September 2004 10Q






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

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2004

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 1-16619


KERR-McGEE CORPORATION
(Exact Name of Registrant as Specified in its Charter)


 
Delaware
73-1612389
(State or Other Jurisdiction of
(I.R.S. Employer
Incorporation or Organization)
Identification No.)


Kerr-McGee Center, Oklahoma City, Oklahoma 73125
(Address of Principal Executive Offices and Zip Code)

Registrant's telephone number, including area code (405) 270-1313


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 

Number of shares of common stock, $1.00 par value, outstanding as of October 31, 2004:
151,692,157.






 
KERR-McGEE CORPORATION
 
     
 
INDEX
 
     
 
PART I - FINANCIAL INFORMATION
 
     
Item 1. Financial Statements
PAGE
 
   
 
Consolidated Statement of Income for the Three and Nine Months Ended September 30, 2004 and 2003
1
 
   
 
Consolidated Balance Sheet at September 30, 2004 and December 31, 2003
2
 
   
 
Consolidated Statement of Cash Flows for the Nine Months Ended
September 30, 2004 and 2003
3
 
   
 
Notes to Consolidated Financial Statements
4
 
   

Item 2. Management's Discussion and Analysis of Financial Condition
                and Results of Operations
38
 
 
 
Item 3. Quantitative and Qualitative Disclosures about Market Risk
48
 
 
 
Item 4. Controls and Procedures
52
     
Forward-Looking Information
52
   
 
PART II - OTHER INFORMATION
 
 
 
 
Item 1. Legal Proceedings
52
   
Item 5. Other Information
53
   
Item 6. Exhibits
53
 
 
 
SIGNATURE
53
 
 
 
   


  
     


PART I - FINANCIAL INFORMATION

Item 1. Financial Statements.

KERR-McGEE CORPORATION AND SUBSIDIARY COMPANIES
CONSOLIDATED STATEMENT OF INCOME
(UNAUDITED)

 
   
Three Months
 
Nine Months
 
   
Ended
 
Ended
 
   
September 30,
 
September 30,
 
(Millions of dollars, except per-share amounts)
 
2004
 
2003
 
2004
 
2003
 
       
 
     
 
 
Revenues
 
$
1,366.2
 
$
1,006.1
 
$
3,579.6
 
$
3,158.3
 
     
   
   
   
 
Costs and Expenses
   
   
   
   
 
Costs and operating expenses
   
530.9
   
409.9
   
1,366.5
   
1,233.4
 
Selling, general and administrative expenses
   
84.6
   
98.3
   
248.3
   
248.3
 
Shipping and handling expenses
   
43.4
   
34.4
   
119.5
   
101.4
 
Depreciation and depletion
   
362.8
   
180.6
   
744.1
   
563.2
 
Accretion expense
   
8.2
   
6.3
   
21.6
   
18.8
 
Asset impairments
   
7.4
   
6.8
   
21.7
   
11.9
 
Loss (gain) associated with assets held for sale
   
(.1
)
 
(11.2
)
 
7.2
   
(16.9
)
Exploration, including dry holes and amortization of
     undeveloped leases
   
98.9
   
79.8
   
215.0
   
286.9
 
Taxes, other than income taxes
   
44.8
   
23.5
   
101.8
   
69.9
 
Provision for environmental remediation and restoration,
     net of reimbursements
   
74.3
   
47.2
   
80.9
   
66.4
 
Interest and debt expense
   
67.9
   
62.8
   
180.6
   
191.2
 
Total Costs and Expenses
   
1,323.1
   
938.4
   
3,107.2
   
2,774.5
 
     
   
   
   
 
     
43.1
   
67.7
   
472.4
   
383.8
 
Other Expense
   
(20.4
)
 
(17.5
)
 
(27.7
)
 
(42.7
)
     
         
   
 
Income from Continuing Operations before Income Taxes
   
22.7
   
50.2
   
444.7
   
341.1
 
Provision for Income Taxes
   
(15.3
)
 
(21.1
)
 
(174.5
)
 
(138.0
)
     
   
   
   
 
Income from Continuing Operations
   
7.4
   
29.1
   
270.2
   
203.1
 
Loss from Discontinued Operations
(net of income tax benefit)
   
-
   
(.3
)
 
-
   
(.1
)
Cumulative Effect of Change in Accounting Principle
     (net of benefit for income taxes of $18.2)
   
-
   
-
   
-
   
(34.7
)
     
   
   
   
 
Net Income
 
$
7.4
 
$
28.8
 
$
270.2
 
$
168.3
 
     
   
   
   
 
Income (Loss) per Common Share
   
   
   
   
 
Basic -
   
   
   
   
 
Continuing operations
 
$
.05
 
$
.29
 
$
2.29
 
$
2.02
 
Discontinued operations
   
-
   
-
   
-
   
-
 
Cumulative effect of change in accounting principle
   
-
   
-
   
-
   
(.34
)
     
   
   
       
Total
 
$
.05
 
$
.29
 
$
2.29
 
$
1.68
 
Diluted -
   
   
   
   
 
Continuing operations
 
$
.05
 
$
.29
 
$
2.22
 
$
1.98
 
Discontinued operations
   
-
   
-
   
-
   
-
 
Cumulative effect of change in accounting principle
   
-
   
-
   
-
   
(.31
)
     
   
   
   
 
Total
 
$
.05
 
$
.29
 
$
2.22
 
$
1.67
 
     
   
   
   
 
Dividends Declared per Common Share
 
$
.45
 
$
.45
 
$
1.35
 
$
1.35
 
     
   
   
   
 
The accompanying notes are an integral part of this statement.
   
   
   
   
 


  
  - 1 -  

 

KERR-McGEE CORPORATION AND SUBSIDIARY COMPANIES
CONSOLIDATED BALANCE SHEET
(UNAUDITED)

   
September 30,
 
December 31,
 
(Millions of dollars)
 
2004
 
2003
 
   
 
 
 
 
ASSETS
 
 
 
 
 
Current Assets
 
 
 
 
 
Cash
 
$
128.2
 
$
142.0
 
Accounts receivable
   
682.5
   
583.3
 
Inventories
   
380.2
   
393.4
 
Investment in equity securities
   
-
   
509.8
 
Deposits, prepaid expenses and other assets
   
181.3
   
127.6
 
Deferred income taxes
   
435.2
   
76.0
 
Current assets associated with properties held for disposal
   
-
   
.4
 
Total Current Assets
   
1,807.4
   
1,832.5
 
     
   
 
Property, Plant and Equipment
   
18,715.4
   
14,272.8
 
Less reserves for depreciation, depletion and amortization
   
(7,880.5
)
 
