Eastman Chemical - 10-Q quarterly report FY

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

Commission file number 1-12626

EASTMAN CHEMICAL COMPANY
(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (423) 229-2000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes   x    No   o

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

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EASTMAN CHEMICAL COMPANY AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF EARNINGS (LOSS),
COMPREHENSIVE INCOME (LOSS) and RETAINED EARNINGS

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

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EASTMAN CHEMICAL COMPANY AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF FINANCIAL POSITION

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

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EASTMAN CHEMICAL COMPANY AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

The accompanying unaudited interim consolidated financial statements have been prepared by Eastman Chemical Company (the “Company” or “Eastman”) in accordance and consistent with the accounting policies stated in the Company’s 2001 Annual Report on Form 10-K as amended and the Quarterly Reports on Form 10-Q for the first and second quarters of 2002 and should be read in conjunction with the consolidated financial statements appearing in the Form 10-K as amended by Form 10-K/A. In the opinion of the Company, all normally recurring adjustments necessary for a fair presentation have been included in the unaudited interim consolidated financial statements. The unaudited interim consolidated financial statements are based in part on estimates made by management.

The Company has reclassified certain 2001 amounts to conform to the 2002 presentation.

2. INVENTORIES

Inventories valued on the LIFO method were approximately 70% of total inventories in each of the periods.

3. PAYABLES AND OTHER CURRENT LIABILITIES

The current portion of U.S. defined benefit pension plan liabilities is an estimate of the Company’s funding requirements through September 30, 2003.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

4. BORROWINGS

Eastman has access to a $600 million revolving credit facility (the “Credit Facility”) expiring in July 2005. The Credit Facility was reduced from $800 million to $600 million in the second quarter 2002 following the issuance of $400 million in fixed rate debt described below. Any borrowings under the Credit Facility are subject to interest at varying spreads above quoted market rates, principally LIBOR. The Credit Facility requires facility fees on the total commitment that vary based on Eastman’s credit rating. The rate for such fees was 0.15% as of September 30, 2002 and December 31, 2001. The Credit Facility contains a number of covenants and events of default, including the maintenance of certain financial ratios. Eastman was in compliance with all such covenants for all periods presented.

Eastman typically utilizes commercial paper, generally with maturities of 90 days or less, to meet its liquidity needs. The Credit Facility provides liquidity support for commercial paper borrowings and general corporate purposes. Accordingly, outstanding commercial paper borrowings reduce borrowings available under the Credit Facility. Because the Credit Facility expires in July 2005, the commercial paper borrowings supported by the Credit Facility are classified as long-term borrowings because the Company has the ability to refinance such borrowings long term. As of September 30, 2002, the Company’s commercial paper borrowings were $84 million at an effective interest rate of 1.94%. At December 31, 2001, the Company’s outstanding Credit Facility and commercial paper borrowings were $637 million at an effective interest rate of 3.17%.

On April 3, 2002, the Company issued notes in the principal amount of $400 million due 2012 and bearing interest at 7% per annum. Proceeds from the sale of the notes, net of $3 million in transaction fees, were $394 million and were used to repay portions of outstanding borrowings under the Credit Facility and commercial paper borrowings.

Through interest rate swaps entered into during the first quarter 2002, the effective interest rates of the notes due in 2004 were converted to variable rates that averaged 3.83% at September 30, 2002. The recording of the fair value of the interest rate swaps and the corresponding debt resulted in increases of $14 million in other noncurrent assets and long-term borrowings at September 30, 2002.

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5. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

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

6. EARNINGS (LOSS) AND DIVIDENDS PER SHARE

Certain shares underlying options outstanding during the third quarter and first nine months 2002 were excluded from the computation of diluted earnings per share because the options’ exercise prices were greater than the average market price of the common shares during those periods. Excluded from the third quarter and first nine months 2002 calculations were shares underlying options to purchase 7,087,254 shares of common stock at a range of prices from $40.10 to $73.94 and 6,970,729 shares of common stock at a range of prices from $40.10 to $73.94, respectively. Certain shares underlying options outstanding during the third quarter 2001 were excluded from the computation of diluted earnings per share because the options’ exercise prices were greater than the average market price of the common shares. Excluded from the third quarter 2001 calculation were shares underlying options to purchase 5,467,104 shares of common stock at a range of prices from $42.13 to $73.94. As a result of the net loss reported for the first nine months 2001, common shares underlying options were excluded from the calculation of diluted earnings (loss) per share because their effect would have been anti-dilutive. Excluded from the first nine months 2001 calculations were shares underlying options to purchase 5,663,607 shares of common stock at a range of prices from $33.01 to $73.94.

Additionally, 200,000 shares underlying an option issued to the former Chief Executive Officer in 1997 were excluded from diluted earnings per share calculations for third quarter and first nine months 2001 because the stock price conditions to exercise had not been met as to any of the shares as of September 30, 2001. The entire option was cancelled and forfeited on September 16, 2002, as none of the price vesting conditions had been met.

The Company declared cash dividends of $0.44 per share in the third quarter 2002 and 2001 and $1.32 per share in the first nine months 2002 and 2001.

