Filed by Bowne Pure Compliance
Table of Contents

 
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2008
or
     
o   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 1-584
FERRO CORPORATION
(Exact name of registrant as specified in its charter)
     
Ohio   34-0217820
(State of Corporation)   (IRS Employer Identification No.)
     
1000 Lakeside Avenue   44114
Cleveland, OH   (Zip Code)
(Address of Principal executive offices)    
216-641-8580
(Telephone Number)
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 þ NO o
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 þ   Accelerated filer o   Non-accelerated filer o (Do not check if a smaller reporting company)   Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). YES o NO þ
At October 31, 2008, there were 43,743,117 shares of Ferro Common Stock, par value $1.00, outstanding.
 
 

 

 


 

TABLE OF CONTENTS
         
PART I
 
       
  Page 3
 
       
  Page 21
 
       
  Page 33
 
       
  Page 35
 
       
PART II
 
       
  Page 36
 
       
  Page 37
 
       
  Page 43
 
       
  Page 43
 
       
  Page 43
 
       
  Page 43
 
       
  Page 43
 
       
 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32.1
 Exhibit 32.2

 

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PART I — FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Ferro Corporation and Consolidated Subsidiaries
Condensed Consolidated Statements of Income
                                 
    Three months ended     Nine months ended  
    September 30,     September 30,  
    2008     2007     2008     2007  
    (Dollars in thousands, except per share amounts)  
Net sales
  $ 608,588     $ 550,701     $ 1,866,240     $ 1,634,064  
Cost of sales
    494,577       450,553       1,515,526       1,319,609  
 
                       
Gross profit
    114,011       100,148       350,714       314,455  
Selling, general and administrative expenses
    78,274       71,069       238,122       234,212  
Restructuring charges
    9,042       5,826       22,280       7,689  
Other expense (income):
                               
Interest expense
    12,497       14,488       39,740       46,220  
Interest earned
    (213 )     (271 )     (484 )     (1,425 )
Loss on extinguishment of debt
    5,531             5,531        
Foreign currency losses (gains), net
    1,660       (10 )     769       924  
Miscellaneous expense (income), net
    727       (13 )     4,659       (399 )
 
                       
Income before taxes
    6,493       9,059       40,097       27,234  
Income tax expense
    1,605       3,472       16,688       10,814  
 
                       
Income from continuing operations
    4,888       5,587       23,409       16,420  
Loss from discontinued operations, net of tax
    57       2       73       216  
 
                       
Net income
    4,831       5,585       23,336       16,204  
Dividends on preferred stock
    225       252       675       797  
 
                       
Net income available to common shareholders
  $ 4,606     $ 5,333     $ 22,661     $ 15,407  
 
                       
 
                               
Per common share data
                               
Basic earnings:
                               
From continuing operations
  $ 0.11     $ 0.12     $ 0.53     $ 0.36  
From discontinued operations
    0.00       0.00       0.00       0.00  
 
                       
 
  $ 0.11     $ 0.12     $ 0.53     $ 0.36  
 
                       
Diluted earnings:
                               
From continuing operations
  $ 0.11     $ 0.12     $ 0.52     $ 0.36  
From discontinued operations
    0.00       0.00       0.00       0.00  
 
                       
 
  $ 0.11     $ 0.12     $ 0.52     $ 0.36  
 
                       
 
                               
Cash dividends declared
  $ 0.145     $ 0.145     $ 0.435     $ 0.435  
 
                       
See accompanying notes to condensed consolidated financial statements.

 

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Ferro Corporation and Consolidated Subsidiaries
Condensed Consolidated Balance Sheets
                 
    September 30,     December 31,  
    2008     2007  
    (Dollars in thousands)  
ASSETS
 
Current assets
               
Cash and cash equivalents
  $ 14,524     $ 12,025  
Accounts and trade notes receivable, net
    253,183       245,369  
Note receivable from Ferro Finance Corporation
    29,708       29,577  
Inventories
    306,254       262,799  
Deferred income taxes
    23,549       15,764  
Other receivables
    52,500       33,419  
Other current assets
    7,412       8,239  
 
           
Total current assets
    687,130       607,192  
Other assets
               
Property, plant and equipment, net
    506,382       519,959  
Goodwill
    290,088       291,070  
Amortizable intangible assets, net
    11,899       9,071  
Deferred income taxes
    99,210       100,935  
Other non-current assets
    112,581       110,033  
 
           
Total assets
  $ 1,707,290     $ 1,638,260  
 
           
 
               
LIABILITIES AND SHAREHOLDERS’ EQUITY
 
Current liabilities
               
Loans payable and current portion of long-term debt
  $ 7,372     $ 5,444  
Accounts payable
    263,189       269,591  
Income taxes
    23,926        
Accrued payrolls
    33,286       26,415  
Accrued expenses and other current liabilities
    90,235       108,882  
 
           
Total current liabilities
    418,008       410,332  
Other liabilities
               
Long-term debt, less current portion
    601,997       520,645  
Postretirement and pension liabilities
    130,151       140,988  
Deferred income taxes
    9,416       9,848  
Other non-current liabilities
    53,068       56,644  
 
           
Total liabilities
    1,212,640       1,138,457  
Minority interests
    10,318       9,896  
Series A convertible preferred stock (approximates redemption value)
    12,517       13,623  
Shareholders’ equity
               
Common stock
    52,323       52,323  
Paid-in capital
    167,105       166,391  
Retained earnings
    471,463       468,190  
Accumulated other comprehensive loss
    (18,827 )     (7,765 )
Common shares in treasury, at cost
    (200,249 )     (202,855 )
 
           
Total shareholders’ equity
    471,815       476,284  
 
           
Total liabilities and shareholders’ equity
  $ 1,707,290     $ 1,638,260  
 
           
See accompanying notes to condensed consolidated financial statements.

 

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Ferro Corporation and Consolidated Subsidiaries
Condensed Consolidated Statement of Shareholders’ Equity and Comprehensive Income
                                                         
                                            Accumulated     Total  
    Common Shares                             Other     Share-  
    in Treasury     Common     Paid-in     Retained     Comprehensive     holders’  
    Shares     Amount     Stock     Capital     Earnings     Loss     Equity  
    (In thousands)  
Balances at December 31, 2007
    8,753     $ (202,855 )   $ 52,323     $ 166,391     $ 468,190     $ (7,765 )   $ 476,284  
Net income
                                    23,336               23,336  
Other comprehensive income (loss), net of tax:
                                                       
Foreign currency translation adjustments
                                            (15,014 )     (15,014 )
Postretirement benefit liability adjustments
                                            2,676       2,676  
Raw material commodity swap adjustments
                                            454       454  
Interest rate swap adjustments
                                            456       456  
 
                                         
Total comprehensive income
                                                    11,908  
Cash dividends:
                                                       
Common
                                    (18,883 )             (18,883 )
Preferred
                                    (675 )             (675 )
Income tax benefits
                            32                       32  
Stock-based compensation transactions
    (173 )     2,606               682                       3,288  
Adjustment to initially apply FAS No. 158 as of January 1, 2008
                                    (505 )     366       (139 )
 
                                         
Balances at September 30, 2008
    8,580     $ (200,249 )   $ 52,323     $ 167,105     $ 471,463     $ (18,827 )   $ 471,815  
 
                                         
See accompanying notes to condensed consolidated financial statements.

 

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Ferro Corporation and Consolidated Subsidiaries
Condensed Consolidated Statements of Cash Flows
                 
    Nine months ended  
    September 30,  
    2008     2007  
    (Dollars in thousands)  
Cash flows from operating activities
               
Net income
  $ 23,336     $ 16,204  
Depreciation and amortization
    57,770       63,825  
Precious metals deposits
          70,073  
Accounts and trade notes receivable, inventories, and accounts payable
    (66,426 )     13,696  
Note receivable from Ferro Finance Corporation
    (131 )     (6,804 )
Other changes in current assets and liabilities, net
    (3,106 )     (27,964 )
Other adjustments, net
    (9,532 )     (7,701 )
 
           
Net cash provided by continuing operations
    1,911       121,329  
Net cash used for discontinued operations
    (73 )     (48 )
 
           
Net cash provided by operating activities
    1,838       121,281  
Cash flows from investing activities
               
Capital expenditures for property, plant and equipment
    (51,805 )     (43,247 )
Expenditures for other assets
    (3,400 )      
Proceeds from sale of assets and businesses
    586       2,704  
Dividends received from affiliates
    336       551  
 
           
Net cash used for investing activities
    (54,283 )     (39,992 )
Cash flows from financing activities
               
Net borrowings (repayments) under short-term facilities
    2,102       (740 )
Proceeds from convertible notes
    172,500        
Proceeds from revolving credit facility
    756,440       592,167  
Proceeds from term loan facility
          55,000  
Extinguishment of 9 1/8% notes
    (205,269 )      
Principal payments on revolving credit facility
    (638,227 )     (700,864 )
Principal payments on term loan facility
    (8,689 )     (2,287 )
Debt issue costs paid
    (5,462 )     (1,783 )
Proceeds from exercise of stock options
    58       9,217  
Cash dividends paid
    (19,558 )     (19,570 )
Other financing activities
    1,464       (4,442 )
 
           
Net cash provided by (used for) financing activities
    55,359       (73,302 )
Effect of exchange rate changes on cash and cash equivalents
    (415 )     849  
 
           
Increase in cash and cash equivalents
    2,499       8,836  
Cash and cash equivalents at beginning of period
    12,025       16,985  
 
           
Cash and cash equivalents at end of period
  $ 14,524     $ 25,821  
 
           
 
               
Cash paid during the period for:
               
Interest
  $ 46,247     $ 46,925  
Income taxes
  $ 8,379     $ 11,387  
See accompanying notes to condensed consolidated financial statements.

 

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Ferro Corporation and Consolidated Subsidiaries
Notes to Condensed Consolidated Financial Statements
1. Basis of Presentation
Ferro Corporation (“Ferro,” “we,” “us” or “the Company”) prepared these unaudited condensed consolidated financial statements of Ferro Corporation and its consolidated subsidiaries in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements and, therefore, should be read in conjunction with the consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2007. The preparation of financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect the timing and amount of assets, liabilities, equity, revenues and expenses reported and disclosed. Actual amounts could differ from our estimates, resulting in changes in revenues or costs that could have a material impact on the Company’s results of operations, financial position, or cash flows. In our opinion, we made all adjustments that are necessary for a fair presentation, and those adjustments are of a normal recurring nature unless otherwise noted. Due to differing business conditions, our various initiatives, and some seasonality, the results for the three and nine months ended September 30, 2008, are not necessarily indicative of the results expected in subsequent quarters or for the full year.
2. Accounting Standards Adopted in the Nine Months Ended September 30, 2008
On January 1, 2008, we adopted FASB Statement No. 157, Fair Value Measurements, (“FAS No. 157”), FASB Staff Position No. FAS 157-1, Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement Under Statement 13, (“FSP No. FAS 157-1”), and FASB Staff Position No. FAS 157-2, Effective Date of FASB Statement No. 157, (“FSP No. FAS 157-2”). Effective July 1, 2008, we also adopted FASB Staff Position No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset is not Active, (“FSP No. FAS 157-3”). FAS No. 157 defines fair value, establishes a framework and gives guidance regarding the methods used for measuring fair value, and expands disclosures about fair value measurements, but does not require any new fair value measurements. FSP No. FAS 157-1 excludes FASB Statement No. 13, Accounting for Leases, (“FAS No. 13”) as well as other accounting pronouncements that address fair value measurement on lease classification or measurement under FAS No. 13 from the scope of FAS No. 157. FSP No. FAS 157-2 delays the effective date of FAS No. 157 for all nonrecurring fair value measurements of nonfinancial assets and nonfinancial liabilities until fiscal years beginning after November 15, 2008. FSP No. FAS 157-3 amends FAS No. 157 to give an example of how to determine the fair value of a financial asset in an inactive market, but does not change the fair value measurement principles of FAS No. 157. The portions of these pronouncements that were not delayed were adopted prospectively, and their adoption reduced the disclosed fair value of our borrowings under the revolving credit and term loan facilities and reduced the carrying value of our interest rate swaps. We are currently evaluating the impact on our consolidated financial statements of adopting the deferred portions of these pronouncements on January 1, 2009.
On January 1, 2008, we adopted the measurement provisions of FASB Statement No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB Statements No. 87, 88, 106, and 132(R), (“FAS No. 158”). The measurement provisions require companies to measure defined benefit plan assets and obligations as of the annual balance sheet date. Previously, we used September 30 as the measurement date for U.S. pension and other postretirement benefits. We have elected to use the September 30, 2007, measurement of assets and benefit obligations to calculate the fiscal year 2008 expense. Expense for the gap period from September 30 to December 31 is recognized as of January 1, 2008, as a charge of $0.5 million, net of tax, to retained earnings and a credit of $0.4 million, net of tax, to accumulated other comprehensive income.
On January 1, 2008, we adopted FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115, (“FAS No. 159”). This statement permits us to choose, at specified election dates, to measure eligible items at fair value (the “fair value option”). For items for which the fair value option has been elected, we would report unrealized gains and losses in earnings at each subsequent reporting date and recognize up-front costs and fees in earnings as incurred. We have not elected to measure any eligible items at fair value, and we do not have any current plans to do so. Therefore, adoption of FAS No. 159 did not have an effect on our consolidated financial statements.