(6,870.1
)
     
10,834.9
   
7,402.7
 
     
   
 
Investments and Other Assets
   
534.8
   
564.7
 
Goodwill
   
1,198.3
   
357.3
 
Other Intangible Assets
   
97.1
   
64.4
 
Long-Term Assets Associated with Properties Held for Disposal
   
-
   
28.3
 
     
   
 
Total Assets
 
$
14,472.5
 
$
10,249.9
 
     
   
 
LIABILITIES AND STOCKHOLDERS' EQUITY
   
   
 
Current Liabilities
   
   
 
Accounts payable
 
$
516.9
 
$
475.5
 
Long-term debt due within one year
   
351.5
   
574.3
 
Taxes on income
   
84.1
   
126.6
 
Taxes, other than income taxes
   
69.5
   
36.5
 
Derivative liabilities
   
721.4
   
354.2
 
Accrued liabilities
   
720.9
   
664.5
 
Total Current Liabilities
   
2,464.3
   
2,231.6
 
     
   
 
Long-Term Debt
   
3,565.8
   
3,081.2
 
     
   
 
Deferred Income Taxes
   
2,185.2
   
1,334.7
 
Asset Retirement Obligations
   
494.3
   
384.6
 
Oil and Gas Derivative Liabilities
   
270.4
   
2.1
 
Other Liabilities and Deferred Credits
   
579.4
   
563.9
 
Long-Term Liabilities Associated with Properties Held for Disposal
   
-
   
16.0
 
     
3,529.3
   
2,301.3
 
Stockholders' Equity
   
   
 
Common stock, par value $1 - 300,000,000 shares
   
   
 
authorized, 151,591,996 shares issued at 9-30-04
   
   
 
and 100,892,354 shares issued at 12-31-03
   
151.6
   
100.9
 
Capital in excess of par value
   
4,182.4
   
1,708.3
 
Preferred stock purchase rights
   
1.0
   
1.0
 
Retained earnings
   
1,037.1
   
927.2
 
Accumulated other comprehensive loss
   
(390.4
)
 
(45.4
)
Common shares in treasury, at cost - 150,280 shares
   
   
 
at 9-30-04 and 31,924 at 12-31-03
   
(7.6
)
 
(1.6
)
Deferred compensation
   
(61.0
)
 
(54.6
)
Total Stockholders' Equity
   
4,913.1
   
2,635.8
 
     
   
 
Total Liabilities and Stockholders’ Equity
 
$
14,472.5
 
$
10,249.9
 

The "successful efforts" method of accounting for oil and gas exploration and production activities has been followed in preparing this balance sheet.

The accompanying notes are an integral part of this statement.


 
  - 2 -  

 

KERR-McGEE CORPORATION AND SUBSIDIARY COMPANIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(UNAUDITED)


   
Nine Months Ended
 
   
September 30,
 
(Millions of dollars)
 
2004
 
2003
 
   
 
     
Operating Activities
 
 
     
Net income
 
$
270.2
 
$
168.3
 
Adjustments to reconcile net income to net cash
   
   
 
provided by operating activities -
   
   
 
Depreciation, depletion and amortization
   
784.5
   
617.1
 
Accretion expense
   
21.6
   
18.8
 
Asset impairments
   
21.7
   
11.9
 
(Gain) loss associated with assets held for sale
   
7.2
   
(10.7
)
Dry hole costs
   
80.1
   
162.7
 
Deferred income taxes
   
86.5
   
85.8
 
Provision for environmental remediation and
   
   
 
restoration, net of reimbursements
   
80.9
   
66.3
 
Cumulative effect of change in accounting principle
   
-
   
34.7
 
Noncash items affecting net income
   
165.1
   
121.7
 
Other net cash used in operating activities
   
(190.6
)
 
(84.5
)
Net Cash Provided by Operating Activities
   
1,327.2
   
1,192.1
 
     
   
 
Investing Activities
   
   
 
Capital expenditures
   
(832.0
)
 
(749.4
)
Dry hole costs
   
(45.8
)
 
(162.7
)
Cash acquired in Westport acquisition (1)
   
43.0
   
-
 
Proceeds from sales of assets
   
10.6
   
258.6
 
Acquisitions
   
-
   
(69.6
)
Other investing activities
   
8.4
   
(36.6
)
Net Cash Used in Investing Activities
   
(815.8
)
 
(759.7
)
     
   
 
Financing Activities
   
   
 
Issuance of long-term debt
   
900.0
   
31.5
 
Repayment of long-term debt
   
(1,277.9
)
 
(225.0
)
Issuance of common stock
   
34.1
   
-
 
Dividends paid
   
(136.6
)
 
(135.9
)
Settlement of Westport derivatives
   
(45.1
)
 
-
 
Other financing activities
   
-
   
(.6
)
Net Cash Used in Financing Activities
   
(525.5
)
 
(330.0
)
     
   
 
Effects of Exchange Rate Changes on Cash and Cash Equivalents
   
.3
   
2.6
 
     
   
 
Net Increase (Decrease) in Cash and Cash Equivalents
   
(13.8
)
 
105.0
 
     
   
 
Cash and Cash Equivalents at Beginning of Period
   
142.0
   
89.9
 
     
   
 
Cash and Cash Equivalents at End of Period
 
$
128.2
 
$
194.9
 


(1)  See Notes B and E for information regarding the business combination and related noncash
investing and financing activities.

The accompanying notes are an integral part of this statement.


  
  - 3 -  

 

KERR-McGEE CORPORATION AND SUBSIDIARY COMPANIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004


A. Basis of Presentation and Accounting Policies

Basis of Presentation

The condensed financial statements included herein have been prepared by the company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission and, in the opinion of management, include all adjustments, consisting only of adjustments that are normal and recurring in nature, necessary to present fairly the resulting operations for the indicated periods. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations. Although the company believes that the disclosures are adequate to make the information presented not misleading, these condensed financial statements should be read in conjunction with the financial statements and the notes thereto included in the company's latest annual report on Form 10-K.

Business Segments

The company has three reportable segments: oil and gas exploration and production, production and marketing of titanium dioxide pigment (chemicals - pigment), and production and marketing of other chemicals (chemicals - other). Other chemicals include the company’s electrolytic manufacturing and marketing operations and forest products treatment business.

Employee Stock Option Plans

The company accounts for its stock option plans under the intrinsic-value method permitted by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” Accordingly, no stock-based employee compensation cost is reflected in net income for the issuance of stock options under the company’s plans, since all options were fixed-price options with an exercise price equal to the market value of the underlying common stock on the date of grant.

