully operational in the first quarter of 2007 and continuing qualifications of the ParaStar PET product with customers. In second quarter 2007, the Company completed the sale of its San Roque, Spain PET facility in its Performance Polymers segment.  For the first six months 2007, sales revenue attributed to PET product manufactured at the San Roque, Spain PET site was $25 million, all of which was recorded in the first quarter 2007, and for the second quarter and first six months 2006, sales revenue was $50 million and $94 million, respectively.

In fourth quarter 2006, the Company sold its Batesville, Arkansas manufacturing facility and related assets in the PCI segment and its PE and Epolene polymer businesses and related assets of the Performance Polymers and Coatings, Adhesives, Specialty Polymers, and Inks ("CASPI") segments.  For the second quarter and first six months of 2006, sales revenue of $214 million and $442 million, respectively and operating earnings of $17 million and $43 million, respectively, were attributed to these divested product lines.  As part of the PE divestiture, the Company entered into a transition agreement for contract ethylene sales, for which revenues and operating earnings are reflected in the PCI segment results in second quarter and first six months 2007.

The Company continues to evaluate its portfolio of businesses and product lines to better focus on its core strengths and improve overall profitability.  The Company is considering strategic options for its underperforming PET manufacturing facilities outside the United States that could lead to further restructuring, divestiture, or consolidation in the Performance Polymers segment to improve profitability, and which may result in asset impairment and restructuring charges.



23

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS               

RESULTS OF OPERATIONS
 
 
Second Quarter
 
Volume Effect
 
Price Effect
 
Product
Mix Effect
 
Exchange
Rate
Effect
(Dollars in millions)
2007
 
2006
 
Change
 
                           
Sales
$
1,895
$
1,929
 
(2) %
 
(5) %
 
2 %
 
-- %
 
1 %
                             
Sales - contract ethylene sales
 
74
 
--
                   
Sales - divested product lines
 
--
 
214
                   
Sales – excluding listed items
 
1,821
 
1,715
 
6 %
 
-- %
 
4 %
 
1 %
 
1 %
                             

Sales revenue in second quarter 2007 compared to the second quarter 2006 decreased $34 million.  Sales revenue in the second quarter 2007 included $74 million of revenue from contract ethylene sales under the transition agreement resulting from the divestiture of the Performance Polymers segment's PE business in the fourth quarter 2006.  Sales revenue in second quarter 2006 included $214 million of revenue from divested product lines.  Excluding divested product lines and contract ethylene sales, revenues increased 6 percent primarily due to higher selling prices.

 
First Six Months
 
Volume Effect
 
Price Effect
 
Product
Mix Effect
 
Exchange
Rate
Effect
(Dollars in millions)
2007
 
2006
 
Change
 
                           
Sales
$
3,690
$
3,732
 
(1) %
 
(4) %
 
1 %
 
1 %
 
1 %
                             
Sales - contract ethylene sales
 
144
 
--
                   
Sales - divested product lines
 
--
 
442
                   
Sales – excluding listed items
 
3,546
 
3,290
 
8 %
 
3 %
 
3 %
 
-- %
 
1 %
                             

Sales revenue in the first six months 2007 compared to the first six months 2006 decreased $42 million.  Sales revenue in the first six months 2007 included $144 million of revenue from contract ethylene sales under the transition agreement.  Sales revenue in first six months 2006 included $442 million of revenue from divested product lines.  Excluding divested product lines and contract ethylene sales, revenues increased 8 percent primarily due to higher sales volume, particularly in the PCI and Specialty Plastics ("SP") segments, and higher selling prices.

24

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS               


 
Second Quarter
 
First Six Months
(Dollars in millions)
2007
 
2006
 
Change
 
2007
 
2006
 
Change
                       
Gross Profit
$
320
$
350
 
(8) %
$
613
$
681
 
(10) %
As a percentage of sales
 
17 %
 
18 %
     
17 %
 
18 %
   
                         
Accelerated depreciation included in cost of goods sold
 
14
 
--
     
28
 
--
   
                         
Gross Profit excluding accelerated depreciation
 
334
 
350
 
(4) %
 
641
 
681
 
(5) %
As a percentage of sales
 
18 %
 
18 %
     
17 %
 
18 %
   

Gross profit and gross profit as a percentage of sales for second quarter 2007 decreased compared to the second quarter 2006.  Second quarter 2007 included accelerated depreciation costs of $14 million resulting from the scheduled shutdown of cracking units in Longview, Texas and of higher cost PET polymer assets in Columbia, South Carolina.  The Company's second quarter 2007 raw material and energy costs increased by approximately $50 million compared with second quarter 2006.