 

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On January 1, 2008, we adopted Emerging Issues Task Force Issue No. 06-11, Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards, (“EITF No. 06-11”). EITF No. 06-11 requires that the income tax benefit from dividends that are charged to retained earnings and paid to employees for nonvested equity shares be recognized as an increase to paid-in capital. Previously, we recognized this income tax benefit as an increase to retained earnings. Beginning in 2008, we report this income tax benefit as an increase to paid-in capital.
3. Newly Issued Accounting Pronouncements
In December 2007, the FASB issued Statement No. 141(R), Business Combinations, (“FAS No. 141(R)”) and Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51, (“FAS No. 160”). These statements change the way that companies account for business combinations and noncontrolling interests (e.g., minority interests). Both standards are to be applied prospectively for fiscal years beginning after December 15, 2008. However, FAS No. 160 requires entities to apply the presentation and disclosure requirements retrospectively to comparative financial statements. In 2009, we will retrospectively reclassify the amount of minority interests in consolidated subsidiaries to equity and separately report the amount of net income or loss attributable to minority interests.
In March 2008, the FASB issued Statement No. 161, Disclosures about Derivative Instruments and Hedging Activities — an amendment of FASB Statement No. 133, (“FAS No. 161). This Statement requires enhanced disclosures about an entity’s derivative and hedging activities. This Statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. This Statement encourages, but does not require, comparative disclosures for earlier periods at initial adoption. We do not expect the adoption of FAS No. 161 to have a material impact on our consolidated financial statements.
In April 2008, the FASB issued Staff Position No. FAS 142-3, Determination of the Useful Life of Intangible Assets, (“FSP No. FAS 142-3”). This pronouncement amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No. 142, Goodwill and Other Intangible Assets. FSP No. FAS 142-3 is to be applied prospectively and is effective for financial statements issued for fiscal years beginning after December 15, 2008, with early adoption prohibited. We are currently evaluating its effect on our financial statements.
In May 2008, the FASB issued Staff Position No. APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement), (“FSP No. APB 14-1”). This pronouncement specifies that issuers of such instruments should separately account for the liability and equity components in a manner that will reflect the entity’s nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods. FSP No. APB 14-1 is to be applied retrospectively and is effective for financial statements issued for fiscal years and interim periods beginning after December 15, 2008. If this pronouncement had been applied at September 30, 2008, the carrying value of the liability component of the 6.50% Convertible Senior Notes would have been approximately $152.7 million, including $0.4 million of imputed interest, and the carrying value of the equity component would have been approximately $19.6 million, net of $0.6 million of allocated third-party transaction costs.
4. Inventories
Inventories consisted of the following:
                 
    September 30,     December 31,  
    2008     2007  
    (Dollars in thousands)  
Raw materials
  $ 94,975     $ 74,659  
Work in process
    50,639       41,640  
Finished goods
    160,640       146,500  
 
           
Total
  $ 306,254     $ 262,799  
 
           

 

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In the production of some of our products, we use precious metals, some of which we obtain from financial institutions under consignment agreements with terms of one year or less. The financial institutions retain ownership of the precious metals and charge us fees based on the amounts we consign. These fees were $1.1 million and $0.8 million for the three months ended September 30, 2008 and 2007, respectively, and $3.4 million and $2.8 million for the nine months ended September 30, 2008 and 2007, respectively, and were charged to cost of sales. We had on hand $125.8 million at September 30, 2008, and $148.3 million at December 31, 2007, of precious metals owned by financial institutions, measured at fair value based on market prices for identical assets.
5. Property, Plant and Equipment
Property, plant and equipment is reported net of accumulated depreciation of $668.0 million at September 30, 2008, and $713.5 million at December 31, 2007.
6. Financing and Long-term Debt
Loans payable and current portion of long-term debt consisted of the following:
                 
    September 30,     December 31,  
    2008     2007  
    (Dollars in thousands)  
Loans payable to banks
  $ 3,128     $ 954  
Current portion of long-term debt
    4,244       4,490  
 
           
Total
  $ 7,372     $ 5,444  
 
           
Long-term debt consisted of the following:
                 
    September 30,     December 31,  
    2008     2007  
    (Dollars in thousands)  
$172.5 million 6.50% Convertible Senior Notes
  $ 172,500     $  
$200 million 9 1/8% Senior Notes, net of unamortized discounts
          199,636  
Revolving credit facility
    132,070       13,857  
Term loan facility
    293,261       301,950  
Capitalized lease obligations
    7,863       8,924  
Other notes
    547       768  
 
           
 
    606,241       525,135  
Less current portion
    (4,244 )     (4,490 )
 
           
Total
  $ 601,997     $ 520,645  
 
           
Credit Rating
At September 30, 2008, the Company’s corporate credit rating was B1, with a positive outlook, by Moody’s Investor Services, Inc. and B+, with a stable outlook, by Standard & Poor’s Rating Group.
6.50% Convertible Senior Notes
In August 2008, Ferro issued $172.5 million of 6.50% Convertible Senior Notes due 2013 (the “Convertible Notes”). The proceeds from the offering, along with available cash, including borrowings under Ferro’s revolving credit facility, were used to purchase all of Ferro’s outstanding 9 1/8% Senior Notes. The Convertible Notes bear interest at a rate of 6.5% per year, payable semi-annually in arrears on February 15 and August 15 of each year, beginning on February 15, 2009. The Convertible Notes mature on August 15, 2013.

 

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The Convertible Notes are convertible, under certain circumstances, using a net share settlement process, into a combination of cash and shares of Ferro’s common stock. The initial base conversion price of the Convertible Notes is approximately $32.34, based on the initial base conversion rate of 30.9253 shares of common stock per $1,000 principal amount of Convertible Notes. Upon conversion of a Convertible Note, the holder will receive cash equal to the principal amount of the Convertible Note and shares of common stock to the extent the Convertible Note’s conversion value exceeds the principal amount. In addition, upon certain circumstances, Ferro will increase the applicable conversion rate for a holder who elects to convert its Convertible Notes. The number of additional shares of common stock is determined pursuant to a specified formula, which is dependent on the Company’s stock price at the time of conversion. Ferro may be required to repurchase the Convertible Notes if Ferro is involved in certain types of corporate transactions or other events constituting a fundamental change.
9 1/8% Senior Notes
In June 2008, Ferro commenced a cash tender offer to purchase any and all of its outstanding $200 million aggregate principal amount of 9 1/8% Senior Notes due 2009 (the “9 1/8% Notes”). In August and September, we purchased all of the 9 1/8% Notes for $205.3 million, including call premiums and tender costs, and recorded a loss of $5.5 million, including unamortized discounts and fees. We financed the purchase of the 9 1/8% Notes and related costs from the issuance of the Convertible Notes, along with available cash, including borrowings under Ferro’s revolving credit facility.
Revolving Credit and Term Loan Facilities
In 2006, we entered into an agreement with a group of lenders for a $700 million credit facility, consisting of a multi-currency senior revolving credit facility and a senior term loan facility. In 2007, we cancelled the unused portion of the term loan facility and amended the credit facility (the “Amended Credit Facility”). At September 30, 2008, the Amended Credit Facility consisted of a $300 million revolving credit facility, which matures in 2011, and a $305 million term loan facility, which matures in 2012. As part of the agreement, we can request an increase of $50 million in the revolving credit facility. We had $159.3 million at September 30, 2008, and $277.5 million at December 31, 2007, available under the revolving credit facility, after reductions for standby letters of credit secured by this facility. In 2007, we began making periodic principal payments on the term loans. We are required to make minimum quarterly principal payments of $0.8 million from July 2008 to July 2011. During the last year of the loan’s life, we are required to repay the remaining balance of the term loans in four quarterly installments. Currently, those last four payments will be $71.0 million each. In addition to the minimum quarterly payments, each April we may be required to make an additional principal payment. The amount of this additional payment is dependent on the Company’s leverage and certain cash flow metrics. Any additional payment that is required reduces, on a dollar-for-dollar basis, the amount due in the last four quarterly payments. In April 2008, we made an additional principal payment of $6.4 million.
The interest rates under the Amended Credit Facility are equal to the sum of (A) either (1) LIBOR or (2) the higher of the Federal Funds Rate plus 0.5% or the Prime Rate and (B) for the revolving credit facility, a variable margin based on the Company’s leverage, or for the term loan facility, a fixed margin. As part of the 2007 amendments, $175 million of borrowings under the term loan facility were restricted to using three-month LIBOR in determining their interest rates. This change was made in connection with interest rate swap agreements executed in 2007. These swap agreements effectively fixed the interest rate through June 2011 on $150 million of borrowings under the term loan facility. The average interest rate for revolving credit borrowings was 4.4% at September 30, 2008, and 6.5% at December 31, 2007, and the effective interest rate for term loan borrowings after adjusting for the interest rate swaps was 6.2% at September 30, 2008, and 7.2% at December 31, 2007.
Receivable Sales Programs
We have several programs to sell, on an ongoing basis, pools of our trade accounts receivable. These programs accelerate cash collections at favorable financing costs and help us manage the Company’s liquidity requirements. The costs associated with these programs are reported as interest expense and were $5.1 million and $5.3 million for the nine months ended September 30, 2008 and 2007, respectively.

 

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In our largest program, we sell substantially all of Ferro’s U.S. trade accounts receivable to Ferro Finance Corporation (“FFC”), a wholly-owned unconsolidated qualified special purpose entity (“QSPE”). FFC finances its acquisition of trade receivable assets by issuing beneficial interests in (securitizing) the receivables to multi-seller receivables securitization companies (the “Conduits”). In June 2008, we amended the program to reduce the maximum proceeds and the conduits’ commitment levels from $100 million to $75 million. Ferro had received net proceeds of $75.0 million at September 30, 2008, and $54.6 million at December 31, 2007, for outstanding receivables. FFC and the Conduits have no recourse to Ferro’s other assets for failure of debtors to pay when due, as the assets transferred are legally isolated in accordance with the U.S. bankruptcy laws. Ferro, on behalf of FFC and the Conduits, provides normal collection and administration services for the trade accounts receivable sold.
Activity from this program for the nine months ended September 30 is detailed below:
                 
    2008     2007  
    (Dollars in thousands)  
Trade accounts receivable sold to FFC
  $ 840,151     $ 739,005  
Cash proceeds from FFC
    840,405       731,454  
Trade accounts receivable collected and remitted to FFC and the conduits
    820,027       726,553  
In addition, we maintain several international programs to sell trade accounts receivable, primarily without recourse. The commitments supporting these programs can be withdrawn at any time and totaled $78.0 million at September 30, 2008, and $80.8 million at December 31, 2007. Ferro had received net proceeds under the international programs of $28.8 million at September 30, 2008, and $42.1 million at December 31, 2007, for outstanding receivables. Ferro provides normal collection and administration services for the trade accounts receivable sold to certain financial institutions.
Activity from these programs for the nine months ended September 30 is detailed below:
                 
    2008     2007  
    (Dollars in thousands)  
Trade accounts receivable sold to financial institutions
  $ 186,054     $ 128,788  
Cash proceeds from financial institutions
    184,628       125,024  
Trade accounts receivable collected and remitted to financial institutions for programs where we provide collection and administrative services
    60,863       65,060  
7. Financial Instruments
The following financial instruments are measured at fair value for disclosure purposes. The carrying values of these instruments may or may not be their fair values.
6.50% Convertible Senior Notes. The carrying amount of the Convertible Notes was $172.5 million and their fair value was $159.7 million at September 30, 2008. The fair value of these notes is based on a third party’s estimated bid price.
9 1/8% Senior Notes. The carrying amount of the 9 1/8% Notes was $199.6 million and their fair value was $205.0 million at December 31, 2007. The fair value of these notes is based on a third party’s estimated bid price.
Revolving credit facility. The carrying amount of the revolving credit facility was $132.1 million at September 30, 2008, and $13.9 million at December 31, 2007. The fair value of the revolving credit facility was $122.9 million at September 30, 2008, and $13.9 million at December 31, 2007. The fair value of the revolving credit facility is based on the present value of expected future cash flows and assumptions about current interest rates. Beginning in 2008 in connection with the adoption of FAS No. 157, the fair value also reflects assumptions about the creditworthiness of the Company that market participants would use in pricing the debt.
Term loan facility. The carrying amount of the term loan facility was $293.3 million at September 30, 2008, and $302.0 million at December 31, 2007. The fair value of the term loan facility was $272.9 million at September 30, 2008, and $302.0 million at December 31, 2007. The fair value of the term loan facility is based on the present value of expected future cash flows and assumptions about current interest rates. Beginning in 2008 in connection with the adoption of FAS No. 157, the fair value also reflects assumptions about the creditworthiness of the Company that market participants would use in pricing the debt.

 

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The following financial instruments are measured and recorded at fair value on a recurring basis. The inputs to the valuation techniques used to measure fair value are classified into the following categories:
         
Level 1:  
Quoted market prices in active markets for identical assets or liabilities.
Level 2:  
Observable market-based inputs or unobservable inputs that are corroborated by market data.
Level 3:  
Unobservable inputs that are not corroborated by market data.
The carrying amount, fair value, and classification within the fair value hierarchy of these financial instruments were as follows:
                                         
            Fair Value Measurements        
    September 30,     at September 30, 2008     December 31,  
    2008     Level 1     Level 2     Level 3     2007  
    (Dollars in thousands)  
Assets
                                       
Foreign currency forward contracts
  $ 1,374     $     $ 1,374     $     $ 16  
Precious metals forward contracts
                            755  
 
                             
Total fair value
  $ 1,374     $     $ 1,374     $     $ 771  
 
                             
 
                                       
Liabilities
                                       
Interest rate swaps
  $ (7,401 )   $     $ (7,401 )   $     $ (8,109 )
Foreign currency forward contracts
    (73 )           (73 )           (284 )
Raw material commodity swaps
    (938 )           (938 )           (1,499 )
Precious metals forward contracts
    (6 )           (6 )            
 
                             
Total fair value
  $ (8,418 )   $     $ (8,418 )   $     $ (9,892 )
 
                             
Interest rate swaps. To reduce our exposure to interest rate changes on variable-rate debt, we entered into interest rate swap agreements in 2007. These swaps effectively converted $150 million of our variable-rate term loan facility to a fixed rate. We mark these agreements to fair value and recognize the resulting gains or losses as other comprehensive income or loss. In 2007, the fair value of the interest rate swaps was based on settlement prices provided by the counterparties. Beginning in 2008 in connection with the adoption of FAS No. 157, the fair value of the swaps is based on the present value of expected future cash flows, which reflects assumptions about current interest rates and the creditworthiness of the Company that market participants would use in pricing the swaps.
Foreign currency forward contracts. We manage foreign currency risks principally by entering into forward contracts to mitigate the impact of currency fluctuations on transactions. We mark these contracts to fair value based on market prices for comparable contracts and recognize the resulting gains or losses in net foreign currency gains or losses.
Raw material commodity swaps. We hedge a portion of our exposure to changes in the pricing of certain raw material commodities principally using swap arrangements that allow us to fix the price of the commodities for future purchases. We mark these contracts to fair value based on market prices for comparable contracts and recognize the resulting gains or losses as other comprehensive income or loss. After the contracts mature and the materials are sold, the gains and losses are recognized as part of cost of sales.