Statement of Financial Accounting Standards (FAS) No. 123, "Accounting for Stock-Based Compensation," prescribes a fair-value method of accounting for employee stock options under which compensation expense is measured based on the estimated fair value of stock options at the grant date and recognized over the period of time that the options vest. The following table illustrates the effect on net income and earnings per share as if the company had applied the fair-value recognition provisions of FAS 123 to stock-based employee compensation.

   
Three
 
Nine
 
   
Months Ended
 
Months Ended
 
(Millions of dollars,
 
September 30,
 
September 30,
 
except per share amounts)
 
2004
 
2003
 
2004
 
2003
 
Net income as reported
 
$
7.4
 
$
28.8
 
$
270.2
 
$
168.3
 
Less stock-based compensation expense determined
   
   
   
   
 
using a fair-value method, net of taxes
   
(3.2
)
 
(4.0
)
 
(10.0
)
 
(12.1
)
Pro forma net income
 
$
4.2
 
$
24.8
 
$
260.2
 
$
156.2
 
     
   
   
   
 
Net income per share -
   
   
   
   
 
Basic -
   
   
   
   
 
As reported
 
$
.05
 
$
.29
 
$
2.29
 
$
1.68
 
Pro forma
   
.03
   
.25
   
2.20
   
1.56
 
     
   
   
   
 
Diluted -
   
   
   
   
 
As reported
   
.05
   
.29
   
2.22
   
1.67
 
Pro forma
   
.03
   
.25
   
2.15
   
1.56
 


 
  - 4 -  

 

Goodwill and Other Intangible Assets

In accordance with FAS 142, "Goodwill and Other Intangible Assets," goodwill and certain indefinite-lived intangibles are not amortized but are reviewed annually for impairment, or more frequently if impairment indicators arise. The annual test for impairment was completed in the second quarter of 2004, with no impairment indicated. The amounts tested for impairment excluded goodwill and intangible assets recorded in connection with the company’s merger with Westport Resources Corporation (Westport) on June 25, 2004.

Reclassifications

Certain reclassifications have been made to the prior year financial statements to conform with the current year presentation.


B. Business Combination

On June 25, 2004, Kerr-McGee completed its merger with Westport, an independent oil and gas exploration and production company with operations in the Rocky Mountain, Mid-Continent and Gulf Coast areas onshore U.S. and in the Gulf of Mexico. The merger increased Kerr-McGee’s proved reserves by approximately 30%, bringing the combined company’s total reserves as of December 31, 2003, to approximately 1.3 billion barrels of oil equivalent had the merger occurred at that date.

On the effective date of the merger, each issued and outstanding share of Westport common stock was converted into .71 shares of Kerr-McGee common stock. As a result, Kerr-McGee issued 48.9 million shares of common stock to Westport's stockholders. The common stock exchanged in the merger was valued at $2.4 billion based on Kerr-McGee’s weighted average stock price two days before and after April 7, 2004, the date the merger was publicly announced. Kerr-McGee also exchanged 1.9 million stock options for options held by Westport employees. The fair value of the vested options exchanged was $33.7 million, determined using the Black-Scholes option pricing model.

The acquisition price, net of cash acquired of $43 million, totaled $4.6 billion, which includes the value of common stock and stock options exchanged, plus debt and other liabilities assumed, and merger costs. Westport’s assets and liabilities are reflected in the company’s balance sheet at September 30, 2004, and Westport’s results of operations are included in the company’s statement of income after June 25, 2004. The purchase price was allocated to specific assets and liabilities based on their estimated fair values at the merger date, with $841 million recorded as goodwill and $599 million recorded for net deferred tax liabilities. Certain data necessary to complete the company’s final purchase price allocation is not yet available, which includes, but is not limited to, identification and valuation of pre-acquisition contingencies and final tax returns that provide the underlying tax bases of Westport’s assets and liabilities at June 25, 2004. The company expects to complete its purchase price allocation later this year at which time the preliminary allocation will be revised and goodwill will be adjusted, if necessary. The company does not expect any significant changes to result from finalizing the Westport purchase price allocation.

The strategic benefits of the merger and the principal factors that contributed to Kerr-McGee recognizing goodwill are as follows:

  · Provides complementary high-quality assets in core U.S. onshore and Gulf of Mexico regions;
  · Enhances the stability of high-margin production;
  · Expands low-risk exploitation opportunities;
  · Increases free cash flow for Kerr-McGee’s high-potential exploration opportunities;
  · Reduces leverage and enables greater financial flexibility; and
  · Provides opportunities for synergies and related cost savings.


  
  - 5 -  

 


The condensed balance sheet information presented below shows the allocation of purchase price to Westport’s assets and liabilities as of the merger date:
 
Condensed Balance Sheet
 
(Millions of dollars)
 
       
Assets
     
Current Assets
     
Cash
 
$
43.0
 
Accounts receivable
   
120.0
 
Derivative assets
   
2.2
 
Other current assets
   
26.7
 
Deferred income taxes
   
83.9
 
Total Current Assets
   
275.8
 
         
Property, Plant & Equipment:
       
Proved oil and gas properties
   
2,363.0
 
Unproved oil and gas properties
   
1,063.5
 
Other assets
   
60.4
 
Total Property, Plant & Equipment
   
3,486.9
 
         
Derivative Assets
   
4.0
 
Goodwill
   
841.2
 
Transportation Contracts
   
44.4
 
         
Total Assets
 
$
4,652.3
 
         
Liabilities and Stockholders’ Equity
       
Current Liabilities
       
Accounts payable and accrued liabilities
 
$
189.2
 
Derivative liabilities
   
153.6
 
Total Current Liabilities
   
342.8
 
         
Long-Term Debt
   
1,045.5
 
Deferred Income Taxes
   
683.0
 
Asset Retirement Obligations
   
70.3
 
Derivative Liabilities
   
48.3
 
Total Liabilities
   
2,189.9
 
         
Stockholders’ Equity
   
2,462.4
 
         
Total Liabilities and Stockholders’ Equity
 
$
4,652.3
 



  
  - 6 -  

 


The pro forma information presented below has been prepared to give effect to the Westport merger as if it had occurred at the beginning of the periods presented. The pro forma information is presented for illustrative purposes only and is based on estimates and assumptions deemed appropriate by Kerr-McGee. If the Westport merger had occurred in the past, Kerr-McGee’s operating results would have been different from those reflected in the pro forma information below; therefore, the pro forma information should not be relied upon as an indication of the operating results that Kerr-McGee would have achieved if the merger had occurred at the beginning of each period presented. The pro forma information also should not be used as an indication of the future results that Kerr-McGee will achieve after the Westport merger.