Gross profit for the first six months 2007 decreased compared to the first six months 2006.  The first six months 2007 included accelerated depreciation costs of $28 million resulting from the scheduled shutdown of cracking units in Longview, Texas and of higher cost PET polymer assets in Columbia, South Carolina.  The Company's first six months 2007 raw material and energy costs increased by approximately $100 million compared with first six months 2006.

 
Second Quarter
 
First Six Months
(Dollars in millions)
2007
 
2006
 
Change
 
2007
 
2006
 
Change
                       
Selling, General and
                     
Administrative Expenses
$
113
$
113
 
-- %
$
214
$
211
 
1 %
Research and Development
                       
Expenses
 
37
 
44
 
(16) %
 
73
 
86
 
(15) %
 
$
150
$
157
 
(4) %
$
287
$
297
 
(3) %
As a percentage of sales
 
8 %
 
8 %
     
8 %
 
8 %
   

Selling, general and administrative ("SG&A") expenses for the second quarter 2007 remained flat as compared to second quarter 2006.  SG&A costs for the first six months 2007 increased slightly over the first six months 2006 primarily driven by higher incentive compensation expense.

Research and development ("R&D") expenses decreased $7 million and $13 million in second quarter 2007 compared to second quarter 2006 and first six months 2007 compared to first six months 2006, respectively.  This decrease is primarily due to lower expenses in the Performance Polymers segment resulting from the commercialization of ParaStar next generation PET resins using IntegRex technology.

25

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS               

Asset Impairments and Restructuring Charges, Net

Asset impairments and restructuring charges, net, totaled $2 million and $23 million for the second quarter and first six months 2007, respectively, compared to $3 million and $10 million in the second quarter and first six months 2006.  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, primarily related to recent divestitures, see the Performance Polymers and SP segment discussions and Note 6 to the Company's unaudited consolidated financial statements.

Operating Earnings
Second Quarter
 
First Six Months
 
2007
 
2006
 
Change
 
2007
 
2006
 
Change
(Dollars in millions, except per share amounts)
                     
                         
Operating earnings
$
168
$
190
 
(12) %
$
303
$
374
 
(19)%
Accelerated depreciation included in cost of goods sold
 
14
 
--
     
28
 
--
   
Asset impairments and restructuring charges
 
2
 
3
     
23
 
10
   
Operating earnings excluding accelerated depreciation and asset impairment and restructuring charges
$
184
$
193
 
(5) %
$
354
$
384
 
(8) %

Interest Expense, Net

 
Second Quarter
 
First Six Months
(Dollars in millions)
2007
 
2006
 
Change
 
2007
 
2006
 
Change
                       
Gross interest costs
$
29
$
28
   
$
58
$
56
   
Less:  Capitalized interest
 
4
 
2
     
5
 
3
   
Interest expense
 
25
 
26
 
(4)%
 
53
 
53
 
--%
Interest income
 
10
 
5
     
20
 
12
   
Interest expense, net
$
15
$
21
 
(29)%
$
33
$
41
 
(20)%
                       

Gross interest costs for the second quarter and first six months 2007 were higher compared to the first quarter and first six months 2006 due to higher average interest rates.

For 2007, the Company expects net interest expense to decrease compared to 2006 due to higher interest income driven by higher invested cash balances.

Other (Income) Charges, Net

 
Second Quarter
 
First Six Months
(Dollars in millions)
2007
 
2006
 
Change
 
2007
 
2006
 
Change
                       
Other (income)
$
(4)
$
(4)
$
-- %
$
(11)
$
(7)
$
57 %
Other charges
 
1
 
2
 
(50) %
 
5
 
4
 
25 %
Other (income) charges, net
$
(3)
$
(2)
$
50 %
$
(6)
$
(3)
$
100 %
Included in other income are the Company’s portion of earnings from its equity investments, net gains on foreign e

26

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS               

xchange transactions, and other non-operating income related to Holston Defense Corporation's post-retirement benefits.  Included in other charges are net losses on foreign exchange transactions and fees on securitized receivables.

Provision for Income Taxes
 
 
Second Quarter
First Six Months
(Dollars in millions)
2007
 
2006
 
2007
 
2006
               
Provision for
income taxes
$
51
$
57
$
94
$
117
Effective tax rate
 
32.7%
 
33.5%
 
34.0%
 
34.9%

 
The second quarter and first six months 2007 effective tax rates reflect the Company's normal tax rate on reported operating earnings before income tax, excluding discrete items, of approximately 34 percent.  The decreases in the effective tax rates for second quarter and first six months 2007 compared to second quarter and first six months 2006 are primarily attributable to higher foreign earnings in favorable tax jurisdictions.