 

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Precious metals forward contracts. We enter into forward purchase arrangements with precious metals suppliers to completely cover the value of fixed price sales contracts for products with precious metal content. Some of these agreements, with purchase commitments totaling $13.0 million at September 30, 2008, are designated as normal purchase contracts and are not marked to fair value. We mark the remaining precious metal contracts to fair value based on market prices for comparable contracts and recognize the resulting gains or losses as miscellaneous income or expense.
8. Income Taxes
Income tax expense for the first nine months of 2008 was $16.7 million, or 41.6% of pre-tax income. Income tax expense for the first nine months of 2007 was $10.8 million, or 39.7% of pre-tax income. The reasons for the increase in the effective tax rate were a change in the mix of income by country and a decrease in the U.S. tax cost on foreign dividends. The effective tax rate was also impacted by an unfavorable tax court decision in Brazil, an increase in the valuation allowance, and favorable adjustments to prior-year accruals which, in aggregate, totaled $2.4 million.
During the first nine months of 2008, we allocated income tax expense directly to shareholders’ equity for the following items: $0.7 million for postretirement benefit liability adjustments, $0.2 million for raw material commodity swap adjustments, $0.2 million for interest rate swap adjustments, and $0.2 million for the adjustments to initially apply FAS No. 158. During the first nine months of 2007, we allocated income tax expense (benefit) directly to shareholders’ equity for the following items: $0.5 million for postretirement benefit liability adjustments, $(1.2) million for raw material commodity swap adjustments, and $(1.8) million for interest rate swap adjustments.
The Company conducts business globally, and, as a result, the U.S. parent company and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. In the normal course of business, the U.S. parent company and its subsidiaries are subject to examination by taxing authorities throughout the world, including Spain, France, Germany, Netherlands, Italy, Japan, China, Portugal, and the United Kingdom. With few exceptions, we are not subject to federal, state, local or non-U.S. income tax examinations for years before 2000.
9. Contingent Liabilities
As previously disclosed, in February 2003, we produced documents in connection with an investigation by the United States Department of Justice into possible antitrust violations in the heat stabilizer industry. In April 2006, we were notified by the Department of Justice that the Government had closed its investigation. Before closing its investigation, the Department of Justice took no action against the Company or any of its current or former employees. In 2003, the Company was named as a defendant in several lawsuits alleging civil damages and requesting injunctive relief relating to the conduct the Government was investigating, and, in June 2008, the Company was named in four more indirect purchaser lawsuits related to an existing lawsuit in the Eastern District of Pennsylvania. In July 2007, we entered into a definitive written settlement agreement in the class action lawsuit involving direct purchasers. The settlement agreement was approved by the United States District Court for the Eastern District of Pennsylvania in December 2007. Although the Company decided to bring this matter to a close through settlement, the Company did not admit to any of the alleged violations and continues to deny any wrongdoing. The Company is vigorously defending the remaining six civil actions alleging antitrust violations in the heat stabilizer industry. These actions are in their early stages; therefore, we cannot determine the outcomes of these lawsuits at this time. In December 2006, we filed a lawsuit against the former owner of our heat stabilizer business seeking indemnification for the defense of these lawsuits and any resulting payments by the Company. In April 2008, the United States District Court for the Northern District of Ohio dismissed our lawsuit, and we have appealed the court’s decision to the United States Court of Appeals for the Sixth Circuit.
There are various other lawsuits and claims pending against the Company and its consolidated subsidiaries. In our opinion, the ultimate liabilities, if any, and expenses resulting from such lawsuits and claims will not materially affect the consolidated financial position, results of operations, or cash flows of the Company.
The Company had bank guarantees and standby letters of credit issued by financial institutions, which totaled $14.4 million at September 30, 2008, and $17.7 million at December 31, 2007. These agreements primarily relate to Ferro’s insurance programs, potential environmental remediation liabilities, and foreign tax payments. If the Company fails to perform its obligations, the guarantees and letters of credit may be drawn down by their holders, and we would be liable to the financial institutions for the amounts drawn.

 

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10. Retirement Benefits
Information concerning net periodic benefit costs of our U.S. pension plans (including our unfunded nonqualified plans), non-U.S. pension plans, and postretirement health care and life insurance benefit plans for the three months ended September 30 is as follows:
                                                 
    U.S. Pension Plans     Non-U.S. Pension Plans     Other Benefit Plans  
    2008     2007     2008     2007     2008     2007  
    (Dollars in thousands)  
Components of net periodic cost:
                                               
Service cost
  $ 50     $ 317     $ 1,308     $ 1,663     $ 16     $ 124  
Interest cost
    5,177       5,026       2,955       2,359       731       836  
Expected return on plan assets
    (5,663 )     (5,140 )     (2,148 )     (1,871 )            
Amortization of prior service cost
    25       39       29       27       (411 )     (349 )
Net amortization and deferral
    624       1,456       53       148              
Curtailment and settlement effects
                (133 )                 (814 )
Special termination benefits
                      2,189              
 
                                   
Net periodic benefit cost
  $ 213     $ 1,698     $ 2,064     $ 4,515     $ 336     $ (203 )
 
                                   
Information concerning net periodic benefit costs of our U.S. pension plans (including our unfunded nonqualified plans), non-U.S. pension plans, and postretirement health care and life insurance benefit plans for the nine months ended September 30 is as follows:
                                                 
    U.S. Pension Plans     Non-U.S. Pension Plans     Other Benefit Plans  
    2008     2007     2008     2007     2008     2007  
    (Dollars in thousands)  
Components of net periodic cost:
                                               
Service cost
  $ 150     $ 948     $ 4,366     $ 4,888     $ 48     $ 428  
Interest cost
    15,531       15,083       8,934       6,937       2,193       2,554  
Expected return on plan assets
    (16,989 )     (15,392 )     (6,484 )     (5,499 )            
Amortization of prior service cost
    75       118       78       82       (1,233 )     (935 )
Net amortization and deferral
    1,872       4,405       165       434              
Curtailment and settlement effects
          250       (133 )                 (814 )
Special termination benefits
                      2,189              
 
                                   
Net periodic benefit cost
  $ 639     $ 5,412     $ 6,926     $ 9,031     $ 1,008     $ 1,233  
 
                                   
The change in net periodic cost is due primarily to restructuring activities related to closing the Company’s Rotterdam, Netherlands, and Niagara Falls, New York, manufacturing facilities, the freezing of pension benefits at several U.S. plants, and the limiting of eligibility for retiree medical and life insurance coverage for nonunion employees. We recorded curtailment gains of $0.1 million in the third quarter of 2008 and special termination benefits of $2.2 million in the third quarter of 2007 for pension benefits related to the Rotterdam, Netherlands, closing. We recorded curtailment gains of $0.7 million in the third quarter of 2007 for other benefits and curtailment losses of $0.3 million in the first quarter of 2007 for pension benefits related to the Niagara Falls, New York, closing.

 

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11. Stock-Based Compensation
The following table contains the total stock-based compensation expense recorded in selling, general and administrative expense for the nine months ended September 30:
                 
    2008     2007  
    (Dollars in thousands)  
Stock options
  $ 1,753     $ 2,333  
Performance shares
    187       794  
Deferred stock units
    411       505  
Restricted shares
    307        
 
           
Total
  $ 2,658     $ 3,632  
 
           
The following table contains information regarding the stock-based compensation as of and for the nine-month period ended September 30, 2008:
                                 
                    Aggregate        
            Weighted-     Grant Date     Remaining  
    Number of     Average Fair     Fair Value of     Service or  
    Shares or     Value per     Shares or     Performance  
    Units Granted     Share or Unit     Units Granted     Period  
                    (Dollars in     (In years)  
                    thousands)        
Stock options
    513,100     $ 4.27     $ 2,191       3.4  
Performance shares
    77,825       17.26       1,343       2.4  
Deferred stock units
    34,200       16.69       571       0.4  
Restricted shares
    99,600       17.51       1,744       2.4  
The stock-based compensation transaction in shareholders’ equity consisted of the following for the nine months ended September 30, 2008:
                         
    Common Shares        
    in Treasury     Paid-in  
    Shares     Amount     Capital  
    (In thousands)  
Stock options
    (3 )   $ 367     $ 2,236  
Performance shares, net
          25       (654 )
Deferred stock units
    (33 )     143        
Directors’ deferred compensation
          (558 )     558  
Preferred stock conversions
    (38 )     689        
Restricted shares
    (99 )     1,940       (1,458 )
 
                 
Total
    (173 )   $ 2,606     $ 682  
 
                 
Restricted Share Awards
Under the 2006 Long-Term Incentive Plan, the Company may award restricted shares of Ferro common stock. The restricted shares vest in three years from the date of the award and are forfeited if the recipient’s employment terminates, except in the case of death or disability. During the vesting period, the recipient is not entitled to exercise rights pertaining to the restricted shares, including the right to vote such shares, and dividends on the restricted shares are deferred without interest. Following the vesting period, the recipient may not dispose of the shares for two years, without Ferro’s prior written consent. The first restricted shares were awarded in 2008.

 

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12. Restructuring and Cost Reduction Programs
During 2008, we continued several restructuring programs across a number of our business segments with the objectives of leveraging our global scale, realigning and lowering our cost structure and optimizing capacity utilization. The programs are primarily associated with North America and Europe. Management continues to evaluate our business, and therefore, there may be supplemental provisions for new plan initiatives as well as changes in estimates to amounts previously recorded, as payments are made or actions are completed.
In July 2006, we announced that we were restructuring our European operations, including a portion of our Performance Coatings and Color and Glass Performance Materials segments. This program affected operations in Spain, Italy, Portugal, France, Netherlands, and Germany. We expect these actions to significantly reduce the cost structure of our manufacturing operations.
The initial phase of this European restructuring resulted in a workforce reduction of 127 employees in these two segments and we are evaluating further workforce reductions. A decision to proceed with actions related to any additional charges will be made after the Company has completed required consultations with employee representatives at the affected sites. Revised total anticipated charges through 2009 amount to $11.5 million. Charges incurred through 2007 amounted to $9.0 million. Restructuring charges for the nine months ended September 30, 2008, include $1.1 million for employee severance costs, other costs of $0.7 million, and $0.3 million of accrual reversals.
In May 2007, we began the next phase of our European restructuring by initiating discussions with representatives of workers at our Rotterdam, Netherlands, porcelain enamel manufacturing site. In September 2007, we reached an agreement with the Rotterdam Works Council. As a result, the Company discontinued porcelain enamel manufacturing at its Rotterdam facility in the third quarter of 2008 and consolidated production at other European facilities. This consolidation resulted in the reduction of 84 employees. Restructuring charges are expected to total $26.5 million. During 2007, we recorded $11.8 million in restructuring charges and an additional $0.5 million for inventory write downs included in cost of sales. During the first nine months of 2008, we recorded $8.9 million for employee severance costs, $3.8 million for future minimum lease obligations, and $0.9 million in other costs, partly offset by a pension curtailment credit of $0.1 million.
In addition to the European restructuring efforts, we initiated worldwide restructuring plans for our Performance Coatings, Color and Glass Performance Materials, Polymer Additives, and Specialty Plastics segments in November 2007, March 2008, and April 2008. These restructuring plans resulted in the reduction of 109 employees. Total estimated employee termination charges through 2008 are $5.4 million. During 2007, we recorded total charges of $1.4 million. In the first nine months of 2008, we recorded $4.0 million of additional restructuring charges.
In February 2008, we announced the closing of a Plastics facility in Aldridge, United Kingdom. This closure resulted in the reduction of 10 employees and total costs of $0.6 million. During the first nine months of 2008, we recorded $0.4 million in severance costs and $0.2 million in lease termination costs.
In June 2008, we announced the partial closing of a Performance Coatings facility in Americana, Brazil. This closure resulted in the reduction of 66 employees and total costs of $1.5 million. During the first nine months of 2008, we recorded $1.1 million in severance costs and $0.4 million of asset impairment costs.
In September 2008, we closed the Polymer Additives facility in Castanheira, Portugal, which resulted in the elimination of 10 employees with a total cost of $1.2 million. During September 2008, we recorded $0.2 million in severance costs, $0.5 million in contract termination costs, and $0.5 million in asset impairment costs.

 

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We have summarized the activities and accrual balances related to our restructuring and cost reduction programs below:
                                 
    Employee                    
    Termination     Other     Asset        
    Benefits     Costs     Impairment     Total  
    (Dollars in thousands)  
Balance, December 31, 2007
  $ 8,381     $ 1,560     $     $ 9,941  
Restructuring charges
    15,346       6,025       909       22,280  
Cash payments
    (21,570 )     (1,723 )           (23,293 )
Currency translation adjustment
    (193 )     (363 )           (556 )
Non-cash items
    (76 )     (178 )     (909 )     (1,163 )
 
                       
Balance, September 30, 2008
  $ 1,888     $ 5,321     $     $ 7,209  
 
                       
We expect to make cash payments to settle the remaining liability for employee termination benefits and other costs primarily within the next 12 months, except where legal or contractual restrictions prevent us from doing so.
13. Discontinued Operations
Discontinued operations relate to the Powder Coatings, Petroleum Additives and Specialty Ceramics businesses that we sold in 2002 and 2003. There were no sales or cash flows from investing or financing activities from discontinued operations in the nine months ended September 30, 2008 or 2007. The loss from discontinued operations includes ongoing legal costs and reserve adjustments directly related to discontinued operations. Discontinued operations resulted in the following pre-tax losses and related income tax benefits:
                                 
    Three months ended     Nine months ended  
    September 30,     September 30,  
    2008     2007     2008     2007  
    (Dollars in thousands)  
Pre-tax losses
  $ 94     $ 4     $ 120     $ 355  
Tax benefits
    37       2       47       139  
 
                       
Net of tax losses
  $ 57     $ 2     $ 73     $ 216  
 
                       
We have continuing environmental remediation obligations that are related to these divestitures, and we had accrued $3.3 million at September 30, 2008, and $3.3 million at December 31, 2007, for these matters.