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7. ASSET IMPAIRMENTS AND RESTRUCTURING CHARGES

Write-off of prepaid asset

During the second quarter 2001, Eastman terminated an agreement with a supplier that guaranteed the Company’s right to buy a specified quantity of a certain raw material annually through 2007 at prices determined by the pricing formula specified in the agreement. In prior years, the Company paid a total of $239 million to the supplier and deferred those costs to be amortized over the 15-year period during which the product was to be received. The Company began amortizing those costs in 1993 and had recorded accumulated amortization of $131 million at March 31, 2001. As a result of the termination of this agreement, a charge of $108 million, representing unamortized deferred cost, was charged to the Polymers segment’s earnings during the second quarter 2001 as no continuing economic benefits will be received pertaining to this contract.

Write-off of impaired polyethylene assets

During the second quarter 2001, management identified and announced certain assets that were intended to be spun-off at year-end 2001 related to the Company’s efforts to spin-off the specialty chemicals and plastics businesses. An indirect result of these decisions would have been that the continuing operations would have been required to purchase certain raw materials and utilities that were historically produced internally for use in the manufacture of polyethylene. Considering the purchase price of these raw materials and utilities, the carrying value of certain assets used to consume ethylene at the Longview, Texas facility in the manufacture of polyethylene exceeded the expected future cash flows attributable to such assets.

Subsequent to the second quarter 2001, the spin-off was canceled. However, management determined that the continued operation of these assets was not economically attractive and is anticipating reversing the flow of pipelines at the Longview facility to provide an alternate outlet for ethylene, and creating an option to shut down the impaired assets. Based upon the resulting cash flows from the probable future use of these assets, an impairment loss of $103 million was charged to the Polymers segment’s earnings during the second quarter 2001. The impairment represents the excess of the carrying value over the discounted estimated future cash flows related to the products produced by the impacted assets.

Restructuring and asset impairments of the fine chemicals product line

As a result of the on-going restructuring of the Company’s fine chemicals product line, Eastman recorded restructuring charges, including related asset write-downs, totaling approximately $70 million in 2001. These charges resulted from the Company’s on-going restructuring of its fine chemicals product line to reduce costs, and from the write-down of assets determined to be impaired. The restructuring initiative and related asset impairments involve the Company’s Performance Chemicals and Intermediates (“PCI”) segment and include assets at the Company’s Tennessee and Arkansas sites within the United States, a plant in Wales, and a plant in Hong Kong.

Charges in the fourth quarter and the third quarter 2001 of $1 million and $6 million, respectively, pertained primarily to severance accruals for employees impacted by the plant shutdowns, closure costs, and write-downs of fixed assets. Charges totaling approximately $63 million recorded during the second quarter 2001 related to certain fine chemicals product lines that did not fit the Company’s long-term strategic objectives and for assets determined to be impaired.

The impairments at the foreign sites included the write-down of fixed assets and other long-term deposits. The restructuring and asset impairments at the domestic sites primarily pertained to write-downs of fixed assets net of the effect of a reversal of a customer deposit, related to a custom synthesis product contract. In 2001, the Company received notification that the contract would be terminated June 30, 2002. The Company planned to use the related assets to meet contractual requirements, and then to permanently idle such assets. These assets were written down to fair value in the second quarter 2001 using discounted estimated net cash flows from contracts that were currently in effect. Subsequently, the customer initiated discussions with the Company which resulted in an agreement being reached in June 2002 to extend the custom synthesis product contract one year based on renegotiated terms.

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Restructuring of the Coatings, Adhesives, Specialty Polymers, and Inks (“CASPI”) segment

Consolidation and restructuring of the operations of the CASPI segment resulted in restructuring charges, including related asset write-downs, of approximately $77 million in 2001. In the fourth quarter 2001, the Company recognized a charge of approximately $27 million related to the closure of an operating site in Duesseldorf, Germany. Also in the fourth quarter 2001, charges of approximately $6 million and $3 million, respectively, were recognized related to the impairment of other operating assets in Savannah, Georgia and Banbury, England. In the third quarter 2001, the Company recognized a charge of approximately $21 million related to the closure of a Moundville, Alabama plant that was obtained in the acquisition of Lawter International, Inc. In the second quarter 2001, the Company recognized a charge of approximately $20 million related to the closure of plants in Philadelphia, Pennsylvania and Portland, Oregon that were obtained in the acquisition of McWhorter Technologies, Inc. A change in estimate for the Philadelphia and Portland shutdown reserves resulted in a $1 million credit to earnings in the third quarter 2002.

The restructuring charges include write-downs of the fixed assets at these facilities, severance accruals for employees impacted by the plant shutdowns, and other costs associated with closing the facilities. The Philadelphia and Portland facilities were closed in 2001, and the Moundville, Duesseldorf, and Banbury sites closed in 2002. The Savannah site is expected to close in mid-2003. The fair value of the impacted assets was determined using the discounted estimated net cash flows related to the products produced by the impacted assets.