   
Pro Forma Information
 
   
Three Months
 
Nine Months
 
   
Ended
 
Ended
 
   
September 30,
 
September 30,
 
(Millions of dollars, except per-share amounts)
 
2004 (1)
 
2003
 
2004
 
2003
 
                   
Revenues
 
$
1,366.2
 
$
1,193.1
 
$
4,030.1
 
$
3,701.3
 
                           
Income from Continuing Operations
   
7.4
   
49.1
   
331.1
   
247.1
 
                           
Net Income
   
7.4
   
48.8
   
331.1
   
208.3
 
                           
Income per Common Share -
                         
Basic
 
$
.05
 
$
.33
 
$
2.21
 
$
1.40
 
Diluted
   
.05
   
.32
   
2.16
   
1.40
 
                           

(1) Reflects actual results since the Westport merger closed June 25, 2004.


C. Derivatives

The company is exposed to risk from fluctuations in crude oil and natural gas prices, foreign currency exchange rates, and interest rates. To reduce the impact of these risks on earnings and to increase the predictability of its cash flow, from time to time the company enters into certain derivative contracts, primarily swaps and collars for a portion of its oil and gas production, forward contracts to buy and sell foreign currencies, and interest rate swaps.

  
  - 7 -  

 


The following tables summarize the balance sheet presentation of the company’s derivatives as of September 30, 2004 and December 31, 2003:


   
As of September 30, 2004
 
   
Derivative Fair Value
     
   
Current
Long-Term
 
Current
 
Long-Term
 
Deferred Gain
 
   
Asset
 
Asset
 
Liability
 
Liability
 
(Loss) in AOCI(1)
 
Oil and gas commodity derivatives -
 
 
 
 
             
Kerr-McGee positions
 
$
37.1
 
$
12.4
 
$
(530.5
)
$
(221.4
)
$
(423.9
)
Acquired Westport positions
   
.7
   
1.7
   
(175.0
)
 
(45.7
)
 
(24.5
)
Gas marketing-related derivatives
   
13.6
   
3.2
   
(13.4
)
 
(3.3
)
 
-
 
Foreign currency forward contracts
   
11.9
   
1.7
   
(2.5
)
 
-
   
13.4
 
Interest rate swaps
   
-
   
-
   
-
   
11.5
   
-
 
Other
   
3.2
   
.8
   
-
   
-
   
2.6
 
     
   
               
 
Total derivative contracts
 
$
66.5
 
$
19.8
 
$
(721.4
)
$
(258.9
)
$
(432.4
)


   
As of December 31, 2003
 
   
Derivative Fair Value
     
   
Current
 
Long-Term
 
Current
 
Long-Term
 
Deferred Gain
 
   
Asset
 
Asset
 
Liability
 
Liability
 
(Loss) in AOCI(1)
 
                       
Oil and gas commodity derivatives
 
$
7.7
 
$
14.9
 
$
(181.3
)
$
-
 
$
(106.3
)
Gas marketing-related derivatives
   
8.0
   
2.1
   
(6.9
)
 
(2.1
)
 
-
 
Foreign currency forward contracts
   
28.0
   
-
   
(11.1
)
 
-
   
17.0
 
Interest rate swaps
   
-
   
-
   
-
   
15.1
   
-
 
DECS call option
   
-
   
-
   
(154.9
)
 
-
   
-
 
Other
   
.3
   
.5
   
-
   
-
   
.5
 
                                 
Total derivative contracts
 
$
44.0
 
$
17.5
 
$
(354.2
)
$
13.0
 
$
(88.8
)


(1)  Amounts deferred in accumulated other comprehensive income (AOCI) are reflected net of tax.

  
  - 8 -  

 


The following tables summarize the gain (loss) and classification of the company’s financial derivative instruments in the Consolidated Statement of Income for the three and nine month periods ending September 30, 2004 and 2003:

   
Three Months Ended
 
Nine Months Ended
 
   
September 30, 2004
 
September 30, 2004
 
                           
       
Costs and
 
Other
     
Costs and
 
Other
 
   
Revenues
 
Expenses
 
Expense
 
Revenues
 
Expenses
 
Expense
 
   
 
     
 
             
Hedge Activity:
 
 
     
 
             
Oil and gas commodity derivatives
 
$
(193.0
)
$
-
 
$
-
 
$
(409.8
)
$
-
 
$
-
 
Foreign currency contracts
   
-
   
4.5
   
-
   
.3
   
12.6
   
-
 
Interest rate swaps
   
-
   
3.8
   
-
   
-
   
13.1
   
-
 
Other
   
-
   
.3
   
-
   
-
   
.6
   
-
 
Total hedging contracts
   
(193.0
)
 
8.6
   
-
   
(409.5
)
 
26.3
   
-
 
     
         
                   
Nonhedge Activity:
   
         
                   
Oil and gas commodity derivatives -
   
         
                   
Kerr-McGee positions
   
(.3
)
 
-
   
.9
   
(10.0
)
 
-
   
3.1
 
Acquired Westport positions
   
(42.0
)
 
-
   
-
   
(26.9
)
 
-
   
-
 
Gas marketing-related derivatives
   
1.2
   
-
   
(.1
)
 
4.6
   
-
   
(1.0
)
DECS call option
   
-
   
-
   
(29.1
)
 
-
   
-
   
(101.0
)
Other
   
-
   
-
   
.3
   
-
   
-
   
(.5
)
Total nonhedge contracts
   
(41.1
)
 
-
   
(28.0
)
 
(32.3
)
 
-
   
(99.4
)
     
                               
Total derivative contracts
 
$
(234.1
)
$
8.6
 
$
(28.0
)
$
(441.8
)
$
26.3
 
$
(99.4
)


   
Three Months Ended
 
Nine Months Ended
 
   
September 30, 2003
 
September 30, 2003
 
                           
       
Costs and
 
Other
     
Costs and
 
Other
 
   
Revenues
 
Expenses
 
Expense
 
Revenues
 
Expenses
 
Expense
 
   
 
 
 
 
 
 
 
     
 
 
Hedge Activity:
 
 
 
 
 
 
 
 
     
 
 
Oil and gas commodity derivatives
 
$
(58.5
)
$
-
 
$
-
 
$
(225.1
)
$
-
 
$
-
 
Foreign currency contracts
   
-
   
.9
   
-
   
-
   
5.9
   
-
 
Interest rate swaps
   
-
   
2.9
   
-
   
-
   
8.4
   
-
 
Total hedging contracts
   
(58.5
)
 
3.8
   
-
   
(225.1
)
 
14.3
   
-
 
     
   
   
   
         
 
Nonhedge Activity:
   
   
   
   
         