 

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14. Earnings per Share
Details of the calculation of basic and diluted earnings per share are shown below:
                                 
    Three months ended     Nine months ended  
    September 30,     September 30,  
    2008     2007     2008     2007  
    (In thousands, except per share amounts)  
Basic earnings per share computation:
                               
Net income available to common shareholders
  $ 4,606     $ 5,333     $ 22,661     $ 15,407  
Add: Loss from discontinued operations
    57       2       73       216  
 
                       
 
  $ 4,663     $ 5,335     $ 22,734     $ 15,623  
 
                       
 
                               
Weighted-average common shares outstanding
    43,266       43,030       43,226       42,881  
 
                               
Basic earnings per share from continuing operations
  $ 0.11     $ 0.12     $ 0.53     $ 0.36  
 
                       
 
                               
Diluted earnings per share computation:
                               
Net income available to common shareholders
  $ 4,606     $ 5,333     $ 22,661     $ 15,407  
Add: Loss from discontinued operations
    57       2       73       216  
Plus: Convertible preferred stock
                       
 
                       
 
  $ 4,663     $ 5,335     $ 22,734     $ 15,623  
 
                       
 
                               
Weighted-average common shares outstanding
    43,266       43,030       43,226       42,881  
Assumed conversion of convertible senior notes
                       
Assumed conversion of convertible preferred stock
                       
Assumed satisfaction of performance share conditions
    76       59       72       54  
Assumed satisfaction of deferred stock unit conditions
    20       24       11       14  
Assumed exercise of stock options
    161                    
 
                       
Weighted-average diluted shares outstanding
    43,523       43,113       43,309       42,949  
 
                       
 
                               
Diluted earnings per share from continuing operations
  $ 0.11     $ 0.12     $ 0.52     $ 0.36  
 
                       
15. Comprehensive Income
The components of comprehensive income were as follows:
                                 
    Three months ended     Nine months ended  
    September 30,     September 30,  
    2008     2007     2008     2007  
    (Dollars in thousands)  
Net income
  $ 4,831     $ 5,585     $ 23,336     $ 16,204  
Other comprehensive income, net of tax:
                               
Foreign currency translation adjustments
    (36,261 )     15,441       (15,014 )     28,183  
Postretirement benefit liability adjustments
    3,090       (137 )     2,676       (140 )
Raw material commodity swap adjustments
    (1 )     (391 )     454       (1,903 )
Interest rate swap adjustments
    (150 )     (2,089 )     456       (2,840 )
 
                       
Comprehensive income
  $ (28,491 )   $ 18,409     $ 11,908     $ 39,504  
 
                       

 

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16. Reporting for Segments
The Company has six reportable segments: Performance Coatings, Electronic Materials, Color and Glass Performance Materials, Polymer Additives, Specialty Plastics and Other Businesses. We have combined our Tile Coating Systems and Porcelain Enamel business units into one reportable segment, Performance Coatings, based on their similar economic and operating characteristics. We have also combined two of our segments, Pharmaceuticals and Fine Chemicals, into one reportable segment, Other Businesses, because they do not meet the quantitative thresholds for separate disclosure.
The accounting policies of our segments are consistent with those described for our consolidated financial statements in the summary of significant accounting policies contained in our Annual Report on Form 10-K for the year ended December 31, 2007. We measure segment income for internal reporting purposes as income from continuing operations before unallocated corporate expenses, restructuring charges, other expense (income) items, such as interest expense, and income tax expense. Unallocated corporate expenses primarily consist of corporate employment costs and professional services.
Net sales to external customers by segment are presented in the table below. Sales between segments were not material.
                                 
    Three months ended     Nine months ended  
    September 30,     September 30,  
    2008     2007     2008     2007  
    (Dollars in thousands)  
Performance Coatings
  $ 162,523     $ 153,742     $ 501,819     $ 451,058  
Electronic Materials
    155,122       116,645       452,317       338,412  
Color and Glass Performance Materials
    115,013       113,575       374,083       329,195  
Polymer Additives
    93,081       85,230       284,107       252,903  
Specialty Plastics
    58,097       62,236       183,499       198,994  
Other Businesses
    24,752       19,273       70,415       63,502  
 
                       
Total net sales
  $ 608,588     $ 550,701     $ 1,866,240     $ 1,634,064  
 
                       
Below are each segment’s income and reconciliations to income before taxes from continuing operations:
                                 
    Three months ended     Nine months ended  
    September 30,     September 30,  
    2008     2007     2008     2007  
    (Dollars in thousands)  
Performance Coatings
  $ 12,135     $ 8,449     $ 34,400     $ 29,947  
Electronic Materials
    17,095       8,522       43,527       19,534  
Color and Glass Performance Materials
    9,712       11,727       40,695       39,462  
Polymer Additives
    4,385       3,417       11,703       10,576  
Specialty Plastics
    2,796       3,586       7,520       10,961  
Other Businesses
    2,645       593       7,405       7,982  
 
                       
Total segment income
    48,768       36,294       145,250       118,462  
Unallocated corporate expenses
    13,031       7,215       32,658       38,219  
Restructuring charges
    9,042       5,826       22,280       7,689  
Other expense, net
    20,202       14,194       50,215       45,320  
 
                       
Income before taxes from continuing operations
  $ 6,493     $ 9,059     $ 40,097     $ 27,234  
 
                       

 

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We sell our products throughout the world, and we attribute sales to countries based on the country where we generate the customer invoice. We have detailed net sales by geographic region in the table below:
                                 
    Three months ended     Nine months ended  
    September 30,     September 30,  
    2008     2007     2008     2007  
    (Dollars in thousands)  
United States
  $ 281,502     $ 232,405     $ 811,678     $ 710,423  
International
    327,086       318,296       1,054,562       923,641  
 
                       
Total net sales
  $ 608,588     $ 550,701     $ 1,866,240     $ 1,634,064  
 
                       
17. Subsequent Event
On September 29, 2008, we entered into an agreement for the sale of our fine chemicals business to Novolyte Technologies LP, an affiliate of Arsenal Capital Management LP. On October 31, 2008, we amended the agreement, primarily to reduce the selling price from $66.0 million to $60.0 million, and closed the sale of the U.S. portion of the business for $52.0 million. The remaining $8.0 million of purchase price will be held in escrow until the completion of an equity transfer of Ferro (Suzhou) Energy Storage Materials Co. Ltd. (“Ferro Suzhou”), a wholly-owned subsidiary of Ferro, which owns the fine chemicals business’ manufacturing facilities in Suzhou, China. The equity transfer of Ferro Suzhou is subject to certain conditions, including government approval of the equity transfer in China and the receipt of certain permits or licenses. The equity transfer is expected to be completed by the end of 2008.
At September 30, 2008, the fine chemicals business had approximately $25 million of property, plant and equipment, $12 million of accounts receivable, $9 million of inventory, and $7 million of accounts payable and other liabilities.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
Net income for the three months ended September 30, 2008, declined to $4.8 million from $5.6 million in the third quarter of 2007. Income declined primarily as a result of higher selling, general and administrative expenses, a loss on the extinguishment of debt resulting from bond refinancing activities and higher restructuring charges. Partially offsetting these higher costs were increased gross profit, resulting from higher sales, and lower interest expense.
Net sales increased by 10.5% primarily as a result of higher sales in our Electronic Materials, Performance Coatings, and Polymer Additives segments. Sales declined in the Specialty Plastics segment, compared with the third quarter of 2007. The primary drivers for the increased sales were improved product pricing and product mix, as well as changes in foreign currency exchange rates. Higher product pricing included increased pass-through of higher precious metal costs.
Raw material costs continued to be volatile in the quarter. While prices of a number of commodities fell during the quarter, these prices did not immediately translate to lower costs within the supply chain. Petrochemical-based input costs declined during the quarter, for instance, but temporary shutdowns of refining capacity in the U.S. Gulf Coast resulting from late-summer hurricanes delayed the downstream effects of lower crude oil prices. In aggregate, raw material prices were higher than in the prior-year period.
Gross profit increased during the third quarter, both in dollar terms and as a percent of sales, compared with the third quarter of 2007. Gross profit percentage continues to be negatively impacted by higher precious metal costs, which we generally pass through to customers with minimal gross profit contribution.
Selling, general and administrative (“SG&A”) expense increased in the 2008 third quarter compared to the prior year. The principal drivers for the increase were changes in foreign currency exchange rates, and higher incentive compensation and benefit expenses. As a percentage of net sales, our 2008 third quarter SG&A expense was 12.9%, unchanged from the third quarter of 2007.
Interest expense declined in the three months ended September 30, 2008, compared with the prior-year period. The decline was due to lower interest rates on our debt, partially offset by higher average borrowing levels. During the third quarter, we issued new convertible bonds. The proceeds from the new bonds, along with additional borrowings under our revolving credit facility, were used to repay our 9 1/8% coupon senior notes, due January 2009. The repayment of the senior notes resulted in a loss on extinguishment of debt of $5.5 million during the quarter.
Outlook
Economic conditions weakened during the quarter, resulting in reduced demand from customers in a number of regions around the world. Contributing to the weakness was a reduction in the availability of credit in many worldwide markets, which is expected to have a continuing negative effect on future consumer and business spending. Markets in the United States that are related to residential housing, automobiles and automotive parts, and appliances are expected to remain weak until there is a general increase in economic activity and consumer demand. Markets outside the United States have been stronger in recent quarters, but international markets, particularly in continental Europe, weakened during the third quarter and are expected to exhibit weak customer demand in the coming quarter, although some of this reduced demand is expected to be offset by higher sales in North Africa, the Middle East and Eastern Europe. Demand for our electronic materials used in solar cells is strong and is expected to continue to show year-over-year growth, although rapid expansion of capacity among solar cell manufacturers could lead to some increased demand volatility due to short-term supply chain imbalances in the future.
We expect to continue to record charges associated with our current and future restructuring programs, particularly related to our rationalization of our manufacturing operations in Europe.
Factors that could adversely affect our future financial performance are described under the heading “Risk Factors” in Item 1A of Part II of this Quarterly Report on Form 10-Q for the quarter ended September 30, 2008.

 

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Results of Operations
Comparison of the three months ended September 30, 2008 and 2007
                                 
    Three months ended              
    September 30,              
    2008     2007     $ Change     % Change  
    (Dollars in thousands,          
    except per share amounts)          
Net sales
  $ 608,588     $ 550,701     $ 57,887       10.5 %
Cost of sales
    494,577       450,553       44,024       9.8 %
 
                         
Gross profit
    114,011       100,148       13,863       13.8 %
Gross profit percentage
    18.7 %     18.2 %                
Selling, general and administrative expenses
    78,274       71,069       7,205       10.1 %
Restructuring charges
    9,042       5,826       3,216       55.2 %
Other expense (income):
                               
Interest expense
    12,497       14,488       (1,991 )     (13.7 %)
Interest earned
    (213 )     (271 )     58       (21.4 %)
Loss on extinguishment of debt
    5,531             5,531        
Foreign currency losses (gains), net
    1,660       (10 )     1,670       (16,700.0 %)
Miscellaneous expense (income), net
    727       (13 )     740       (5,692.3 %)
 
                         
Income before taxes
    6,493       9,059       (2,566 )     (28.3 %)
Income tax expense
    1,605       3,472       (1,867 )     (53.8 %)
 
                         
Income from continuing operations
    4,888       5,587       (699 )     (12.5 %)
Loss from discontinued operations, net of tax
    57       2       55       2,750.0 %
 
                         
Net income
  $ 4,831     $ 5,585     $ (754 )     (13.5 %)
 
                         
 
Diluted earnings per share
  $ 0.11     $ 0.12     $ (0.01 )     (8.3 %)
 
                         
Sales for the quarter ended September 30, 2008, increased by 10.5%, driven by increased product prices, including pass-throughs for higher precious metal costs, improved product mix, and favorable changes in foreign currency exchange rates. Aggregated sales volume had a slightly negative effect on sales for the quarter, as a result of lower volume in Specialty Plastics, Polymer Additives and Color and Glass Performance Materials, partially offset by increased sales volume in Electronic Materials.
Gross profit increased in the 2008 third quarter primarily as a result of increased product pricing and lower manufacturing costs, partially offset by higher raw material costs. Gross profit was reduced by $1.5 million in the quarter as a result of costs related to manufacturing rationalization activities and asset write-offs. Charges for manufacturing rationalization activities were $0.5 million in the third quarter of 2007. Gross profit as a percent of sales was negatively impacted by higher raw materials costs, including precious metal costs. Precious metal costs are generally passed through to customers with minimal gross profit contributions.
Selling, general and administrative (“SG&A”) expenses were 12.9% of net sales in the 2008 third quarter, unchanged from the third quarter of 2007. SG&A spending in the third quarter increased, in dollar terms, primarily due to changes in foreign currency exchange rates, increased benefit expenses and higher incentive compensation accruals. The 2008 third-quarter SG&A expense also included charges of $1.9 million primarily related to corporate development activities, partially offset by a favorable insurance settlement.
Restructuring charges were $9.0 million in the 2008 third quarter, an increase from $5.8 million in the third quarter of 2007. The 2008 third quarter charges were primarily related to our manufacturing rationalization activities in Europe related to our Performance Coatings and Color and Glass Performance Materials segments.

 

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Interest expense declined in the 2008 third quarter as a result of lower average interest rates, partially offset by higher borrowing levels.
During the 2008 third quarter, we refinanced our 9 1/8% coupon senior notes using the proceeds of a new convertible bond issue and additional borrowing from our revolving credit facility. In connection with the repayment of the previous senior notes, we recorded a loss on extinguishment of debt of $5.5 million during the quarter. This loss consists of costs that would have been reported as interest expense during the remaining life of the previous senior notes had we not extinguished the debt early.
Income tax expense for the three months ending September 30, 2008, was $1.6 million, or 24.7% of pre-tax income, compared to $3.5 million, or 38.5% of pre-tax income, in the third quarter of 2007. The reasons for the decrease in the effective tax rate were a change in the mix of income by country and a decrease in the U.S. tax cost on foreign dividends.
There were no new businesses included in discontinued operations in the third quarter of 2008.
                                 
    Three months ended              
    September 30,              
    2008     2007     $ Change     % Change  
    (Dollars in thousands)          
Segment Sales
                               
Performance Coatings
  $ 162,523     $ 153,742     $ 8,781       5.7 %
Electronic Materials
    155,122       116,645       38,477       33.0 %
Color & Glass Performance Materials
    115,013       113,575       1,438       1.3 %
Polymer Additives
    93,081       85,230       7,851       9.2 %
Specialty Plastics
    58,097       62,236       (4,139 )     (6.7 %)
Other Businesses
    24,752       19,273       5,479       28.4 %
 
                         
Total segment sales
  $ 608,588     $ 550,701     $ 57,887       10.5 %
 
                         
 
                               
Segment Operating Income
                               
Performance Coatings
  $ 12,135     $ 8,449     $ 3,686       43.6 %
Electronic Materials
    17,095       8,522       8,573       100.6 %
Color & Glass Performance Materials
    9,712       11,727       (2,015 )     (17.2 %)
Polymer Additives
    4,385       3,417       968       28.3 %
Specialty Plastics
    2,796       3,586       (790 )     (22.0 %)
Other Businesses
    2,645       593       2,052       346.0 %
 
                         
Total segment operating income
  $ 48,768     $ 36,294     $ 12,474       34.4 %
 
                         
Performance Coatings Segment Results. Sales increased in Performance Coatings primarily due to higher sales of tile coatings. The sales increase was driven by favorable changes in foreign exchange rates and higher sales volume of tile coatings, partially offset by lower sales volume of porcelain enamel products. Sales increased in Europe, Asia and Latin America, and declined in the United States. Operating income increased as a result of a combination of improved product pricing, manufacturing cost improvements, lower SG&A expense and increased sales volume, partially offset by higher raw material costs.
Electronic Materials Segment Results. Sales increased in Electronic Materials, driven by continued strong demand for metal pastes and powders, particularly those products used to manufacture solar cells. The higher sales were driven by higher product pricing, including increased precious metal costs which generally are passed through to our customers with minimal gross profit contribution. Sales grew as a result of sharply higher shipments from our manufacturing facilities in the United States, although much of this product volume is used by customers in other regions. Operating income increased as a result of the positive effects of increased sales of higher-margin products, and benefits from manufacturing productivity improvements, partially offset by higher SG&A expense.