Other asset impairments and restructuring charges

During fourth quarter 2001, the Company recorded asset impairment charges related to under-utilized assets including $10 million related to the discontinuation of the precolored-green PET product line in Kingsport, Tennessee; $10 million related to cessation of production at the Company’s solid-stating facility in Toronto, Ontario; $15 million related to deterioration of demand for certain specialty plastics products produced in Kingsport, Tennessee; and $3 million related to impaired assets in Europe. Approximately $20 million of these charges are reflected in the Polymers segment, $15 million in the Specialty Plastics (“SP”) segment, and $3 million in the PCI segment. The fair value of the impacted assets was determined using the discounted estimated net cash flows related to the products produced by the impacted assets.

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The following table summarizes the charges and change in estimate described above, the noncash reductions attributable to asset impairments and the cash reductions in shutdown reserves for severance costs and site closure costs paid.

8. OTHER NONRECURRING OPERATING CHARGES

Other nonrecurring operating charges totaling $2 million and $14 million were recognized in the third quarter and first nine months 2001, respectively. The Company recorded charges of $5 million and $9 million in the third quarter and first nine months 2001, respectively, associated with efforts to spin-off the specialty chemicals and plastics businesses. Also in the first nine months 2001, the Company recognized a charge of $5 million associated with the write-off of acquired in-process research and development costs related to the acquisition of certain businesses from Hercules Incorporated (“Hercules Businesses”). Initially recorded as a charge of $8 million in the second quarter 2001, the write-off of in-process research and development was subsequently revised to $5 million with a $3 million credit to earnings in the third quarter 2001.

9. ACQUISITIONS

Ariel Research Corporation

In January 2002, Eastman acquired Ariel Research Corporation (“Ariel”) for approximately $8 million, including $6 million cash paid at closing and a $2 million promissory note to be paid one year after closing, subject to certain post-closing adjustments. Ariel is a provider of worldwide regulatory information, software products and services that enable corporations to manage product safety and stewardship functions, including requirements for workplace, environmental and dangerous goods compliance.

The transaction, which was financed with available cash and commercial paper borrowings, was accounted for by the purchase method of accounting and, accordingly, the results of Ariel for the period from the acquisition date are included in the accompanying consolidated financial statements and reported in the PCI segment. Tangible assets acquired were recorded at their fair values. Definite-lived intangible assets of approximately $7 million are being amortized on a straight-line basis over 3 to 10 years. Assuming this transaction had been made at January 1, 2001, the consolidated pro forma results for the nine months ended September 30, 2001 would not be materially different from reported results.

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Certain Businesses of Hercules Incorporated

On May 1, 2001, the Company completed the asset acquisition of the Hercules Businesses for approximately $252 million. The facilities acquired are located in the United States, the Netherlands and Mexico. Additionally, certain assets acquired are operated under contracts with Hercules at a shared facility in the United States.

The transaction, which was financed with available cash and commercial paper borrowings, was accounted for by the purchase method of accounting and, accordingly, the results of the Hercules Businesses for the period from the acquisition date are included in the accompanying consolidated financial statements and reported in the CASPI segment. Tangible assets acquired were recorded at their fair values. Goodwill and other intangible assets of approximately $33 million, which represents the excess of cost over the fair value of net tangible assets acquired, were being amortized on a straight-line basis over 17 to 40 years. Effective January 1, 2002, in connection with the adoption of Statement of Financial Accounting Standard (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” definite-lived intangible assets of approximately $2 million are being amortized on a straight-line basis over 17 years. Acquired in-process research and development of approximately $8 million was written off during the second quarter 2001, and subsequently revised to $5 million with a $3 million credit to earnings in the third quarter 2001. Assuming this transaction had been made at January 1, 2001, the consolidated pro forma results for the nine months ended September 30, 2001 would not be materially different from reported results.

10. DERIVATIVE FINANCIAL INSTRUMENTS HELD OR ISSUED FOR PURPOSES OTHER THAN TRADING

Effective January 1, 2001, the Company adopted SFAS No. 133, as amended by SFAS No. 138, “Accounting for Derivative Instruments and Hedging Activities,” which requires that all derivative instruments be reported on the balance sheet at fair value and establishes criteria for designation and effectiveness of hedging relationships. Instruments with a fair market value of $33 million, previously not required to be recorded and primarily pertaining to the Company’s raw materials and energy cost hedging program, were recognized as miscellaneous receivables in the Consolidated Statement of Financial Position on January 1, 2001. Previously deferred gains of $68 million from the settlement of currency options were reclassified from other current liabilities. Accordingly, the following amounts were recorded as of January 1, 2001:

The above amount resulted in an after-tax credit of $58 million to accumulated other comprehensive income (loss), a component of stockholders’ equity, and an after-tax gain of $4 million included in net earnings as of January 1, 2001.

At September 30, 2002, the remaining mark-to-market gains from currency, commodity and certain interest rate hedges that were included in accumulated other comprehensive income (loss) totaled approximately $6 million. If realized, substantially all of this balance will be reclassified into earnings during the next twelve months. The mark-to-market gains or losses on non-qualifying, excluded and ineffective portions of hedges are recognized in cost of sales or other income and charges immediately. Such amounts did not have a material impact on earnings during the third quarter or first nine months 2002.