The second quarter and first six months 2006 effective tax rates reflect the Company's expected tax rate on reported operating earnings before income tax, excluding discrete items, of approximately 35 percent.  The second quarter and first six months 2006 effective tax rates were impacted by lower foreign earnings in favorable tax jurisdictions.  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 second quarter and first six months 2006.

Net Earnings
           
   
Second Quarter
 
First Six Months
(Dollars in millions, except per share amounts)
 
2007
 
2006
 
2007
 
2006
                 
Net earnings
$
105
$
114
$
182
$
219
Accelerated depreciation included in cost of goods sold, net of tax
 
8
 
--
 
18
 
--
Asset impairments and restructuring charges, net of tax
 
1
 
2
 
16
 
9
Net earnings excluding accelerated depreciation and asset impairment and restructuring charges, net of tax
$
114
$
116
$
216
$
228

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.   For additional information concerning the Company’s operating businesses and products, refer to Note 21, "Segment Information", to the consolidated financial statements in Part II, Item 8 of the Company's 2006 Annual Report on Form 10-K.

Revenues and R&D and other expenses not identifiable to an operating segment are not included in segment operating results for either of the periods presented and are shown in Note 14, "Segment Information", as "other" revenues and operating losses in this Form 10-Q.

In fourth quarter 2006, certain product lines were transferred from the PCI segment to the Performance Polymers segment.  Accordingly, the prior year's amounts for sales and operating earnings have been adjusted to retrospectively apply these changes to all periods presented.

27

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS               


CASPI Segment
 
Second Quarter
 
First Six Months
         
Change
         
Change
(Dollars in millions)
2007
 
2006
 
$
 
%
 
2007
 
2006
 
$
 
%
                               
Sales
$
376
$
362
$
14
 
4 %
$
721
$
711
$
10
 
1 %
 
Volume effect
       
(14)
 
(4)%
         
(41)
 
(6)%
 
Price effect
       
14
 
4 %
         
30
 
4 %
 
Product mix effect
       
9
 
2 %
         
8
 
1 %
 
Exchange rate effect
       
5
 
2 %
         
13
 
2 %
                               
Operating earnings
66
 
68
 
(2)
 
(3) %
 
131
 
123
 
8
 
7 %
                               
Asset impairments and
                             
restructuring charges, net
--
 
1
 
(1)
     
--
 
8
 
(8)
   
                               
Operating earnings excluding asset impairments and restructuring charges, net
66
 
69
 
(3)
 
(4) %
 
131
 
131
 
--
 
-- %

Sales revenue increased $14 million in second quarter 2007 compared to second quarter 2006 and $10 million in the first six months 2007 compared to first six months 2006.  Excluding Epolene product lines divested in fourth quarter 2006, sales revenue increased due to an increase in selling prices in response to higher raw material and energy costs.

Excluding asset impairments and restructuring charges of $1 million for the second quarter 2006, operating earnings decreased $3 million for second quarter 2007 compared to second quarter 2006.Excluding asset impairments and restructuring charges of $8 million for the first six months 2006, operating earnings were flat for the first six months 2007 compared to the first six months 2006.Asset impairments and restructuring charges were related to previously closed manufacturing facilities. 

Fibers Segment
 
Second Quarter
 
First Six Months
         
Change
         
Change
(Dollars in millions)
2007
 
2006
 
$
 
%
 
2007
 
2006
 
$
 
%
                               
Sales
$
239
$
238
$
1
 
-- %
$
473
$
468
$
5
 
1 %
 
Volume effect
       
(10)
 
(4)%
         
(20)
 
(4)%
 
Price effect
       
10
 
4 %
         
18
 
4 %
 
Product mix effect
       
--
 
-- %
         
5
 
1 %
 
Exchange rate effect
       
1
 
-- %
         
2
 
-- %
                               
Operating earnings
51
 
61
 
(10)
 
(16) %
 
110
 
127
 
(17)
 
(13) %

Sales revenue increased $1 million in second quarter 2007 compared to second quarter 2006 and increased $5 million in the first six months 2007 compared to first six months 2006 due to higher selling prices partially offset by lower sales volume.  Selling prices increased in response to higher raw material and energy costs, while the lower sales volume was attributed to customer buying patterns in acetate tow and lower demand for acetyl chemicals resulting from a customer's operational disruption.


28

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS               

Operating earnings decreased $10 million for second quarter 2007 compared to second quarter 2006 and $17 million for first six months 2007 compared to first six months 2006 primarily due to lower sales volume for acetate tow and acetyl chemicals product lines and higher raw material and energy costs, particularly for wood pulp.