 

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Color and Glass Performance Materials Segment Results. Sales increased in Color and Glass Performance Materials as the effects of favorable foreign currency exchange rates and improved product pricing more than offset lower sales volume. Demand from customers in Europe declined during the quarter, although sales for the full quarter were slightly higher compared to the third quarter of 2007. Operating income declined as a result of lower sales volume, higher manufacturing costs, an increased bad debt reserve, and higher raw material costs, partially offset by lower SG&A expense.
Polymer Additives Segment Results. Sales increased in Polymer Additives as a result of improved product pricing and product mix, as well as favorable changes in foreign currency exchange rates. Sales increased in Europe and the United States, the segment’s two primary sales regions. Operating income increased primarily as a result of higher product pricing and improved product mix, partially offset increased raw material costs.
Specialty Plastics Segment Results. Sales declined in Specialty Plastics as a result of continued weak customer demand in the United States and Europe. The weak demand resulted in lower sales volume, which was partially offset by higher product pricing. Operating income declined from the prior-year period as a result of lower manufacturing volume and higher raw material costs, partially offset by increased product pricing. Lower manufacturing costs and SG&A expenses, achieved through reduction in employee positions, also contributed positively to operating income.
Other Businesses Segment Results. Sales increased in Other Businesses as a result of higher sales volume of fine chemical and pharmaceutical products. Operating income increased as a result of the higher sales volume and improved product mix.
                                 
    Three months ended              
    September 30,              
    2008     2007     $ Change     % Change  
    (Dollars in thousands)          
Geographic Revenues
                               
United States
  $ 281,502     $ 232,405     $ 49,097       21.1 %
International
    327,086       318,296       8,790       2.8 %
 
                         
Total
  $ 608,588     $ 550,701     $ 57,887       10.5 %
 
                         
Sales increased in the United States, Europe and Latin America during the three months ended September 30, 2008, compared with the prior-year period. Sales in Asia were little changed from the third quarter of 2007. In the United States, the sales increase was driven by Electronic Materials products, with additional contributions from increased sales in Polymer Additives. U.S. sales declined in Specialty Plastics. International sales increased primarily as a result of higher European sales of Polymer Additives and increased Performance Coatings products sales in all international regions.

 

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Comparison of the nine months ended September 30, 2008 and 2007
                                 
    Nine months ended              
    September 30,              
    2008     2007     $ Change     % Change  
    (Dollars in thousands,          
    except per share amounts)          
Net sales
  $ 1,866,240     $ 1,634,064     $ 232,176       14.2 %
Cost of sales
    1,515,526       1,319,609       195,917       14.8 %
 
                         
Gross profit
    350,714       314,455       36,259       11.5 %
Gross profit percentage
    18.8 %     19.2 %                
Selling, general and administrative expenses
    238,122       234,212       3,910       1.7 %
Restructuring charges
    22,280       7,689       14,591       189.8 %
Other expense (income):
                               
Interest expense
    39,740       46,220       (6,480 )     (14.0 %)
Interest earned
    (484 )     (1,425 )     941       (66.0 %)
Loss on extinguishment of debt
    5,531             5,531        
Foreign currency losses, net
    769       924       (155 )     (16.8 %)
Miscellaneous expense (income), net
    4,659       (399 )     5,058       (1,267.7 %)
 
                         
Income before taxes
    40,097       27,234       12,863       47.2 %
Income tax expense
    16,688       10,814       5,874       54.3 %
 
                         
Income from continuing operations
    23,409       16,420       6,989       42.6 %
Loss from discontinued operations, net of tax
    73       216       (143 )     (66.2 %)
 
                         
Net income
  $ 23,336     $ 16,204     $ 7,132       44.0 %
 
                         
 
                               
Diluted earnings per share
  $ 0.52     $ 0.36     $ 0.16       44.4 %
 
                         
Net sales increased by 14.2% in the nine months ended September 30, 2008, compared with the same period in 2007. The sales increase was driven by higher sales in the Electronic Materials, Performance Coatings, Color and Glass Performance Materials, Polymer Additives and Other Businesses segments. Sales in our Specialty Plastics segment declined. The sales growth primarily was the result of higher product prices, including pass-through of higher precious metal costs, improved product mix, and favorable changes in foreign currency exchange rates. Sales increased in all regions, compared with the first nine months of 2007.
Gross profit increased in the first three quarters of 2008 compared with the first three quarters of 2007, primarily as a result of increased product prices and higher sales, partially offset by higher raw material costs. Gross profit during the first nine months of 2008 was negatively impacted by $3.0 million in charges related to asset write-offs and manufacturing rationalization activities. Gross profit was also reduced by costs of approximately $3.3 million to clean up an accidental discharge of product into the wastewater treatment facility at our Bridgeport, New Jersey, manufacturing location. Gross profit, as a percentage of net sales, was negatively impacted by higher raw material costs, including costs of precious metals. Precious metal costs generally are passed through to customers with minimal gross profit contribution. Gross profit was reduced by $4.7 million in the first nine months of 2007, primarily as a result of accelerated depreciation charges related to our manufacturing rationalization activities. Also, gross profit in the first three quarters of 2007 was reduced by the costs of a temporary interruption of production at our manufacturing site in South Plainfield, New Jersey, and costs that were required to address quality issues at our Evansville, Indiana, manufacturing facility.
Selling, general and administrative (“SG&A”) expenses declined to 12.8% of net sales in the first nine months of 2008 compared with 14.3% of sales in the prior-year period. SG&A expenses for the first nine months of 2008 included charges of $3.8 million primarily related to corporate development activities, asset write-offs and employee severance expenses, partially offset by benefits from litigation settlements and insurance proceeds. SG&A expense in the first nine months of 2007 included charges of $8.4 million, primarily related to reserves for litigation settlements and corporate development activities.

 

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Restructuring charges increased to $22.3 million in the first nine months of 2008 compared with $7.7 million in the first nine months of 2007. The 2008 restructuring charges are primarily related to manufacturing rationalization activities in our Performance Coatings and Color and Glass Performance Materials manufacturing operations in Europe and Brazil, and additional restructuring activities in our Performance Coatings, Color and Glass Performance Materials, Polymer Additives, and Specialty Plastics segments that were initiated in 2007 and the first nine months of 2008.
Interest expense declined during the first nine months of 2008 compared with the prior-year period. In the first nine months of 2007, we recorded a non-recurring $2.0 million write-off of unamortized fees associated with an unused portion of our term loan arrangements. In the first nine months of 2008, our interest expense also declined because our average interest rates on borrowings were lower than in the same period during 2007. The benefit was partially offset by higher borrowing levels.
During the 2008 third quarter, we refinanced our 9 1/8% coupon senior notes using the proceeds of a new convertible bond issue and additional borrowing from our revolving credit facility. In connection with the repayment of the previous senior notes, we recorded a loss on extinguishment of debt of $5.5 million during the quarter. This loss consists of costs that would have been reported as interest expense during the remaining life of the previous senior notes had we not extinguished the debt early.
Miscellaneous expense was $4.7 million in the first nine months of 2008 compared with miscellaneous income of $0.4 million in the first nine months of 2007. The primary drivers of the change were an increased provision for an environmental contingency in Latin America related to a previously closed manufacturing site, a loss on forward contracts in the current period compared to a gain in the prior-year period, and lower gains on the disposal of assets.
Income tax expense for the first nine months of 2008 was $16.7 million, or 41.6% of pre-tax income. Income tax expense for the first nine months of 2007 was $10.8 million, or 39.7% of pre-tax income. The reasons for the increase in the effective tax rate were a change in the mix of income by country and a decrease in the U.S. tax cost on foreign dividends. The effective tax rate was also impacted by an unfavorable tax court decision in Brazil, an increase in the valuation allowance, and favorable adjustments to prior-year accruals which, in aggregate, totaled $2.4 million.
There were no new businesses included in discontinued operations in the first nine months of 2008.

 

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    Nine months ended              
    September 30,              
    2008     2007     $ Change     % Change  
    (Dollars in thousands)          
Segment Sales
                               
Performance Coatings
  $ 501,819     $ 451,058     $ 50,761       11.3 %
Electronic Materials
    452,317       338,412       113,905       33.7 %
Color & Glass Performance Materials
    374,083       329,195       44,888       13.6 %
Polymer Additives
    284,107       252,903       31,204       12.3 %
Specialty Plastics
    183,499       198,994       (15,495 )     (7.8 %)
Other Businesses
    70,415       63,502       6,913       10.9 %
 
                         
Total segment sales
  $ 1,866,240     $ 1,634,064     $ 232,176       14.2 %
 
                         
 
                               
Segment Operating Income
                               
Performance Coatings
  $ 34,400     $ 29,947     $ 4,453       14.9 %
Electronic Materials
    43,527       19,534       23,993       122.8 %
Color & Glass Performance Materials
    40,695       39,462       1,233       3.1 %
Polymer Additives
    11,703       10,576       1,127       10.7 %
Specialty Plastics
    7,520       10,961       (3,441 )     (31.4 %)
Other Businesses
    7,405       7,982       (577 )     (7.2 %)
 
                         
Total segment operating income
  $ 145,250     $ 118,462     $ 26,788       22.6 %
 
                         
Performance Coatings Segment Results. Sales increased in Performance Coatings primarily as a result of increased sales of tile coating products. Sales increased in Europe, Asia and Latin America while sales in the United States declined. The primary drivers of the sales growth were favorable changes in foreign currency exchange rates and increased sales volume of tile coatings products. Operating income increased in the first nine months of 2008 due to higher product prices, volume increases and SG&A reductions, partially offset by raw material cost increases.
Electronic Materials Segment Results. Sales increased in Electronic Materials as a result of increased sales of metal pastes and powders, particularly sales to manufacturers of solar cells. Sales grew as a result of increased product pricing, including higher product prices resulting from the pass-through to customers of higher precious metal costs. Sales also increased as a result of increased sales volume and favorable changes in foreign currency exchange rates. Sales increased from U.S.-based manufacturing operations. Products from our U.S. facilities often are used by our customers in other regions, particularly in Asia. Operating income increased as a result of the positive effects of increased sales of higher-margin products, lower manufacturing costs and benefits from prior-period restructuring activities. Also, during the first nine months of 2007, operating income was reduced by costs associated with a temporary interruption of manufacturing activities at our manufacturing site in South Plainfield, New Jersey.
Color and Glass Performance Materials Segment Results. Sales increased in Color and Glass Performance Materials as a result of growth in sales of glass coatings and performance pigment materials. The higher sales were primarily the result of favorable changes in foreign currency exchange rates and higher product prices. Sales increased in all regions, led by growth in Europe. Operating income improved primarily as a result of improved product pricing and favorable changes in foreign currency exchange rates, partially offset by higher raw material costs.
Polymer Additives Segment Results. Sales increased in Polymer Additives as a result of higher product pricing and favorable changes in foreign exchange rates, partially offset by the effects of lower sales volume. Sales increased in Europe and the United States. During the first nine months of 2008 operating income increased slightly, driven by improved product pricing that was largely offset by higher raw material costs and the negative effects of lower sales volume. Also during the first nine months of 2008 operating income was negatively impacted by $3.3 million in additional manufacturing costs resulting from the clean-up of an accidental discharge of product into the wastewater treatment facility at our Bridgeport, New Jersey, manufacturing location.

 

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Specialty Plastics Segment Results. Sales declined in Specialty Plastics primarily due to continuing weak demand from U.S.-based customers, particularly in the automotive parts and appliance industries. As a result of the weak demand, sales volume declined, more than offsetting the positive effects of increased product pricing and favorable changes in foreign currency exchange rates. Operating income declined as a result of higher raw material costs and lower manufacturing volumes, partially offset by increased product pricing. Cost reduction activities in manufacturing and SG&A expense helped to moderate the decline in operating income.
Other Businesses Segment Results. Sales increased in Other Businesses as a result of increased sales of fine chemical products. Sales of pharmaceutical products in the first nine months of 2008 were lower than the prior-year period. Sales volume of certain of our pharmaceutical products can vary significantly from period to period as a result of our customers’ intermittent production of some low-volume products which use our materials. Operating income declined as a result of a less favorable product mix.
                                 
    Nine months ended              
    September 30,              
    2008     2007     $ Change     % Change  
    (Dollars in thousands)          
Geographic Revenues
                               
United States
  $ 811,678     $ 710,423     $ 101,255       14.3 %
International
    1,054,562       923,641       130,921       14.2 %
 
                         
Total
  $ 1,866,240     $ 1,634,064     $ 232,176       14.2 %
 
                         
Sales increased in all regions during the first nine months of 2008 compared with the prior-year period. In the United States, sales growth was led by increased sales in Electronic Materials, with additional contributions from Polymer Additives and Color and Glass Performance Materials. U.S. sales declined in Specialty Plastics and Performance Coatings. Sales increased in Europe, Asia and Latin America. The international sales growth was led by increased sales of Performance Coatings, Color and Glass Performance Materials, Electronic Materials and Polymer Additives.
Summary of Cash Flows for the nine months ended September 30, 2008 and 2007
                                 
    Nine months ended              
    September 30,              
    2008     2007     $ Change     % Change  
    (Dollars in thousands)          
Net cash provided by operating activities
  $ 1,838     $ 121,281     $ (119,443 )     (98.5 %)
Net cash used for investing activities
    (54,283 )     (39,992 )     (14,291 )     35.7 %
Net cash provided by (used for) financing activities
    55,359       (73,302 )     128,661       (175.5 %)
Effect of exchange rate changes on cash and cash equivalents
    (415 )     849       (1,264 )     (148.9 %)
 
                         
Increase in cash and cash equivalents
  $ 2,499     $ 8,836     $ (6,337 )     (71.7 %)
 
                         
Cash flows from operating activities decreased by $119.4 million in the first nine months of 2008 compared with the same period of 2007. In the first nine months of 2007, we received $70.1 million of deposits held by financial institutions under our precious metals consignment program. Deposit requirements were eliminated during 2007. Cash used for inventories and accounts and trade notes receivable, net of accounts payable, increased $80.1 million, primarily due to increases in raw material prices which are largely passed through to our customers.
Cash used for investing activities increased by $14.3 million, primarily due to higher capital expenditures of $8.6 million, expenditures for other, primarily intangible, assets of $3.4 million to expand a product line, and lower proceeds from sales of assets and businesses of $2.1 million.