The Company is exposed to market risk, such as changes in currency exchange rates, raw material and energy costs and interest rates. The Company uses various derivative financial instruments pursuant to the Company’s hedging policies to mitigate these market risk factors and their effect on the cash flows of the underlying transactions. Designation is performed on a specific exposure basis to support hedge accounting. The changes in fair value of these hedging instruments are offset in part or in whole by corresponding changes in the cash flows of the underlying exposures being hedged. The Company does not hold or issue derivative financial instruments for trading purposes.

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

Currency rate hedging

The Company manufactures and sells its products in a number of countries throughout the world and, as a result, is exposed to movements in foreign currency exchange rates. To manage the volatility relating to these exposures, the Company nets the exposures on a consolidated basis to take advantage of natural offsets. To manage the remaining exposure, the Company enters into forward exchange contracts to hedge certain firm commitments denominated in foreign currencies and currency options and forwards to hedge probable anticipated, but not yet committed, export sales transactions expected within no more than five years and denominated in foreign currencies (principally the British pound, Canadian dollar, euro and the Japanese yen). These contracts are designated as cash flow hedges. The mark-to-market gains or losses on qualifying hedges are included in accumulated other comprehensive income (loss) to the extent effective, and reclassified into cost of sales in the period during which the hedged transaction affects earnings.

Commodity hedging

Raw materials and energy sources used by the Company are subject to price volatility caused by weather, supply conditions, economic variables and other unpredictable factors. To mitigate short-term fluctuations in market prices for propane, ethane and natural gas, the Company enters into forwards and options contracts. These contracts are designated as cash flow hedges. The mark-to-market gains or losses on qualifying hedges are included in accumulated other comprehensive income (loss) to the extent effective, and reclassified into cost of sales in the period during which the hedged transaction affects earnings.

Interest rate hedging

The Company’s policy is to manage interest cost using a mix of fixed and variable rate debt. To manage this mix in a cost-efficient manner, the Company enters into interest rate swaps in which the Company agrees to exchange the difference between fixed and variable interest amounts calculated by reference to an agreed upon notional principal amount. These swaps are designated to hedge the fair value of underlying debt obligations with the interest rate differential reflected as an adjustment to interest expense over the life of the swaps. As these instruments are 100% effective, there is no impact on earnings due to hedge ineffectiveness.

From time to time, the Company also utilizes interest rate derivative instruments, primarily swaps, to hedge the Company’s exposure to movements in interest rates on anticipated debt offerings. These instruments are designated as cash flow hedges and are typically 100% effective. As a result, there is no current impact on earnings due to hedge ineffectiveness. The mark-to-market gains or losses on these hedges are included in accumulated other comprehensive income (loss) to the extent effective, and are reclassified into interest expense over the period of the related debt instruments.

The fair value for fixed-rate borrowings is based upon current interest rates for comparable securities. The Company’s floating-rate instruments have carrying values that approximate fair value.

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11. OTHER (INCOME) CHARGES, NET, AND OTHER NONRECURRING CHARGES

The third quarter 2002 other charges included a net loss due to remeasurement of foreign currency-denominated amounts. For the first nine months 2002, other income reflected a slight gain from foreign currency remeasurement as the impact of the devaluation of the Argentine peso in the first quarter 2002 and the charges recorded in the third quarter 2002 were more than offset by gains recognized in the second quarter 2002. These gains were primarily attributed to the strengthening of the euro during the second quarter 2002.

The third quarter 2001 other income primarily reflected gains from foreign exchange transactions while the first nine months 2001 other charges reflected a slight loss.

In addition to the impacts of foreign currency remeasurements discussed above, other income in all periods presented primarily reflected gains on equity investments. The first nine months 2002 gain is net of a nonrecurring charge of $5 million related to the previously-announced restructuring of Genencor in which the Company owns a 42% equity interest.

In addition to the impacts of foreign currency remeasurements discussed above, other charges in all periods presented primarily related to fees on securitized receivables. Other charges for the first nine months 2002 also included a write-down to fair value of certain technology business venture investments recorded in the second quarter 2002.

Other nonrecurring charges for the third quarter and first nine months 2001 reflected a charge of $2 million related to the Company’s efforts to sell its fine chemicals product line.

12. GOODWILL AND OTHER INTANGIBLE ASSETS

The Company adopted the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets,” effective January 1, 2002. The provisions of SFAS No. 142 prohibit the amortization of goodwill and indefinite-lived intangible assets; require that goodwill and indefinite-lived intangible assets be tested at least annually for impairment; require reporting units to be identified for the purpose of assessing potential future impairments of goodwill; and remove the forty-year limitation on the amortization period of intangible assets that have finite lives.