 
Oil and gas commodity derivatives
   
-
   
-
   
(5.3
)
 
-
   
-
   
(9.4
)
Gas marketing-related derivatives
   
1.5
   
-
   
(1.5
)
 
(8.2
)
 
-
   
(3.9
)
DECS call option
   
-
   
-
   
45.3
   
-
   
-
   
(12.8
)
Other
   
-
   
-
   
(1.0
)
 
-
   
-
   
(1.3
)
Total nonhedge contracts
   
1.5
   
-
   
37.5
   
(8.2
)
 
-
   
(27.4
)
     
   
   
   
         
 
Total derivative contracts
 
$
(57.0
)
$
3.8
 
$
37.5
 
$
(233.3
)
$
14.3
 
$
(27.4
)


The company periodically enters into financial derivative instruments that generally fix the commodity prices to be received for a portion of its oil and gas production in the future. The fair value of these derivative instruments was determined based on prices actively quoted, generally NYMEX and Dated Brent prices. For derivative instruments qualifying as cash flow hedges, gains and losses are deferred in accumulated other comprehensive income and reclassified into earnings when the associated hedged production occurs. The company expects to reclassify after-tax net deferred losses of $344.8 million into earnings during the next 12 months (assuming no further changes in the fair market value of the related contracts). Losses for hedge ineffectiveness are recognized as a reduction to revenues in the Consolidated Statement of Income and were not material for the three and nine month periods ending September 30, 2004 and 2003.

  
  - 9 -  

 


Between March 31, 2004 and April 6, 2004, Kerr-McGee entered into additional financial derivative instruments in the form of fixed-price swaps and costless collars relating to specified quantities of projected 2004-2006 production that was not already hedged. Certain crude oil and natural gas swaps covering the period from August to December 2004 were characterized initially as “nonhedge” derivatives in the second quarter of 2004, since Kerr-McGee’s U.S. production (excluding Westport volumes) was either already hedged or, in the case of Rocky Mountain production, the company did not have sufficient basis swaps in place to ensure that the hedges would be highly effective. Consequently, Kerr-McGee recognized mark-to-market losses of $9.8 million in earnings during the second quarter associated with these derivatives. In July 2004, after the Westport merger closed and with sufficient oil and gas production now available, these swaps were designated as hedges and, as such, the company is recognizing realized gains and losses in earnings as the hedged production is sold.

In connection with the merger, Kerr-McGee recognized a $195.7 million net liability associated with Westport’s existing commodity derivatives at the merger date (June 25, 2004). Some of these derivative instruments were designated as hedges in July 2004 in connection with the re-designation of Kerr-McGee’s merger-related derivatives described above, while others do not qualify for hedge accounting treatment. Kerr-McGee recognized a mark-to-market gain of $15.2 million in earnings during the second quarter since the value of the net derivative liability had decreased to $180.5 million by June 30, 2004.

Westport’s derivatives in place at the merger date consisted of fixed-price oil and gas swaps, natural gas basis swaps, and costless and three-way collars. The fixed-price oil and gas swaps and natural gas basis swaps qualify for hedge accounting and were designated as hedges in July 2004. Accordingly, realized gains and losses on those derivative instruments are reflected in earnings when the hedged production is sold. However, the costless and three-way collars do not qualify for hedge accounting treatment under existing accounting standards because they represent “net written options” at the merger date. As a result, even though these collars effectively reduce commodity price risk for the combined company’s production, Kerr-McGee will continue to recognize mark-to-market gains and losses in future earnings until the collars mature rather than defer such amounts in accumulated other comprehensive income. During the quarter ended September 30, 2004, the company recognized a $42 million pre-tax nonhedge loss in earnings associated with Westport’s costless and three-way collars and the net derivative liability at September 30, 2004, was $99.8 million.

In addition to the company's hedging program, Kerr-McGee has certain natural gas basis swaps associated with Rocky Mountain production settling between 2004 and 2008 that were acquired in the 2001 HS Resources merger. Through December 2003, the company treated these gas basis swaps as nonhedge derivatives, and changes in fair value were recognized in earnings. The company has designated those swaps settling in 2004 and 2005 as hedges since the basis swaps have now been coupled with natural gas fixed-price swaps, while the remainder settling between 2006 and 2008 will continue to be treated as nonhedge derivatives. From time to time, the company also enters into basis swaps to help mitigate its exposure to localized natural gas indices by, in effect, converting a portion of its Rocky Mountain price exposure to NYMEX-based pricing. To the extent such basis swaps are coupled with natural gas fixed-price swaps, they are afforded hedge accounting treatment; otherwise, any mark-to-market gains or losses are recognized in earnings currently.

The company’s marketing subsidiary, Kerr-McGee Energy Services Corporation (KMES) markets natural gas (including equity gas) in the Denver area. Contracts for the physical delivery of gas at fixed prices have not been designated as hedges and are marked-to-market through earnings. KMES has entered into natural gas swaps and basis swaps that largely offset its fixed-price risk on physical contracts and lock in the margins associated with the physical sale. The gains or losses on these derivative contracts, which also are marked-to-market through earnings, substantially offset the gains and losses from the fixed-price physical contracts.

From time to time, the company enters into forward contracts to buy and sell foreign currencies. Certain of these contracts (purchases of Australian dollars and British pound sterling, and sales of euro) have been designated and have qualified as cash flow hedges of the company’s anticipated future cash flows related to pigment sales, operating costs, capital expenditures and raw material purchases. These forward contracts generally have durations of less than three years. Changes in the fair value of these contracts are recorded in accumulated other comprehensive loss and will be recognized in earnings in the periods during which the hedged forecasted transactions affect earnings (i.e., when the forward contracts close in the case of a hedge of sales revenues or operating costs, when the hedged assets are depreciated in the case of a hedge of capital expenditures and when finished inventory is sold in the case of a hedged raw material purchase). The company expects to reclassify after-tax net gains of approximately $4.6 million into earnings during the next 12 months, assuming no further changes in the fair value of the contracts. No hedges were discontinued during the first nine months of 2004, and no ineffectiveness was recognized.


 
  - 10 -  

 

In connection with the issuance of $350 million, 5.375% notes due April 15, 2005, the company entered into an interest rate swap arrangement in April 2002. The terms of the agreement effectively change the interest the company will pay on the debt until maturity from the fixed rate to a variable rate of LIBOR plus .875%. During February 2004, the company reviewed the composition of its outstanding debt and entered into additional interest rate swaps, converting an aggregate of $566 million in fixed-rate debt to variable-rate debt. Under the interest rate swaps, $150 million of 6.625% notes due October 15, 2007, will pay a variable rate of LIBOR plus 3.35%; $109 million of 8.125% notes due October 15, 2005, will pay a variable rate of LIBOR plus 5.86%; and $307 million of 5.875% notes due September 15, 2006, will pay a variable rate of LIBOR plus 3.1%. The company considers these swaps to be a hedge against the change in fair value of the related debt as a result of interest rate changes. Any gain or loss on the swaps is offset by a comparable gain or loss resulting from recording changes in the fair value of the related debt. The critical terms of the swaps match the terms of the debt; therefore, the swaps are considered highly effective and no hedge ineffectiveness has been recognized.