PCI Segment
 
Second Quarter
 
First Six Months
         
Change
         
Change
(Dollars in millions)
2007
 
2006
 
$
 
%
 
2007
 
2006
 
$
 
%
                               
Sales
$
552
$
431
$
121
 
28 %
$
1,050
$
823
$
227
 
28 %
 
Volume effect
       
135
 
31 %
         
269
 
33 %
 
Price effect
       
(1)
 
-- %
         
(49)
 
(6) %
 
Product mix effect
       
(15)
 
(3) %
         
2
 
-- %
 
Exchange rate effect
       
2
 
-- %
         
5
 
1 %
                               
Sales – contract ethylene sales
74
 
--
 
74
     
144
 
--
 
144
   
                               
Sales – divested product lines
--
 
29
 
(29)
     
--
 
59
 
(59)
   
                               
Sales – excluding listed items
478
 
402
 
76
 
19 %
 
906
 
764
 
142
 
19 %
Volume effect
       
53
 
13 %
         
103
 
14 %
Price effect
       
28
 
7 %
         
35
 
5 %
Product mix effect
       
(7)
 
(2) %
         
(1)
 
-- %
Exchange rate effect
       
2
 
1 %
         
5
 
1 %
                               
Operating earnings
57
 
45
 
12
 
27 %
 
111
 
86
 
25
 
29 %
Operating earnings – divested product lines (1)
--
 
1
 
(1)
 
(100)%
 
--
 
3
 
(3)
 
(100)%
Operating earnings – excluding listed items
57
 
44
 
13
 
30 %
 
111
 
83
 
28
 
34 %
                               
Accelerated depreciation included in cost of goods sold
7
 
--
 
7
     
14
 
--
 
14
   
                               
Operating earnings excluding accelerated depreciation
64
 
45
 
19
 
42 %
 
125
 
86
 
39
 
45 %
Operating earnings excluding accelerated depreciation – divested product lines (1)
--
 
1
 
(1)
 
(100)%
 
--
 
3
 
(3)
 
(100)%
Operating earnings excluding accelerated depreciation– excluding listed items
64
 
44
 
20
 
45 %
 
125
 
83
 
42
 
51 %
                               
 
(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.

29

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS               

Sales revenue increased $121 million in second quarter 2007 compared to second quarter 2006 and $227 million in the first six months 2007 compared to first six months 2006 primarily due to contract ethylene sales under the transition agreement resulting from the divestiture of the Performance Polymers segment's PE business in the fourth quarter 2006.  These sales were $74 million and $144 million in second quarter and first six months 2007, respectively. Excluding the contract ethylene sales, sales revenue increased due to an increase in sales volume and higher selling prices. The higher sales volume and increased selling prices were attributed to strong demand, primarily for olefin-based derivative products and acetyl chemicals in Asia Pacific and the United States.

Excluding accelerated depreciation costs of $7 million in second quarter 2007 compared to second quarter 2006, operating earnings increased $19 million due to increased sales volume and higher selling prices.   Excluding accelerated depreciation costs of $14 million in the first six months 2007 compared to first six months 2006, operating earnings increased $39 million due to increased sales volume and higher selling prices.  For second quarter and first six months 2007 contract ethylene sales had minimal impact.  The accelerated depreciation costs are related to the continuation of the planned staged phase-out of older cracking units in 2007 at the Company's Longview, Texas facility.

In the fourth quarter 2006 the Company completed its divestiture of the PCI segment's Batesville, Arkansas manufacturing facility and related assets and specialty organic chemicals product lines.  Sales revenue and operating earnings attributed to the divested product lines were $29 million and $1 million, respectively, in second quarter 2006 and $59 million and $3 million, respectively, in first six months 2006.

30

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS               


Performance Polymers Segment
 
Second Quarter
 
First Six Months
         
Change
         
Change
(Dollars in millions)
2007
 
2006
 
$
 
%
 
2007
 
2006
 
$
 
%
                               
Sales
$
513
$
696
$
(183)
 
(26) %
$
1,019
$
1,341
$
(322)
 
(24) %
 
Volume effect
       
(209)
 
(30) %
         
(357)
 
(27) %
 
Price effect
       
12
 
2 %
         
10
 
1 %
 
Product mix effect
       
4
 
1 %
         
1
 
-- %
 
Exchange rate effect
       
10
 
1 %
         
24
 
2 %
                               
Sales – divested product lines (1)
--
 
168
 
(168)
 
(100)%
 
--
 
348
 
(348)
 
(100)%
                               
Sales – continuing product lines
513
 
528
 
(15)
 
(3) %
 
1,019
 
993
 
26
 
2 %
Volume effect
       
(41)
 
(8) %
         
(9)
 
(1) %
Price effect
       
12
 
2 %
         
10
 
1 %
Product mix effect
       
4
 
1 %
         
1
 
-- %
Exchange rate effect
       
10
 
2 %