In connection with the adoption of SFAS No. 142, the Company completed in the first quarter 2002 the impairment test for intangible assets with indefinite useful lives other than goodwill. As a result of this impairment test, it was determined that the fair value of certain trademarks related to the CASPI segment, as established by appraisal and based on discounted future cash flows, was less than the recorded value. Accordingly, the Company recognized an after-tax impairment charge of approximately $18 million in the first quarter 2002. This charge is reported in the Consolidated Statement of Earnings as the cumulative effect of a change in accounting principle. Additionally, the Company reclassified $12 million of its intangible assets related to assembled workforce and the related deferred tax liabilities of approximately $5 million to goodwill. During the second quarter 2002, the Company performed the transitional impairment test on its goodwill as required upon adoption of this Statement, and determined that no impairment of goodwill existed as of January 1, 2002. The Company completed its annual testing of goodwill and indefinite-lived intangible assets for impairment in the third quarter 2002 and determined that no impairment existed as of September 30, 2002. The Company plans to continue its annual testing of goodwill and indefinite-lived intangible assets for impairment in the third quarter of each year, unless events warrant additional testing.

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Following are the Company’s amortizable intangible assets and indefinite-lived intangible assets. The difference between the gross carrying amount and net carrying amount for each item presented is attributable to accumulated amortization.

As a result of the nonamortization provisions of SFAS No. 142, the Company will no longer record approximately $20 million of annual amortization relating to goodwill and indefinite-lived intangibles, as adjusted for the reclassifications just mentioned.

Changes in the carrying amount of goodwill follow:

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The following table presents prior year earnings and earnings per share as if the nonamortization provisions of SFAS No. 142 had been applied in the prior year.

Amortization expense for definite-lived intangible assets was approximately $4 million and $11 million, respectively, for the third quarter and first nine months 2002. If the nonamortization provisions of SFAS No. 142 had been applied in the prior year, amortization expense would have been $3 million for the third quarter 2001 and $10 million for the first nine months 2001. Estimated amortization expense for 2002 and the five succeeding years is approximately $15 million per year.

13. SEGMENT INFORMATION

The Company’s products and operations are managed and reported in five operating segments. Effective January 1, 2002, the Company implemented a divisional structure that separated the businesses into two divisions. Eastman Division consists of the CASPI segment, the PCI segment and the SP segment. Voridian Division contains the Polymers segment and the Fibers segment. The divisional structure has allowed the Company to align costs more directly with the activities and businesses that generate them. The divisional and segment results for the first three quarters 2002, but not for prior periods, reflect this new cost structure.

With the implementation of the divisional structure, goods and services are transferred between the two divisions at predetermined prices. Accordingly, the divisional structure results in the recognition of interdivisional sales revenue and operating earnings. Such interdivisional transactions are eliminated in the Eastman Chemical Company consolidated financial statements. Prior to 2002, segment sales revenue was recognized only for actual sales to third parties and the intersegment transfer of goods and services, recorded at cost, had no impact on segment earnings.

All Eastman Chemical Company assets were allocated to the divisions as of January 1, 2002. Corporate, general purpose and other nonoperating assets were allocated to segments within each division based on process or product responsibility. Certain infrastructure assets at each site, primarily utilities that were previously allocated to all five segments, were allocated to the primary division at that site. The primary division invoices the other division for services provided by such infrastructure assets.

Effective January 1, 2002, sales and operating results for Cendian Corporation (“Cendian”), the Company’s logistics subsidiary and an Eastman Division initiative, are included in amounts for the CASPI, PCI and SP segments, and

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have been allocated to these segments on the basis of sales revenues for each of these segments. Prior to 2002, sales and operating results for Cendian were allocated to all five segments.

Effective January 1, 2002, certain compounded polyethylene products were moved from the Polymers segment to the SP segment. Accordingly, amounts for 2001 have been reclassified to reflect this change.

The CASPI segment manufactures raw materials, additives and specialty polymers primarily for the paints and coatings, inks and graphic arts, adhesives and other markets. The CASPI segment’s products consist of binders and resins, liquid vehicles, pigment concentrates and additives, unsaturated polyester resins and polyester and acrylic emulsions. Binders and resins, such as alkyd and polyester resins, hydrocarbon resins and rosins and rosin esters, are used in adhesives as a key component and in paints and inks to form a protective coating or film and bind color to the substrate. Liquid vehicles, such as ester, ketone and alcohol solvents, maintain the binders in liquid form for ease of application. Pigment concentrates and additives, such as cellulosic polymers, Texanol® coalescing aid and chlorinated polyolefins, provide different properties or performance enhancements to the end product. Unsaturated polyester resins are used primarily in gel coats and fiberglass reinforced plastics. Polyester and acrylic emulsions are used to protect fibers during processing in textile manufacturing, and for use in water-based paints, inks and adhesives. Paints and coatings raw material end use markets consist of architectural, automotive, transportation, industrial, maintenance, marine and furniture coatings. Inks and graphic arts raw material end use markets consist of offset, gravure, and packaging printing and publishing. Adhesives and sealant raw material end use markets include non-woven, tape, label, hot melt, automotive and packaging applications. Composite resins are used in marine, transportation, construction and consumer goods applications. CASPI segment annual sales are approximately 50% to paints and coatings markets, approximately 25% to adhesives markets, and approximately 25% to inks and graphic arts and other markets.