The company issued 5 1/2% notes exchangeable for common stock (DECS) in August 1999, which allowed each holder to receive between .85 and 1.0 share of Devon common stock or, at the company’s option, an equivalent amount of cash at maturity in August 2004. Embedded options in the DECS provided the company a floor price on Devon’s common stock of $33.19 per share (the put option). The company also had the right to retain up to 15% of the shares if Devon’s stock price was greater than $39.16 per share (the DECS holders had an embedded call option on 85% of the shares). Using the Black-Scholes valuation model, the company recognized any gains or losses resulting from changes in the fair value of the put and call options in other expense. The fluctuation in the value of the put and call derivative financial instruments generally offset the increase or decrease in the market value of the Devon stock classified as trading, which was also recognized in other expense. The company recognized a gain of $29.4 million and a loss of $43.9 million in the three month periods ending September 30, 2004 and 2003, respectively, related to the changes in market value of the Devon stock. In the corresponding nine month periods, the company recognized gains on revaluation of the Devon stock of $103.2 million and $19.3 million, respectively. The DECS were settled on August 2, 2004, with the distribution of shares of Devon common stock.

Selected pigment receivables have been sold in an asset securitization program at their equivalent U.S. dollar value at the date the receivables were sold. The company is collection agent and retains the risk of foreign currency rate changes between the date of sale and collection of the receivables. Under the terms of the asset securitization agreement, the company is required to enter into forward contracts for the value of the euro-denominated receivables sold into the program to mitigate its foreign currency risk.

The company has entered into other forward contracts to sell foreign currencies that will be collected as a result of pigment sales denominated in foreign currencies. These contracts have not been designated as hedges even though they do protect the company from changes in foreign currency rates.


D. Discontinued Operations and Asset Impairments

On March 31, 2003, the company completed the sale of its Kazakhstan operations for $168.6 million in cash, recognizing a loss on sale of $6.1 million in results from discontinued operations during the first quarter of 2003. In connection with this sale, the company recorded an $18.6 million settlement liability for the net cash flow of the Kazakhstan operations from the effective date of the transaction to the closing date. The settlement liability was paid during the third quarter of 2003. The net proceeds received by the company were used to reduce outstanding debt.

In September 2004, the company shut down sulfate-process titanium dioxide pigment production at its Savannah, Georgia facility. In connection with the closure, the company recognized a $7.4 million asset impairment loss on indefinite-lived intangible assets in the third quarter of 2004. See Note L for information on other third quarter provisions related to the shutdown.

  
  - 11 -  

 

Impairment losses totaling $14.3 million and $11.9 million were recognized during the first nine months of 2004 and 2003, respectively, for certain oil and gas producing assets used in operations that are not considered held for sale. The 2004 impairments related primarily to a U.S. Gulf of Mexico field that experienced premature water breakthrough and ceased production sooner than expected.

The company continues to review its options with respect to its 100%-owned Leadon field and, particularly, the associated floating production, storage and offloading (FPSO) facility. Management presently intends to continue operating and producing the field until such time as the operating cash flow generated by the field does not support continued production or until a higher value option is identified. Given the significant value associated with the FPSO relative to the size of the entire project, the company will continue to pursue a long-term solution that achieves maximum value for Leadon - which may include disposing of the field, monetizing the FPSO by selling it as a development option for a third-party discovery, or redeployment in other company operations. As of September 30, 2004, the carrying value of the Leadon field assets totaled $350 million. Given the uncertainty concerning possible outcomes, it is reasonably possible that the company's estimate of future cash flows from the Leadon field and associated fair value could change in the near term due to, among other things, (i) unfavorable changes in commodity prices or operating costs, (ii) a production profile that declines more rapidly than currently anticipated, and/or (iii) unsuccessful results of marketing activities or failure to locate a strategic buyer (or suitable redeployment opportunity of the FPSO). Accordingly, management anticipates that the Leadon field will be subject to periodic impairment review until such time as the field is abandoned or sold. If future cash flows or fair value decrease from that presently estimated, an additional write-down of the Leadon field could occur in the future.

Capitalized costs associated with exploratory wells may be charged to earnings in a future period if management determines that commercial quantities of hydrocarbons have not been discovered. At September 30, 2004, the company had capitalized costs of approximately $181 million associated with such ongoing exploration activities, primarily in the deepwater Gulf of Mexico, Brazil, Alaska and China.

During the third quarter, the company continued to operate its new high-productivity oxidation line for chloride-process titanium dioxide pigment at the Savannah facility, which has been producing improved ore yields. The company is evaluating the performance of this new oxidation line and expects to have a better understanding of how the Savannah site might be reconfigured to exploit its capabilities by early 2005. The possible reconfiguration of the Savannah site, if any, could include redeployment of certain assets, idling of certain assets and reduction of the future useful life of certain assets, resulting in the acceleration of depreciation expense and the recognition of other charges. Additionally, the company is reviewing the future useful lives of certain assets in the company’s other chemical plants, which could result in the acceleration of depreciation expense and the recognition of other charges in the 2004 fourth quarter.


E. Cash Flow Information

Net cash provided by operating activities reflects cash payments for income taxes and interest as follows:

   
Nine Months Ended
 
   
September 30,
 
(Millions of dollars)
 
2004
 
2003
 
           
Income tax payments
 
$
118.9
 
$
92.8
 
Less refunds received
   
(5.6
)
 
(46.5
)
Net income tax payments
 
$
113.3
 
$
46.3
 
               
Interest payments
 
$
231.8
 
$
198.7
 


  
  - 12 -  

 


Noncash items affecting net income included in the reconciliation of net income to net cash provided by operating activities include the following:

   
Nine Months Ended
 
   
September 30,
 
(Millions of dollars)
 
2004
 
2003
 
           
Incentive compensation provisions
 
$
52.9
 
$
31.1
 
Increase in fair value of trading securities (1)
   
(103.2
)
 
(19.3
)
Increase in fair value of embedded options in the DECS (1)
   
101.0
   
12.8
 
Net losses on equity method investments
   
23.3
   
23.7
 
Net periodic postretirement expense
   
19.4
   
24.1
 
Net periodic pension credit for qualified plan
   
(13.1
)
 