 

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Cash flows from financing activities increased by $128.7 million. Changes in borrowing activity resulted in an increase of $140.8 million. In the first nine months of 2008, we borrowed $84.1 million, while in the same period of 2007, we used cash to reduce our debt by $56.7 million. The first nine months of 2007 also included $9.2 million in proceeds to the Company from the exercise of stock options.
Capital Resources and Liquidity
Credit Rating
At September 30, 2008, the Company’s corporate credit rating was B1, with a positive outlook, by Moody’s Investor Services, Inc. and B+, with a stable outlook, by Standard & Poor’s Rating Group.
6.50% Convertible Senior Notes
In August 2008, Ferro issued $172.5 million of 6.50% Convertible Senior Notes due 2013 (the “Convertible Notes”). The proceeds from the offering, along with available cash, including borrowings under Ferro’s revolving credit facility, were used to purchase all of Ferro’s outstanding 9 1/8% Senior Notes. The Convertible Notes bear interest at a rate of 6.5% per year, payable semi-annually in arrears on February 15 and August 15 of each year, beginning on February 15, 2009. The Convertible Notes mature on August 15, 2013. At September 30, 2008, we were in compliance with the covenants under the Convertible Notes’ indentures.
9 1/8% Senior Notes
In June 2008, Ferro commenced a cash tender offer to purchase any and all of its outstanding $200 million aggregate principal amount of 9 1/8% Senior Notes due 2009 (the “9 1/8% Notes”). In August and September, we purchased all of the 9 1/8% Notes for $205.3 million, including call premiums and tender costs, and recorded a loss of $5.5 million, including unamortized discounts and fees. We financed the purchase of the 9 1/8% Notes and related costs from the issuance of the Convertible Notes, along with available cash, including borrowings under Ferro’s revolving credit facility.
Revolving Credit and Term Loan Facility
In 2006, we entered into an agreement with a group of lenders for a $700 million credit facility, consisting of a multi-currency senior revolving credit facility and a senior term loan facility. In 2007, we cancelled the unused portion of the term loan facility and amended the credit facility (the “Amended Credit Facility”). At September 30, 2008, the Amended Credit Facility consisted of a $300 million revolving credit facility, which matures in 2011, and a $305 million term loan facility, which matures in 2012. As part of the agreement, we can request an increase of $50 million in the revolving credit facility. At September 30, 2008, we were in compliance with the covenants of the Amended Credit Facility.
At September 30, 2008, we had borrowed $132.1 million of the revolver and had $159.3 million available, after reductions for standby letters of credit secured by this facility. At September 30, 2008, we had borrowed $293.3 million in term loans. In 2007, we began making periodic principal payments on the term loans. We are required to make minimum quarterly principal payments of $0.8 million from July 2008 to July 2011. During the last year of the loan’s life, we are required to repay the remaining balance of the term loans in four quarterly installments. Currently, those last four payments will be $71.0 million each. In addition to the minimum quarterly payments, each April we may be required to make an additional principal payment. The amount of this additional payment is dependent on the Company’s leverage and certain cash flow metrics. Any additional payment that is required reduces, on a dollar-for-dollar basis, the amount due in the last four quarterly payments. In April 2008, we made an additional principal payment of $6.4 million.

 

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Off Balance Sheet Arrangements
Receivable Sales Programs. We have several programs to sell, on an ongoing basis, pools of our trade accounts receivable. These programs accelerate cash collections at favorable financing costs and help us manage the Company’s liquidity requirements.
In our largest program, which expires in 2009, we sell, on an ongoing basis, substantially all of Ferro’s U.S. trade accounts receivable to Ferro Finance Corporation (“FFC”), a wholly-owned unconsolidated qualified special purpose entity (“QSPE”). FFC finances its acquisition of trade receivable assets by issuing beneficial interests in (securitizing) the receivables to multi-seller receivables securitization companies (“Conduits”). In June 2008, we amended the program to reduce the maximum proceeds and the conduits’ commitment levels from $100 million to $75 million. FFC and the Conduits have no recourse to Ferro’s other assets for failure of debtors to pay when due as the assets transferred are legally isolated in accordance with the U.S. bankruptcy laws. Ferro’s consolidated balance sheet does not include the trade receivables sold, but does include a note receivable from FFC to the extent that cash proceeds from the sales of accounts receivable to FFC have not yet been received by Ferro. At September 30, 2008, Ferro had received net proceeds of $75.0 million for outstanding receivables, and the balance of Ferro’s note receivable from FFC was $29.7 million.
In addition, we maintain several international programs to sell trade accounts receivable, primarily without recourse. The commitments supporting these programs can be withdrawn at any time and totaled $78.0 million at September 30, 2008. Ferro had received net proceeds under the international programs of $28.8 million at September 30, 2008, for outstanding receivables.
Consignment and Customer Arrangements for Precious Metals. In the production of some of our products, we use precious metals, primarily silver for Electronic Materials products and gold for Color and Glass Performance Materials products. We obtain most precious metals from financial institutions under consignment agreements with terms of one year or less. The financial institutions retain ownership of the precious metals and charge us fees based on the amounts we consign. We also process precious metals owned by our customers. At September 30, 2008, we had on hand $125.8 million of precious metals owned by financial institutions, measured at fair value.
Bank Guarantees and Standby Letters of Credit. At September 30, 2008, the Company and its subsidiaries had bank guarantees and standby letters of credit issued by financial institutions, which totaled $14.4 million. These agreements primarily relate to Ferro’s insurance programs, potential environmental remediation liabilities, and foreign tax payments.
Other Financing Arrangements
In addition, the Company maintains other lines of credit and receivable sales programs to provide global flexibility for the Company’s liquidity requirements. Most of these facilities are uncommitted lines for the Company’s international operations.
Liquidity Requirement
Our liquidity requirements primarily include debt service, purchase commitments, working capital requirements, capital investments, postretirement obligations and dividend payments. Ferro’s level of debt and debt service requirements could have important consequences to its business operations and uses of cash flows. However, the liquidity available under our revolving credit agreement, along with liquidity from other financing arrangements, available cash flows from operations, and asset sales, should allow the Company to meet its funding requirements and other commitments.
Recent difficulties experienced by global capital markets could affect the ability of counterparties to perform under our various lines of credit, receivable sales programs, forward contracts and precious metal lease programs. These counterparties are major, reputable, multinational institutions, all having investment-grade credit ratings except for one, which is not rated. Accordingly, we do not anticipate counterparty default. The recent declines in global capital markets have caused a reduction in the value of our pension plan assets. This reduction could have an adverse effect on pension expense and funding requirements for 2009.
We assess on an ongoing basis our portfolio of businesses, as well as our financial and capital structure, to ensure that we have sufficient capital and liquidity to meet our strategic objectives. As part of this process, from time to time we evaluate the possible divestiture of businesses that are not critical to our core strategic objectives and, where appropriate, pursue the sale of such businesses. We also evaluate and pursue acquisition opportunities that we believe will enhance our strategic position. We generally announce publicly divestiture and acquisition transactions only when we have entered into definitive agreements relating to those transactions.
On September 29, 2008, we entered into an agreement for the sale of our fine chemicals business to Novolyte Technologies LP, an affiliate of Arsenal Capital Management LP. On October 31, 2008, we amended the agreement, primarily to reduce the selling price from $66.0 million to $60.0 million, and closed the sale of the U.S. portion of the business for $52.0 million. The remaining $8.0 million of purchase price will be held in escrow until the completion of an equity transfer of Ferro (Suzhou) Energy Storage Materials Co. Ltd. (“Ferro Suzhou”), a wholly-owned subsidiary of Ferro, which owns the fine chemicals business’ manufacturing facilities in Suzhou, China. The equity transfer of Ferro Suzhou is subject to certain conditions, including government approval of the equity transfer in China and the receipt of certain permits or licenses. The equity transfer is expected to be completed by the end of 2008.

 

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Critical Accounting Policies and Their Application
There are no material changes to our critical accounting policies described in “Critical Accounting Policies” within Item 7 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
Newly Adopted Accounting Standards
On January 1, 2008, we adopted FASB Statement No. 157, Fair Value Measurements, (“FAS No. 157”), FASB Staff Position No. FAS 157-1, Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement Under Statement 13, (“FSP No. FAS 157-1”), and FASB Staff Position No. FAS 157-2, Effective Date of FASB Statement No. 157, (“FSP No. FAS 157-2”). Effective July 1, 2008, we also adopted FASB Staff Position No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset is not Active, (“FSP No. FAS 157-3”). FAS No. 157 defines fair value, establishes a framework and gives guidance regarding the methods used for measuring fair value, and expands disclosures about fair value measurements, but does not require any new fair value measurements. FSP No. FAS 157-1 excludes FASB Statement No. 13, Accounting for Leases, (“FAS No. 13”) as well as other accounting pronouncements that address fair value measurement on lease classification or measurement under FAS No. 13 from the scope of FAS No. 157. FSP No. FAS 157-2 delays the effective date of FAS No. 157 for all nonrecurring fair value measurements of nonfinancial assets and nonfinancial liabilities until fiscal years beginning after November 15, 2008. FSP No. FAS 157-3 amends FAS No. 157 to give an example of how to determine the fair value of a financial asset in an inactive market, but does not change the fair value measurement principles of FAS No. 157. The portions of these pronouncements that were not delayed were adopted prospectively, and their adoption reduced the disclosed fair value of our borrowings under the revolving credit and term loan facilities and reduced the carrying value of our interest rate swaps. We are currently evaluating the impact on our consolidated financial statements of adopting the deferred portions of these pronouncements on January 1, 2009.
On January 1, 2008, we adopted the measurement provisions of FASB Statement No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB Statements No. 87, 88, 106, and 132(R), (“FAS No. 158”). The measurement provisions require companies to measure defined benefit plan assets and obligations as of the annual balance sheet date. Previously, we used September 30 as the measurement date for U.S. pension and other postretirement benefits. We have elected to use the September 30, 2007, measurement of assets and benefit obligations to calculate the fiscal year 2008 expense. Expense for the gap period from September 30 to December 31 is recognized as of January 1, 2008, as a charge of $0.5 million, net of tax, to retained earnings and a credit of $0.4 million, net of tax, to accumulated other comprehensive income.
On January 1, 2008, we adopted FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115, (“FAS No. 159”). This statement permits us to choose, at specified election dates, to measure eligible items at fair value (the “fair value option”). For items for which the fair value option has been elected, we would report unrealized gains and losses in earnings at each subsequent reporting date and recognize up-front costs and fees in earnings as incurred. We have not elected to measure any eligible items at fair value, and we do not have any current plans to do so. Therefore, adoption of FAS No. 159 did not have an effect on our consolidated financial statements.
On January 1, 2008, we adopted Emerging Issues Task Force Issue No. 06-11, Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards, (“EITF No. 06-11”). EITF No. 06-11 requires that the income tax benefit from dividends that are charged to retained earnings and paid to employees for nonvested equity shares be recognized as an increase to paid-in capital. Previously, we recognized this income tax benefit as an increase to retained earnings. Beginning in 2008, we report this income tax benefit as an increase to paid-in capital.
Newly Issued Accounting Pronouncements
In December 2007, the FASB issued Statement No. 141(R), Business Combinations, (“FAS No. 141(R)”) and Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51, (“FAS No. 160”). These statements change the way that companies account for business combinations and noncontrolling interests (e.g., minority interests). Both standards are to be applied prospectively for fiscal years beginning after December 15, 2008. However, FAS No. 160 requires entities to apply the presentation and disclosure requirements retrospectively to comparative financial statements. In 2009, we will retrospectively reclassify the amount of minority interests in consolidated subsidiaries to equity and separately report the amount of net income or loss attributable to minority interests.

 

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In March 2008, the FASB issued Statement No. 161, Disclosures about Derivative Instruments and Hedging Activities — an amendment of FASB Statement No. 133, (“FAS No. 161). This Statement requires enhanced disclosures about an entity’s derivative and hedging activities. This Statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. This Statement encourages, but does not require, comparative disclosures for earlier periods at initial adoption. We do not expect the adoption of FAS No. 161 to have a material impact on our consolidated financial statements.
In April 2008, the FASB issued Staff Position No. FAS 142-3, Determination of the Useful Life of Intangible Assets, (“FSP No. FAS 142-3”). This pronouncement amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No. 142, Goodwill and Other Intangible Assets. FSP No. FAS 142-3 is to be applied prospectively and is effective for financial statements issued for fiscal years beginning after December 15, 2008, with early adoption prohibited. We are currently evaluating its effect on our financial statements.
In May 2008, the FASB issued Staff Position No. APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement), (“FSP No. APB 14-1”). This pronouncement specifies that issuers of such instruments should separately account for the liability and equity components in a manner that will reflect the entity’s nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods. FSP No. APB 14-1 is to be applied retrospectively and is effective for financial statements issued for fiscal years and interim periods beginning after December 15, 2008. If this pronouncement had been applied at September 30, 2008, the carrying value of the liability component of the 6.50% Convertible Senior Notes would have been approximately $152.7 million, including $0.4 million of imputed interest, and the carrying value of the equity component would have been approximately $19.6 million, net of $0.6 million of allocated third-party transaction costs.
Risk Factors
Certain statements contained here and in future filings with the SEC reflect the Company’s expectations with respect to future performance and constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These statements are subject to a variety of uncertainties, unknown risks and other factors concerning the Company’s operations and business environment, which are difficult to predict and are beyond the control of the Company. A detailed description of such uncertainties, risks and other factors is contained under the heading “Risk Factors” of Item 1A of Part II of this Quarterly Report on Form 10-Q.