The PCI segment manufactures diversified products in three major groups: acetyl and intermediates; olefins and derivatives; and custom, fine and performance chemicals. Each of these groups accounts for approximately 25% of PCI annual sales with the remaining 25% resulting from other products and interdivisional sales. These products are used in a variety of environments and end uses, including agrochemical, automotive, beverages, catalysts, nutrition, pharmaceuticals, coatings, flooring, medical devices, toys, photographic and imaging, household products, polymers, textiles and consumer and industrials. Custom synthesis and photographic chemicals were historically managed as part of Eastman’s fine chemicals product line.

The SP segment produces highly specialized copolyesters, cellulosic plastics and compounded polyethylene plastics that possess performance properties for value-added end uses such as appliances, in store fixtures and displays, building and construction, electronics and electronic packaging, medical packaging, personal care and cosmetics, performance films, tape and labels, biodegradeables, cups and lids, fiber and strapping, photographic and optical, graphic arts and general packaging. SP segment annual sales are approximately 70% copolyester plastics, approximately 25% cellulosic plastics and approximately 5% compounded polyethylenes and other products.

The Polymers segment manufactures a broad line of PET polymers and polyethylene products for the beverage bottle and consumer and industrial products markets. PET polymers serve as source products for containers for, among other things, carbonated soft drinks, water, beer and personal care items and food containers that are suitable for both conventional and microwave oven use. The Polymers segment also manufactures low density polyethylene and linear low density polyethylene, which are used primarily for packaging and film applications and in extrusion coated containers such as milk and juice cartons.

The Fibers segment manufactures Estron® acetate tow and Estrobond® triacetin plasticizers for the cigarette filter market; acetate yarns for use in apparel, home furnishings and industrial fabrics; and acetate flake and acetyl raw materials for other acetate fiber producers.

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For the third quarter 2002, Eastman Division interdivisional sales eliminated in consolidation include the following: CASPI $16 million, PCI $107 million, and SP $17 million. For the third quarter 2002, Voridian Division interdivisional sales eliminated in consolidation include: Polymers $16 million and Fibers $17 million. For the first nine months 2002, Eastman Division interdivisional sales eliminated in consolidation include the following: CASPI $42 million, PCI $302 million, and SP $49 million. For the first nine months 2002, Voridian Division interdivisional sales eliminated in consolidation include: Polymers $39 million and Fibers $55 million.

Operating earnings presented above include the effect of nonrecurring items described in Notes 7 and 8.

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14. LEGAL MATTERS

General

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

Sorbates litigation

As previously reported, on September 30, 1998, the Company entered into a voluntary plea agreement with the U.S. Department of Justice and agreed to pay an $11 million fine to resolve a charge brought against the Company for violation of Section One of the Sherman Act. Under the agreement, the Company entered a plea of guilty to one count of price-fixing for sorbates, a class of food preservatives, from January 1995 through June 1997. The plea agreement was approved by the United States District Court for the Northern District of California on October 21, 1998. The Company recognized the entire fine in the third quarter of 1998 and is paying the fine in installments over a period of five years. On October 26, 1999, the Company pleaded guilty in a Federal Court of Canada to a violation of the Competition Act of Canada and was fined $780,000 (Canadian). The plea in Canada admitted that the same conduct that was the subject of the United States guilty plea had occurred with respect to sorbates sold in Canada, and prohibited repetition of the conduct and provides for future monitoring. The Canadian fine has been paid and was recognized as a charge against earnings in the fourth quarter of 1999.

In the wake of the September 30, 1998, plea agreement, the Company, along with other defendants, was sued in federal, state and Canadian courts in a number of putative class action lawsuits filed on behalf of purchasers of sorbates and products containing sorbates, claiming those purchasers paid more for sorbates and for products containing sorbates than they would have paid in the absence of the defendants’ price fixing. All but four of these more than twenty lawsuits have been resolved via settlement. Of the remaining cases, one has been settled and the settlement has been approved at the trial court level, but an appeal of that approval is pending. No class has been certified in any of the other three remaining cases, and the trial court in one of them decided in October 2002 that that case would not proceed as a class action. The Company has filed a dispositive motion in one of the other remaining cases and the other case is inactive.

In addition, several states have recently sued the Company and other defendants in connection with the sorbates matter, seeking unspecified damages, restitution and civil penalties on behalf of consumers of sorbates in those

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EASTMAN CHEMICAL COMPANY AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

respective states. Several other states have advised the Company that they intend to bring similar actions against the Company and others.

The Company has recognized charges to earnings in each of the past four years for estimated and actual costs, including legal fees, related to the sorbates fine and litigation. While the Company intends to continue to vigorously defend the remaining sorbates actions unless they can be settled on acceptable terms, the ultimate outcome of the matters still pending and of additional claims that could be made is not expected to have a material impact on the Company’s financial condition, results of operations, or cash flows, although these matters could result in the Company being subject to additional monetary damages, costs or expenses and additional charges against earnings.