(6.0
)
Unrealized loss from nonhedge derivatives
   
34.8
   
13.5
 
All other (2)
   
50.0
   
41.8
 
Total
 
$
165.1
 
$
121.7
 

Other net cash provided by (used in) operating activities in the Consolidated Statement of Cash Flows consists of the following:

   
Nine Months Ended
 
   
September 30,
 
(Millions of dollars)
 
2004
 
2003
 
           
Changes in working capital accounts
 
$
(69.2
)
$
18.8
 
Environmental expenditures
   
(69.9
)
 
(61.8
)
All other (2)
   
(51.5
)
 
(41.5
)
Total
 
$
(190.6
)
$
(84.5
)
               

Information about noncash investing and financing activities not reflected in the Consolidated Statement of Cash Flows follows:

   
Nine Months Ended
 
   
September 30,
 
(Millions of dollars)
 
2004
 
2003
 
           
Noncash investing activities
         
Increase in property, plant and equipment (3)
 
$
3,486.9
 
$
-
 
Decrease in property related to Gunnison operating lease agreement (4)
   
(82.6
)
 
-
 
Increase in intangible assets (3)
   
44.4
   
-
 
Trading securities used for redemption of long-term debt (5)
   
(586.2
)
 
-
 
               
Noncash financing activities
             
Issuance of common stock and stock options (3)
   
2,447.9
   
-
 
Long-term debt assumed (3)
   
1,045.5
   
-
 
Reduction in debt related to Gunnison operating lease agreement (4)
   
(75.3
)
 
-
 
Long-term debt redeemed with trading securities (5)
   
(330.3
)
 
-
 
Settlement of DECS derivative (5)
   
(255.9
)
 
-
 

(1)    See Note C for a discussion of the accounting for the DECS.
(2)    No other individual item is material to total cash flows from operations.
(3)    Noncash transaction related to the Westport merger, see Note B.
(4)    See Note I for a discussion of the Gunnison Synthetic Trust.
(5)    See Note I for a discussion of the redemption of the DECS.


  
  - 13 -  

 

F. Comprehensive Income and Financial Instruments

Comprehensive income (loss) for the three and nine months ended September 30, 2004 and 2003, is as follows:

   
Three Months
 
Nine Months
 
   
Ended
 
Ended
 
   
September 30,
 
September 30,
 
(Millions of dollars)
 
2004
 
2003
 
2004
 
2003
 
       
 
 
 
 
 
 
Net income
 
$
7.4
 
$
28.8
 
$
270.2
 
$
168.3
 
Unrealized gains on securities
   
-
   
(5.1
)
 
-
   
2.3
 
Reclassification of unrealized gains on available-
         
   
   
 
for-sale securities included in net income
   
-
   
-
   
(5.4
)
 
-
 
Change in fair value of cash flow hedges
   
(159.3
)
 
51.9
   
(343.6
)
 
38.2
 
Foreign currency translation adjustment
   
6.7
   
3.6
   
(3.3
)
 
31.6
 
Reclassification of foreign currency translation
included in net income
   
7.0
   
-
   
7.0
   
-
 
Other
   
-
   
-
   
.3
   
.8
 
Comprehensive income (loss)
 
$
(138.2
)
$
79.2
 
$
(74.8
)
$
241.2
 

The company has certain investments that are considered to be available for sale. These financial instruments are carried in the Consolidated Balance Sheet at fair value, which is based on quoted market prices. The company had no securities classified as held to maturity at September 30, 2004 or December 31, 2003. At September 30, 2004 and December 31, 2003, available-for-sale securities for which fair value could be determined were as follows:


   
September 30, 2004
 
December 31, 2003
     
           
Gross
         
Gross
     
           
Unrealized
         
Unrealized
     
   
Fair
     
Holding
 
Fair
     
Holding
     
(Millions of dollars)
 
Value
 
Cost
 
Gain
 
Value
 
Cost
 
Gain
     
                               
Equity securities
 
$
-
 
$
-
 
$
-
 
$
26.8
 
$
9.8
 
$
8.3
   
(1
)
U.S. government obligations
   
3.9
   
3.9
   
-
   
3.9
   
3.9
   
-
       
Total
             
$
-
             
$
8.3
       

(1) This amount includes $8.6 million of gross unrealized hedging losses on 15% of the exchangeable debt at the time of adoption of FAS 133.

The equity securities represent the company’s investment in Devon Energy Corporation common stock. During January 2004, the company sold its remaining Devon shares classified as available for sale for a pretax gain of $9 million. Proceeds from the January sales totaled $27.4 million. The cost of the shares sold and the amount of the gain reclassified from accumulated other comprehensive income were determined using the average cost of the shares held. The company also received proceeds of $11.5 million in January 2004 related to sales of Devon shares in December 2003, with a 2004 settlement date.


G. Inventories

Major categories of inventories at September 30, 2004 and December 31, 2003 are as follows:

   
September 30,
 
December 31,
 
(Millions of dollars)
 
2004
 
2003
 
           
Chemicals and other products
 
$
279.2
 
$
306.7
 
Materials and supplies
   
85.8
   
80.2
 
Crude oil and natural gas liquids
   
15.2
   
6.5
 
Total
 
$
380.2
 
$
393.4
 
 
  - 14 -  

 
H. Equity Affiliates
 
Investments in equity affiliates totaled $112.7 million at September 30, 2004, and $123.1 million at December 31, 2003. Pretax equity loss related to the investments is included in other expense in the Consolidated Statement of Income and totaled $8.6 million and $10.9 million for the three months ended September 30, 2004 and 2003, respectively. For the first nine months of 2004, the loss in equity affiliates totaled $23.3 million, compared with $23.7 million for the same 2003 period.


I. Debt

As of September 30, 2004, long-term debt due within one year consisted of the following:
 
(Millions of dollars)
 
 
 
       
5.375% Notes due april 15, 2005
 
$
350.0
 
Guaranteed Debt of Employe Stock Ownership Plan 9.61% Notes due in installments through January 2, 2005
   
1.5
 
Total
 
$
351.5

As discussed in Note B, the company completed its merger with Westport on June 25, 2004. In connection with the merger, Kerr-McGee assumed the following Westport debt:

(Millions of dollars)
 
Fair Value
 
       
8.25% Notes due 2011 (face value $700 million)
 
$
800.5
 
Revolving credit facility
   
245.0
 
Total
 
$
1,045.5
 

On June 25, 2004, after completion of the merger, Kerr-McGee paid down all outstanding borrowings under the Westport revolving credit facility and the facility was terminated on July 13, 2004.