 

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Item 3. Quantitative and Qualitative Disclosures About Market Risk
Our exposure to market risks is generally limited to fluctuations in interest rates, foreign currency exchange rates, and costs of raw materials and energy.
Our exposure to interest rate risk arises from our debt portfolio. We manage this risk by controlling the mix of fixed versus variable-rate debt after considering the interest rate environment and expected future cash flows. To reduce our exposure to interest rate changes on variable-rate debt, we entered into interest rate swap agreements. These swaps effectively convert a portion of our variable-rate debt to a fixed rate. Our objective is to limit variability in earnings, cash flows and overall borrowing costs caused by changes in interest rates, while preserving operating flexibility.
We operate internationally and enter into transactions denominated in foreign currencies. These transactions expose us to gains and losses arising from exchange rate movements between the dates foreign currencies are recorded and the dates they are settled. We manage this risk by entering into forward currency contracts that offset these gains and losses.
We are also subject to cost changes with respect to our raw materials and energy purchases. We attempt to mitigate raw materials cost increases through product development, price increases, and other productivity improvements. We hedge a portion of our exposure to changes in the pricing of certain raw material commodities through swap arrangements that allow us to fix the pricing of the commodities for future purchases. We also enter into forward purchase arrangements with precious metals suppliers to completely cover the value of fixed price sales contracts for products with precious metal content. Some of these precious metals agreements, with purchase commitments totaling $13.0 million at September 30, 2008, are designated as normal purchase contracts and are not marked to market. In addition, we purchase portions of our natural gas and electricity requirements under fixed price contracts to reduce the volatility of these costs. These energy contracts are designated as normal purchase contracts, are not marked to market, and had purchase commitments totaling $16.9 million at September 30, 2008.

 

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================================================================================

The notional amounts, net carrying amounts of assets (liabilities), and fair values associated with our exposure to these market risks and sensitivity analyses about potential gains (losses) resulting from hypothetical changes in market rates are presented below:
                 
    September 30,     December 31,  
    2008     2007  
    (Dollars in thousands,  
    except as noted)  
Variable-rate debt and utilization of accounts receivable sales programs:
               
Change in annual interest expense from 1% change in interest rates
  $ 3,823     $ 2,636  
Fixed-rate debt:
               
Carrying amount
  $ 173,047     $ 200,404  
Fair value
  $ 160,155     $ 205,705  
Change in fair value from 1% increase in interest rate
  $ (1,656 )   $ (1,929 )
Change in fair value from 1% decrease in interest rate
  $ 1,984     $ 1,957  
Interest rate swaps:
               
Notional amount
  $ 150,000     $ 150,000  
Carrying amount and fair value
  $ (7,401 )   $ (8,109 )
Change in fair value from 1% increase in interest rate
  $ 3,785     $ 5,000  
Change in fair value from 1% decrease in interest rate
  $ (3,889 )   $ (5,181 )
Foreign currency forward contracts:
               
Notional amount
  $ 154,025     $ 142,638  
Carrying amount and fair value
  $ 1,301     $ (268 )
Change in fair value from 10% appreciation of U.S. dollar
  $ 2,323     $ (1,402 )
Change in fair value from 10% depreciation of U.S. dollar
  $ (2,839 )   $ 1,714  
Raw material commodity swaps:
               
Notional amount (in metric tons of base metals)
    772       1,171  
Carrying amount and fair value
  $ (938 )   $ (1,499 )
Change in fair value from 10% change in forward prices
  $ 232     $ 507  
Precious metals forward contracts:
               
Notional amount (in troy ounces)
    64       159,648  
Carrying amount and fair value
  $ (6 )   $ 755  
Change in fair value from 10% change in forward prices
  $ 7     $ 612  

 

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Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Ferro is committed to maintaining disclosure controls and procedures that are designed to ensure that information required to be disclosed in its Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to its management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
As required by Rule 13a-15(b) of the Exchange Act, Ferro has carried out an evaluation, under the supervision and with the participation of its management, including its Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures. The evaluation examined those disclosure controls and procedures as of September 30, 2008, the end of the period covered by this report. As described below, we have taken measures to improve our internal controls and procedures; however, there has not been adequate time for us to conclude that the material weakness in the Company’s internal control over financial reporting described in our Annual Report on Form 10-K for the year ended December 31, 2007, has been fully remediated. Therefore, Ferro’s management, including its Chief Executive Officer and its Chief Financial Officer, has concluded that, as of September 30, 2008, Ferro’s disclosure controls and procedures were not effective.
Additional procedures were performed in order for management to conclude with reasonable assurance that the Company’s condensed consolidated financial statements contained in this Quarterly Report on Form 10-Q present fairly, in all material respects, the Company’s financial position, results of operations and cash flows for the periods presented.
Changes in Internal Control over Financial Reporting
As of December 31, 2007, we identified the following material weakness in internal control over financial reporting:
The Company did not maintain effective controls over user access rights to its financial application systems. Specifically, the control deficiencies detected were: an inadequate design of access security policies and procedures; inadequate design of system segregation of duties requirements; and insufficient monitoring of user access to the related financial transactions and data. This resulted in an environment where certain personnel could have unmonitored access to financial systems and data beyond that required to perform their individual job responsibilities. The Company has concluded that these control deficiencies, when aggregated, result in a reasonable possibility that a material misstatement of the Company’s annual or interim consolidated financial statements will not be prevented or detected on a timely basis.
We have taken measures to improve the effectiveness of our internal control over financial reporting and to address the material weakness described above. The following process and control improvements are changes in our internal control over financial reporting during the three months ended September 30, 2008, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. We will continue to assess our disclosure controls and procedures and will take any further actions that we deem necessary.
    Formal policies and procedures relative to granting access to the Company’s financial systems were redesigned to provide for a more standardized approach and additional safeguards in the process of granting access to financial systems.
 
    Procedures and automated tools, to provide the Company better visibility to and management of access granted to sensitive financial transactions and data, were implemented.
 
    User access to sensitive financial transactions and data in the Company’s financial systems was evaluated and, where possible, was limited to better align user access with employee job responsibilities.
 
    A project to centralize the control and maintenance of the Company’s financial system master files, including customer, vendor, and materials master files, was completed, which strengthen the Company’s assurance of complete and accurate master data.

 

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PART II — OTHER INFORMATION
Item 1. Legal Proceedings
The information on legal proceedings contained in Note 9 to the condensed consolidated financial statements is incorporated here by reference.
As previously disclosed, for the year ended December 31, 2007, we submitted deviation reports required by the Title V air emission permit issued under the New Jersey Air Pollution Control Act (the “Title V Air Permit”), which contained numerous deviations from the standards required by the Title V Air Permit at our South Plainfield, New Jersey, facility. While no penalty has been assessed at this time, we are in the process of negotiating an administrative consent order and a compliance schedule to settle these issues with the New Jersey Department of Environmental Protection (“NJDEP”). We cannot determine the outcome of these settlement negotiations at this time.
As previously disclosed, in each of February 2007 and February 2008, the NJDEP issued an administrative order and notice of civil administrative penalty assessment to the Company for alleged violations at our Bridgeport, New Jersey, facility of the NJDEP laws and regulations regarding water discharge requirements pursuant to the New Jersey Water Pollution Control Act (“WPCA”). In September 2008, we entered into an administrative consent order, which includes a compliance schedule, with the NJDEP. We paid $0.2 million as a result of this administrative consent order.

 

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Item 1A. Risk Factors
Many factors could cause our actual results to differ materially from those suggested by statements contained in this filing and could adversely affect our future financial performance. Such factors include the following:
We depend on reliable sources of energy and raw materials, including petroleum-based materials and other supplies, at a reasonable cost, but the availability of these materials and supplies could be interrupted and/or their prices could escalate and adversely affect our sales and profitability.
We purchase energy and many raw materials, including petroleum-based materials and other supplies, that we use to manufacture our products. Changes in their availability or price could affect our ability to manufacture enough products to meet customers’ demands or to manufacture products profitably. We try to maintain multiple sources of raw materials and supplies where practical, but this may not prevent unanticipated changes in their availability or cost. We may not be able to pass cost increases through to our customers. Significant disruptions in availability or cost increases could adversely affect our manufacturing volume or costs, which could negatively affect product sales or profitability of our operations.
The markets for our products are highly competitive and subject to intense price competition, and that could adversely affect our sales and earnings performance.
Our customers typically have multiple suppliers from which to choose. If we are unwilling or unable to provide products at competitive prices, and if other factors, such as product performance and value-added services do not provide an offsetting competitive advantage, customers may reduce, discontinue, or decide not to purchase our products. If we could not secure alternate customers for lost business, our sales and earnings performance could be adversely affected.
We strive to improve operating margins through sales growth, price increases, productivity gains, improved purchasing techniques and restructuring activities, but we may not achieve the desired improvements.
We work to improve operating profit margins through activities such as growing sales to achieve increased economies of scale, increasing prices, improving manufacturing processes, adopting purchasing techniques that lower costs or provide increased cost predictability, and restructuring businesses to realize cost savings. However, these activities depend on a combination of improved product design and engineering, effective manufacturing process control initiatives, cost-effective redistribution of production, and other efforts that may not be as successful as anticipated. The success of sales growth and price increases depends not only on our actions but also the strength of customer demand and competitors’ pricing responses, which are not fully predictable. Failure to successfully implement actions to improve operating margins could adversely affect our financial performance.
We sell our products into industries where demand has been unpredictable, cyclical or heavily influenced by consumer spending, and such demand and our results of operations may be further impacted by the recent macro-economic circumstances and uncertainty in credit markets.
We sell our products to a wide variety of customers who supply many different market segments. Many of these market segments, such as building and renovation, major appliances, transportation and electronics, are cyclical or closely tied to consumer demand, which is difficult to predict. Incorrect forecasts of demand or unforeseen reductions in demand can adversely affect costs and profitability due to factors such as underused manufacturing capacity, excess inventory, or working capital needs. These factors can result in lower profitability.
Our results of operations are materially affected by conditions in the global capital markets and the economy generally, both in the U.S. and elsewhere around the world. The stress experienced by global capital markets that began in the second half of 2007 has substantially increased. Recently, concerns over inflation, energy costs, geopolitical issues, the availability and cost of credit, the U.S. mortgage market and a declining real estate market have contributed to increased volatility and diminished expectations for the global economy and the markets going forward. These factors, combined with volatile raw materials costs, declining business and consumer confidence and increased unemployment, have precipitated an economic slowdown and fears of a possible recession in a number of markets around the world. As a result of these conditions, our customers may experience cash flow problems and may modify, delay or cancel plans to purchase our products.
Additionally, if customers are not successful in generating sufficient revenue or are precluded from securing financing, they may not be able to pay, or may delay payment of, accounts receivable that are owed to us. Any reduction in demand or inability of our current and/or potential customers to pay us for our products may adversely affect our earnings and cash flow.

 

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The global scope of our operations exposes us to risks related to currency conversion rates and changing economic, social and political conditions around the world.
More than 50% of our net sales during 2007 were outside of the U.S. In order to support global customers, access regional markets and compete effectively, our operations are located around the world. As a result, our operations have additional complexity from changing economic, social and political conditions in multiple locations and we are subject to risks relating to currency conversion rates. Other risks inherent in international operations include the following:
    new and different legal and regulatory requirements and enforcement mechanisms in local jurisdictions;
 
    U.S. export licenses may be difficult to obtain and we may be subject to export duties or import quotas or other trade barriers;
 
    increased costs of, and decreased availability of, transportation or shipping;
 
    credit risk and financial conditions of local customers and distributors;
 
    risk of nationalization of private enterprises by foreign governments or restrictions on investments;
 
    potentially adverse tax consequences, including imposition or increase of withholding and other taxes on remittances and other payments by subsidiaries; and
 
    local political, economic and social conditions, including the possibility of hyperinflationary conditions and political instability in certain countries.
While we attempt to anticipate these changes and manage our business appropriately in each location where we do business, these changes are often beyond our control and difficult to forecast. The consequences of these risks may have significant adverse effects on our results of operations or financial position.
We have a growing presence in the Asia-Pacific region where it can be difficult for a U.S.-based company, such as Ferro, to compete lawfully with local competitors.
Many of our most promising growth opportunities are in the Asia-Pacific region, especially the People’s Republic of China. Although we have been able to compete successfully in those markets to date, local laws and customs can make it difficult for a U.S.-based company to compete on a “level playing field” with local competitors without engaging in conduct that would be illegal under U.S. law. Our strict policy of observing the highest standards of legal and ethical conduct may cause us to lose some otherwise attractive business opportunities to local competition in the region.
Regulatory authorities in the U.S., European Union and elsewhere are taking a much more aggressive approach to regulating hazardous materials, and those regulations could affect sales of our products.
Hazardous material legislation and regulations can restrict the sale of products and/or increase the cost of producing them. Some of our products are subject to restrictions under laws or regulations such as California Proposition 65 or the European Union’s (“EU”) hazardous substances directive. The EU “REACH” registration system became effective June 1, 2007, and requires us to perform toxicity studies of the components of some of our products and to register the information in a central database, increasing the cost of these products. As a result of these hazardous material regulations, customers may avoid purchasing some products in favor of perceived “greener,” less hazardous or less costly alternatives. This factor could adversely affect our sales and operating profits.

 

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Our operations are subject to operating hazards and, as a result, to stringent environmental, health and safety regulations, and compliance with those regulations could require us to make significant investments.
Our production facilities are subject to hazards associated with the manufacture, handling, storage and transportation of chemical materials and products. These hazards can cause personal injury and loss of life, severe damage to, or destruction of, property and equipment and environmental contamination and other environmental damage and could have an adverse effect on our business, financial condition or results of operations.
We strive to conduct our manufacturing operations in a manner that is safe and in compliance with all applicable environmental, health and safety regulations. Compliance with changing regulations may require us to make significant capital investments, incur training costs, make changes in manufacturing processes or product formulations, or incur costs that could adversely affect our profitability, and violations of these laws could lead to substantial fines and penalties. These costs may not affect competitors in the same way due to differences in product formulations, manufacturing locations or other factors, and we could be at a competitive disadvantage, which might adversely affect financial performance.
We depend on external financial resources, and the current economic environment and credit market uncertainty could interrupt our access to capital markets, borrowings, or financial transactions to hedge certain risks, which could adversely affect our financial condition.
As of December 31, 2007, we had approximately $526.1 million of short-term and long-term debt with varying maturities. These borrowings have allowed us to make investments in growth opportunities and fund working capital requirements. In addition, we enter into financial transactions to hedge certain risks, including foreign exchange, commodity pricing, and sourcing of certain raw materials. Our continued access to capital markets, the stability of our lenders and the stability of the parties to our financial transactions that hedge risks are essential for us to meet our current obligations as well as fund our strategic initiatives. An interruption in our access to external financing or financial transactions to hedge risk could adversely affect our business prospects and financial condition. See further information regarding our liquidity in the section “Management Discussion and Analysis of Financial Condition and Results of Operations — Capital Resources and Liquidity” in our most recently filed Quarterly Report on Form 10-Q or Annual Report on Form 10-K and in the notes to the consolidated financial statements included in these reports.
Interest rates on some of our borrowings are variable, and our borrowing costs could be affected adversely by interest rate increases.
Portions of our debt obligations have variable interest rates. Generally, when interest rates rise, our cost of borrowings increases. We estimate, based on the debt obligations outstanding at December 31, 2007, that a one percent increase in interest rates would cause interest expense to increase by approximately $2.6 million annually. Continued interest rate increases could raise the cost of borrowings and adversely affect our financial performance. See further information regarding our interest rates on our debt obligations in “Quantitative and Qualitative Disclosures about Market Risk” in our most recently filed Quarterly Report on Form 10-Q or Annual Report on Form 10-K and in the notes to the consolidated financial statements included in these reports.
Many of our assets are encumbered by liens that have been granted to lenders, and those liens affect our flexibility to dispose of property and businesses.
Our debt obligations are secured by substantially all of our assets. These liens could reduce our ability and/or extend the time to dispose of property and businesses, as these liens must be cleared or waived by the lenders prior to any disposition. These security interests are described in more detail in Note 5 to the consolidated financial statements under Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2007.