Asbestos litigation

Over the years, Eastman has been named as a defendant in lawsuits in various state courts in which plaintiffs allege injury due to exposure to asbestos at Eastman’s manufacturing sites and seek unspecified monetary damages and other relief. Historically, these cases have been dismissed or settled without a material effect on Eastman’s financial results. Recently, Eastman has experienced an increase in the number of asbestos claims and in the settlement demands of plaintiffs. The Company is currently evaluating the allegations and claims made in recent asbestos-related lawsuits and intends to vigorously defend these actions or to settle them on acceptable terms. The Company presently believes that the ultimate resolution of asbestos cases will not have a material impact on the Company’s financial condition, results of operations, or cash flows, although these matters could result in the Company being subject to additional monetary damages, costs or expenses and additional charges against earnings.

15. COMMITMENTS

Lease commitments

During the second quarter 2002, the Company renegotiated a significant operating lease of machinery and equipment extending the terms through June 2007. The new agreement includes provisions that may require the Company to maintain $163 million in restricted cash to serve as collateral for the lease beginning in March 2003 if the lease is not refinanced. The collateral requirements will be included in other assets when and if funded. The Company believes the likelihood of the restricted cash provision becoming operative is remote.

Taking into consideration the terms of the new lease, the Company has various lease commitments totaling approximately $307 million over a period of several years. Of the total lease commitments, approximately 47% relate to machinery and equipment; approximately 35% relate to real property, including office space, storage facilities and land; and approximately 18% relate to railcars. Future lease payments, reduced by sublease income, follow:

Other commitments

In 1999, the Company entered into an agreement that allows the Company to sell certain domestic accounts receivable under a planned continuous sale program to a third party. The agreement permits the sale of undivided interests in domestic trade accounts receivable. Receivables sold to the third party totaled $180 million at September 30, 2002 and $200 million at December 31, 2001. Undivided interests in designated receivable pools were sold to the purchaser with recourse limited to the receivables purchased. Fees paid by the Company under this agreement are based on certain variable market rate indices and totaled approximately $1 million and $2 million in the third quarters 2002 and 2001, respectively, and approximately $3 million and $7 million in the first nine months 2002 and 2001, respectively. Average monthly proceeds from collections reinvested in the continuous sale program were approximately $266 million and $250 million in the third quarters 2002 and 2001, respectively, and approximately $250 million and $240 million in the first nine months 2002 and 2001, respectively. The portion that continues to be recognized in the Statements of Financial Position is domestic trade receivables of $160 million and $124 million at September 30, 2002 and December 31, 2001, respectively.

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EASTMAN CHEMICAL COMPANY AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

16. RECENTLY ISSUED ACCOUNTING STANDARDS

In August 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 143, “Accounting for Asset Retirement Obligations,” which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or normal use of the asset.

The Company is required and plans to adopt the provisions of SFAS No. 143 January 1, 2003. Upon initial application of the provisions of SFAS No. 143, entities are required to recognize a liability for any existing asset retirement obligations adjusted for cumulative accretion to the date of adoption of this Statement, an asset retirement cost capitalized as an increase to the carrying amount of the associated long-lived asset, and accumulated depreciation on that capitalized cost. The cumulative effect, if any, of initially applying this Statement will be recognized as a change in accounting principle. The Company has not yet assessed the impact of this Statement on its financial statements.

In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS No. 144 addresses financial accounting and reporting for the impairment of long-lived assets and for assets to be disposed of and broadens the presentation of discontinued operations to include more disposal transactions. The provisions of this Statement, which were adopted by the Company January 1, 2002, have not had a material impact on its financial condition or results of operations.

In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” This Statement, which updates, clarifies and simplifies existing accounting pronouncements, addresses the reporting of debt extinguishments and accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. The provisions of this Statement are generally effective for the Company’s 2003 fiscal year, or in the case of specific provisions, for transactions occurring after May 15, 2002 or for financial statements issued on or after May 15, 2002. The provisions of this Statement have not had and are not expected to have a material impact on the Company’s financial condition or results of operations.

In July 2002 the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” This Statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” This Statement requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, and concludes that an entity’s commitment to an exit plan does not by itself create a present obligation that meets the definition of a liability. This Statement also establishes that fair value is the objective of initial measurement of the liability. The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. The Company has not yet assessed the impact of this Statement on its financial statements.

17. SUBSEQUENT EVENTS

Income tax matters

During the fourth quarter 2002, the Company will recognize a benefit for certain income tax contingencies that were favorably resolved.

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

This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company’s consolidated financial statements, including related notes, and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in the 2001 Annual Report on Form 10-K as amended by Form 10-K/A, the Forms 10-Q for the first and second quarters 2002, and the unaudited interim financial statements included elsewhere in this report. All references to earnings (loss) per share contained in this report are diluted earnings (loss) per share unless otherwise noted.

RESULTS OF OPERATIONS

SUMMARY OF CONSOLIDATED RESULTS

The Company’s results of operations as presented in the consolidated financial statements of this Form 10-Q are described below.

Sales revenue for the third quarter 2002 of $1.4 billion was essentially flat when compared to the third quarter 2001. Increased sales volumes were offset by decreased selling prices. Sales revenue for the first nine months 2002 of $4.0 billion decreased 3% compared to the first nine months 2001 sales revenue of $4.1 billion. The decline in sales revenue for the first nine months 2002 was mainly attributed to lower selling prices and an unfavorable shift in product mix, which were partially offset by increased sales volumes.

Operating earnings for the third quarter 2002 were $61 million compared to $70 million in the third quarter 2001. Operating earnings for the first nine months 2002 were $219 million compared to an operating loss of $34 million for the first nine months 2001. Operational disruptions at the Company’s plants in Rotterdam, the Netherlands and Columbia, South Carolina negatively impacted operating earnings by approximately $23 million and $28 million for the third quarter and first nine months 2002, respectively. A change in estimate for the shutdown reserves related to the closure of plants in Portland, Oregon and Philadelphia, Pennsylvania that were obtained in the 2001 acquisition of McWhorter Technologies, Inc. (“McWhorter), had a slightly positive impact on results for 2002. Operating earnings for the third quarter and first nine months 2001 were negatively impacted by nonrecurring items totaling approximately $29 million and $335 million, respectively, described more fully below and in Notes 7 and 8 to the consolidated financial statements. Operating results for the third quarter and first nine months 2001 were also negatively impacted by amortization of goodwill and indefinite-lived intangibles totaling approximately $5 million and $15 million, respectively.

Excluding the additional costs from the operational disruptions in third quarter 2002, the nonrecurring items in both periods, and the amortization of goodwill and indefinite-lived intangibles in the third quarter 2001, operating earnings were $83 million for the third quarter 2002 compared to $104 million for the third quarter 2001. Selling prices for the third quarter 2002 declined more than raw material costs, resulting in margin compression. The decline in selling prices had a negative impact on third quarter 2002 operating earnings of approximately $90 million, roughly one fourth of which was offset by a decrease in raw material costs. Higher sales volumes and lower unit costs resulting from increased capacity utilization had a positive impact on operating earnings for the third quarter 2002.

Excluding the impact of the operational disruptions in the first nine months 2002, the nonrecurring items in both periods, and the amortization of goodwill and indefinite-lived intangibles in the first nine months 2001, operating earnings for the first nine months 2002 were $246 million compared to $316 million for the first nine months 2001. Selling prices for the first nine months 2002 decreased more than raw material costs, resulting in margin compression. The decline in selling prices had a negative impact on operating earnings for the first nine months 2002 of approximately $334 million, roughly three fourths of which was offset by a decrease in raw material costs. Operating earnings for the first nine months 2002 were also negatively impacted by an unfavorable shift in product mix, and foreign currency hedging gains recognized in operating earnings in the first nine months 2001 that were not repeated in the first nine months 2002. Higher sales volumes and lower unit costs resulting from increased capacity utilization had a positive impact on operating earnings for the first nine months 2002.

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Diluted earnings per share for the third quarter 2002 were $0.31 compared with $0.36 per share in the third quarter 2001. For the first nine months 2002, the Company reported earnings per share of $0.96 compared with a loss of $1.08 per share for the first nine months 2001.

Sales revenue for the third quarter 2002 was essentially flat compared to the third quarter 2001. Increased sales volumes had a positive impact on sales revenue of 5% or approximately $74 million. Foreign currency exchange rates had a positive effect on sales revenue of 2% or approximately $27 million. These increases were mostly offset by lower selling prices that had a negative impact on revenues of 7% or approximately $90 million. Both the increase in sales volumes and the decrease in selling prices were primarily attributable to the Polymers segment.

The decrease in sales revenue for the first nine months 2002 compared to the first nine months 2001 was due to lower selling prices, primarily for the Polymers segment, and an unfavorable shift in product mix. Lower selling prices had a negative impact on sales revenue of 8% or approximately $334 million, offset mostly by increased sales volumes. The increase in sales volumes was primarily attributed to the Polymers segment and the May 2001 acquisition of certain businesses from Hercules Incorporated (“Hercules Businesses”). An unfavorable shift in product mix had a negative impact on sales revenue of 2% or approximately $101 million. The shift in product mix occurred primarily in the Performance Chemicals and Intermediates (“PCI”) and Fibers segments.

Operational disruptions at the Company's plants in Rotterdam, the Netherlands and Columbia, South Carolina negatively impacted gross profit by approximately $23 million and $28 million for the third quarter and first nine months 2002, respectively. Decreased selling prices had a negative impact on gross profit for the third quarter and first nine months 2002, mostly offset by a decrease in raw material costs and lower unit costs resulting from increased capacity utilization.

Selling and general administrative expenses for the third quarter 2002 were essentially flat compared to the third quarter 2001. The first nine months 2002 selling and general administrative expenses decreased slightly compared to the first nine months 2001 primarily due to cost control efforts.

Research and development costs for the third quarter 2002 increased compared to the third quarter 2001 due to timing of expenditures and a slight increase in spending, but were flat for the first nine months 2002 compared to the first nine months 2001.

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Asset impairments and restructuring charges