 

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We are subject to a number of restrictive covenants under our credit facilities, which could affect our flexibility to fund strategic initiatives, and, if we are unable to maintain compliance with such covenants, could lead to significant challenges in meeting our liquidity requirements.
Our credit facilities contain a number of restrictive covenants as described in more detail in Note 5 to the consolidated financial statements under Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2007. These covenants include customary operating restrictions that limit our ability to engage in certain activities, including additional loans and investments; prepayments, redemptions and repurchases of debt; and mergers, acquisitions and asset sales. We are also subject to customary financial covenants, including a leverage ratio and a fixed charge coverage ratio. These covenants restrict the amount of our borrowings, reducing our flexibility to fund strategic initiatives.
Breaches of these covenants could become defaults under our credit facilities and cause the acceleration of debt payments beyond our ability to pay. Compliance with some of these covenants is based on financial measures derived from our operating results. If economic conditions in key markets deteriorate, we may experience material adverse impacts to our business and operating results, such as through reduced customer demand and inflation. A decline in our business could make us unable to maintain compliance with these financial covenants, in which case, our lenders could demand immediate payment of outstanding amounts and we would need to seek alternate financing sources to pay off such debts and fund our ongoing operations. Such financing may not be available on favorable terms, if at all.
We have significant deferred tax assets, and our ability to utilize these assets will depend on our future performance.
To fully realize the carrying value of our net deferred tax assets, we will have to generate adequate taxable profits in various tax jurisdictions. As of December 31, 2007, we had $102.8 million of net deferred tax assets, after valuation allowances. If we do not generate adequate profits within the time periods required by applicable tax statutes, the carrying value of the tax assets will not be realized. If it becomes unlikely that the carrying value of our net deferred tax assets will be realized, the valuation allowances may need to be increased in our consolidated financial statements, adversely affecting results of operations. Further information on our deferred tax assets is presented in Note 7 to the consolidated financial statements under Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2007.
We are a defendant in several lawsuits that could have an adverse effect on our financial condition and/or financial performance, unless they are successfully resolved.
We are routinely involved in litigation brought by suppliers, customers, employees, governmental agencies and others. Litigation is an inherently unpredictable process and unanticipated negative outcomes are possible. The most significant pending litigation is described under “Legal Proceedings” in our most recently filed Quarterly Report on Form 10-Q or Annual Report on Form 10-K.
Our businesses depend on a continuous stream of new products, and failure to introduce new products could affect our sales and profitability.
One way that we remain competitive in our markets is by developing and introducing new and improved products on an ongoing basis. Customers continually evaluate our products in comparison to those offered by our competitors. A failure to introduce new products at the right time that are price competitive and that provide the features and performance required by customers could adversely affect our sales, or could require us to compensate by lowering prices. The result could be lower sales and/or lower profitability.
We are subject to stringent labor and employment laws in certain jurisdictions in which we operate, we are party to various collective bargaining arrangements, and our relationship with our employees could deteriorate, which could adversely impact our operations.
A majority of our full-time employees are employed outside the United States. In certain jurisdictions where we operate, labor and employment laws are relatively stringent and, in many cases, grant significant job protection to certain employees, including rights on termination of employment. In addition, in certain countries where we operate, our employees are members of unions or are represented by a works council as required by law. We are often required to consult and seek the consent or advice of these unions and/or respective works councils. These regulations and laws, coupled with the requirement to consult with the relevant unions or works councils, could have a significant impact on our flexibility in managing costs and responding to market changes.

 

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Furthermore, with respect to our employees who are subject to collective bargaining arrangements or similar arrangements (approximately 18.2% of our U.S. workforce as of December 31, 2007), there can be no assurance that we will be able to negotiate labor agreements on satisfactory terms or that actions by our employees will not disrupt our business. If these workers were to engage in a strike, work stoppage or other slowdown or if other employees were to become unionized, we could experience a significant disruption of our operations and/or higher ongoing labor costs, which could adversely affect our business, financial condition and results of operations.
Employee benefit costs, especially postretirement costs, constitute a significant element of our annual expenses, and funding these costs could adversely affect our financial condition.
Employee benefit costs are a significant element of our cost structure. Certain expenses, particularly postretirement costs under defined benefit pension plans and healthcare costs for employees and retirees, may increase significantly at a rate that is difficult to forecast and may adversely affect our financial results, financial condition or cash flows. The recent declines in global capital markets have caused a reduction in the value of our pension plan assets. This reduction could have an adverse effect on pension expense and funding requirements for 2009.
Our restructuring initiatives may not provide sufficient cost savings to justify their expense.
We have undertaken and may continue to undertake productivity initiatives, including organizational restructurings, to improve performance and generate cost savings. We developed, initiated, and continue to implement several restructuring programs across a number of our business segments with the objectives of leveraging our global scale, realigning and lowering our cost structure, and optimizing capacity utilization. The programs are primarily focused on North America and Europe. We can make no assurances that these restructuring initiatives will be completed or beneficial to us. Also, we cannot assure you that any estimated cost savings from such activities will be realized.
We are exposed to intangible asset risk.
We have recorded intangible assets, including goodwill, in connection with business acquisitions. We are required to perform goodwill impairment tests at least on an annual basis and whenever events or circumstances indicate that the carrying value may not be recoverable from estimated future cash flows. As a result of our annual and other periodic evaluations, we may determine that the intangible asset values need to be written down to their fair values, which could result in material charges that could be adverse to our operating results and financial position.
We have in the past identified material weaknesses in our internal controls, and the identification of any material weaknesses in the future could affect our ability to ensure timely and reliable financial reports.
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, which is a process designed by our management to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
We conducted an assessment of our internal controls over financial reporting as of December 31, 2007 and concluded that we had a material weakness in those controls. Previously, we had concluded that we had material weaknesses in our internal controls as of December 31, 2004, 2005 and 2006. A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that, there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. As a result of its assessment, management found that we did not maintain effective controls over, and monitoring of, user access rights to our financial application systems. This resulted in an environment where certain personnel could have unmonitored access to financial systems and data beyond that required to perform their individual job responsibilities.

 

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We concluded that these control weaknesses, while they did not result in adjustments to the 2007 annual or interim consolidated financial statements, when aggregated, result in a reasonable possibility that a material misstatement of our annual or interim consolidated financial statements will not be prevented or detected on a timely basis. Accordingly, our management has determined that this condition constituted a material weakness and concluded that our internal control over financial reporting was not effective as of December 31, 2007. We also reported the existence of material weaknesses and the conclusion that our internal controls were not effective as of December 31, 2006, December 31, 2005, and December 31, 2004, as discussed in our Annual Reports on Form 10-K filed with respect to those fiscal years.
During 2007 and 2008 we have continued remediation activities intended to improve our internal controls and procedures; however, there has not been adequate time for us to conclude that the material weakness in our internal control over financial reporting described in our Annual Report for the year ended December 31, 2007, has been fully remediated. Therefore, our management has concluded that, as of September 30, 2008, our disclosure controls and procedures were not effective.
Accordingly, while we have taken actions to address these weaknesses, additional measures may be necessary, and these measures, along with other measures we expect to take to improve our internal controls, may not be sufficient to address the issues identified by us or ensure that our internal controls are effective. If we are unable to correct weaknesses in internal controls in a timely manner, our ability to record, process, summarize and report reliable financial information within the time periods specified in the rules and forms of the SEC will be adversely affected. This failure could materially and adversely impact our business, our financial condition and the market value of our securities.
We are exposed to risks associated with acts of God, terrorists and others, as well as fires, explosions, wars, riots, accidents, embargoes, natural disasters, strikes and other work stoppages, quarantines and other governmental actions, and other events or circumstances that are beyond our control.
Ferro Corporation is exposed to risks from various events that are beyond our control, which may have significant effects on our results of operations. While we attempt to mitigate these risks through appropriate insurance, contingency planning and other means, we may not be able to anticipate all risks or to reasonably or cost-effectively manage those risks that we do anticipate. As a result, our results of operations could be adversely affected by circumstances or events in ways that are significant and/or long lasting.
The risks and uncertainties identified above are not the only risks that we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial also may adversely affect us. If any known or unknown risks and uncertainties develop into actual events, these developments could have material adverse effects on our financial position, results of operations, and cash flows.

 

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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Not applicable.
Item 3. Defaults Upon Senior Securities
Not applicable.
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable.
Item 5. Other Information
Not applicable.
Item 6. Exhibits
The exhibits listed in the attached Exhibit Index are filed pursuant to Item 6 of Form 10-Q.

 

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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
         
 
  FERRO CORPORATION    
 
  (Registrant)    
 
       
Date: November 5, 2008
       
 
  /s/ James F. Kirsch    
 
 
 
James F. Kirsch
   
 
  Chairman, President and Chief Executive Officer (Principal Executive Officer)    
 
       
Date: November 5, 2008
       
 
       
 
  /s/ Sallie B. Bailey    
 
 
 
Sallie B. Bailey
   
 
  Vice President and Chief Financial Officer (Principal Financial Officer)    

 

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EXHIBIT INDEX
The following exhibits are filed with this report or are incorporated here by reference to a prior filing in accordance with Rule 12b-32 under the Securities and Exchange Act of 1934.
Exhibit:
         
  3    
Articles of incorporation and by-laws
       
 
  3.1    
Eleventh Amended Articles of Incorporation. (Reference is made to Exhibit 4.1 to Ferro Corporation’s Registration Statement on Form S-3, filed March 5, 2008, which Exhibit is incorporated here by reference.)
       
 
  3.2    
Certificate of Amendment to the Eleventh Amended Articles of Incorporation of Ferro Corporation filed December 28, 1994. (Reference is made to Exhibit 4.2 to Ferro Corporation’s Registration Statement on Form S-3, filed March 5, 2008, which Exhibit is incorporated here by reference.)
       
 
  3.3    
Certificate of Amendment to the Eleventh Amended Articles of Incorporation of Ferro filed June 19, 1998. (Reference is made to Exhibit 4.3 to Ferro Corporation’s Registration Statement on Form S-3, filed March 5, 2008, which Exhibit is incorporated here by reference.)
       
 
  3.4    
Ferro Corporation Code of Regulations. (Reference is made to Exhibit 4.4 to Ferro Corporation’s Registration Statement on Form S-3, filed March 5, 2008, which Exhibit is incorporated here by reference.)
       
 
  4    
Instruments defining rights of security holders, including indentures
       
 
  4.1    
Senior Indenture, dated as of March 5, 2008, by and between Ferro Corporation and U.S. Bank National Association. (Reference is made to Exhibit 4.5 to Ferro Corporation’s Registration Statement on Form S-3, filed March 5, 2008, which Exhibit is incorporated here by reference.)
       
 
  4.2    
First Supplemental Indenture, dated August 19, 2008, by and between Ferro Corporation and U.S. Bank National Association (with Form of 6.50% Convertible Senior Note due 2013). (Reference is made to Exhibit 4.2 to Ferro Corporation’s Current Report on Form 8-K, filed August 19, 2008, which Exhibit is incorporated here by reference.)
       
 
       
The Company agrees, upon request, to furnish to the U.S. Securities and Exchange Commission a copy of any instrument authorizing long-term debt that does not authorize debt in excess of 10% of the total assets of the Company and its subsidiaries on a consolidated basis.
       
 
  10    
Material Contracts
       
 
  10.1    
Underwriting Agreement, dated as of August 13, 2008, by and among Ferro Corporation and the underwriters named therein, pertaining to $150 million in aggregate principal amount of 6.50% Convertible Senior Notes due 2013. (Reference is made to Exhibit 10.1 to Ferro Corporation’s Current Report on Form 8-K, filed August 14, 2008, which Exhibit is incorporated here by reference.)
       
 
  10.2    
First Amendment to Asset Purchase Agreement, dated October 31, 2008, between Ferro Corporation and Novolyte Technologies LP. (Reference is made to Exhibit 10.1 to Ferro Corporation’s Current Report on Form 8-K, filed November 4, 2008, which Exhibit is incorporated here by reference.)
       
 
  10.3    
Asset Purchase Agreement, dated as of September 29, 2008, between Ferro Corporation and Novolyte Technologies LP. (Reference is made to Exhibit 10.1 to Ferro Corporation’s Current Report on Form 8-K, filed October 3, 2008, which Exhibit is incorporated here by reference.)
       
 
  10.4    
Suzhou Equity Transfer Agreement, dated October 31, 2008, among Novolyte Technologies Limited, Novolyte Technologies LP and Ferro Corporation. (Reference is made to Exhibit 10.3 to Ferro Corporation’s Current Report on Form 8-K, filed November 4, 2008, which Exhibit is incorporated here by reference.)
       
 
  10.5    
Form of Change in Control Agreement. (Reference is made to Exhibit 10(h) to Ferro Corporation’s Annual Report on Form 10-K for the year ended December 31, 2004, which Exhibit is incorporated here by reference.) (Mark H. Duesenberg, Vice President, General Counsel and Secretary signed a change in control agreement effective September 17, 2008.)

 

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  31.1    
Certification of Principal Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a).
       
 
  31.2    
Certification of Principal Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a).
       
 
  32.1    
Certification of Principal Executive Officer Pursuant to 18 U.S.C. 1350.
       
 
  32.2    
Certification of Principal Financial Officer Pursuant to 18 U.S.C. 1350.

 

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