During June 2004, Kerr-McGee purchased Westport 8.25% Notes with an aggregate principal amount of $14.5 million ($16.1 million fair value). On July 1, 2004, Kerr-McGee issued a notice of redemption for the remaining 8.25% Westport notes and the notes were redeemed on July 31, 2004, at an aggregate redemption price of $785.5 million. The redemption price consisted of the face value of $700 million, less the amount previously purchased by Kerr-McGee of $14.5 million, plus a make-whole premium of $100 million.

On July 1, 2004, Kerr-McGee issued $650 million of 6.95% notes due July 1, 2024, with interest payable semi-annually. The notes were issued at 99.2%, resulting in a discount of $5 million which will be recognized as additional interest expense over the term of the notes. The proceeds from this debt issuance, together with proceeds from borrowings under the company’s revolving credit facilities, were used to redeem the 8.25% Westport notes discussed above.

On August 2, 2004, the company’s DECS were settled with the distribution of shares of Devon common stock, at which time the fair values of the embedded put and call options in the DECS were nil and $255.9 million, respectively, and the fair value of the 8.4 million Devon shares was $586.2 million. The fair value of the Devon shares less the call option liability resulted in a net asset carrying value of $330.3 million, which was exactly offset by the fair value of the DECS resulting in no gain or loss on redemption of the debt. The company recognized a charge against earnings of $6.9 million related to a cumulative translation adjustment recorded prior to 1999 when the company accounted for its investment in Devon using the equity method. Under the provisions of FAS 52, “Foreign Currency Translation,” the proportionate share of Devon’s cumulative translation adjustment was removed from equity and reported in earnings during August 2004, the period during which the liquidation of the associated investment occurred.


 
  - 15 -  

 

Certain of the company's long-term debt agreements contain restrictive covenants, including a minimum consolidated tangible net worth requirement of $2 billion and a maximum total debt to total capitalization ratio of 65%, as defined in the agreements. At September 30, 2004, the company’s consolidated tangible net worth was $4.4 billion and its total debt to total capitalization ratio was 40%, as computed in accordance with the agreements.

During 2001, the company entered into a leasing arrangement with Kerr-McGee Gunnison Trust (Gunnison Synthetic Trust) for the construction of the company's share of a platform to be used in the development of the Gunnison field, in which the company has a 50% working interest. Under the terms of the agreement, the company financed its share of construction costs for the platform under a synthetic lease credit facility between the trust and groups of financial institutions for up to $157 million, with the company making lease payments sufficient to pay interest at varying rates on the notes. Construction of the platform was completed in December 2003, with the company's share of construction costs totaling $149 million. On December 31, 2003, $65.6 million of the synthetic lease facility was converted to a leveraged lease structure, whereby the company leases an interest in the platform under an operating lease agreement from a separate business trust.

Both the Gunnison Synthetic Trust and the new operating lease trust are considered variable interest entities under the provisions of FASB Interpretation No. 46, “Consolidation of Variable Interest Entities - an Interpretation of ARB No. 51.” As such, the company is required to analyze its relationship with each trust to determine whether the company is the primary beneficiary and, if so, required to consolidate the trusts. Based on the analyses performed, the company is not the primary beneficiary of the operating lease trust; however, the company was considered the primary beneficiary of the Gunnison Synthetic Trust. Accordingly, the remaining assets and liabilities of the Gunnison Synthetic Trust were reflected in the company’s Consolidated Balance Sheet at December 31, 2003, which included $82.6 million in property, plant and equipment, $3.8 million in accrued liabilities, $75.3 million in long-term debt, and $3.5 million in minority interest. On January 15, 2004, the remaining $82.6 million of the synthetic lease facility was converted to a leveraged lease structure, and the related lessor trust is not subject to consolidation. As a result, the associated property and debt are not reflected in the company’s Consolidated Balance Sheet at September 30, 2004.



  
  - 16 -  

 

J. Earnings Per Share

The following table sets forth the computation of basic and diluted earnings per share (EPS) from continuing operations for the three-month and nine-month periods ended September 30, 2004 and 2003.


   
For the Three Months Ended September 30,
 
   

2004 

 

2003 

 
                           
   
Income from
         
Income from
         
(In millions, except
 
Continuing
     
Per-Share
 
Continuing
     
Per-Share
 
per-share amounts)
 
Operations
 
Shares
 
Income
 
Operations
 
Shares
 
Income
 
                           
Basic EPS
 
$
7.4
   
150.1
 
$
.05
 
$
29.1
   
100.1
 
$
.29
 
Effect of dilutive securities:
                                     
Restricted stock
   
-
   
.5
         
-
   
.7
       
Stock options
   
-
   
.6
         
-
   
.1
       
Diluted EPS
 
$
7.4
   
151.2
 
$
.05
 
$
29.1
   
100.9
 
$
.29
 
 



   
For the Nine Months Ended September 30,
 
   
2004
 
2003
 
                           
   
Income from
         
Income from
         
(In millions, except
 
Continuing
     
Per-Share
 
Continuing
     
Per-Share
 
per-share amounts)
 
Operations
 
Shares
 
Income
 
Operations
 
Shares
 
Income
 
                           
Basic EPS
 
$
270.2
   
118.1
 
$
2.29
 
$
203.1
   
100.1
 
$
2.02
 
Effect of dilutive securities:
                                     
5 ¼% convertible debentures
   
16.0
   
9.8
         
16.0
   
9.8
       
Restricted stock
   
-
   
.4
         
-
   
.7
       
Stock options
   
-
   
.4
         
-
   
.1
       
Diluted EPS
 
$
286.2
   
128.7
 
$
2.22
 
$
219.1
   
110.7
 
$
1.98
 


K. Accounts Receivable Sales

In December 2000, the company began an accounts receivable monetization program for its pigment business through the sale of selected accounts receivable with a three-year, credit-insurance-backed asset securitization program. On July 30, 2003, the company restructured the existing accounts receivable monetization program to include the sale of receivables originated by the company’s European chemical operations. During the third quarter of 2004, the company completed its renewal of the program, extending the term through July 27, 2005. The maximum availability under the program is $165 million. Under the terms of the program, selected qualifying customer accounts receivable may be sold monthly to a special-purpose entity (SPE), which in turn sells an undivided ownership interest in the receivables to a third-party multi-seller commercial paper conduit sponsored by an independent financial institution. The company sells, and retains an interest in, excess receivables to the SPE as over-collateralization for the program. The company's retained interest in the SPE's receivables is classified in trade accounts receivable in the accompanying Consolidated Balance Sheet. The retained interest is subordinate to, and provides credit enhancement for, the conduit's ownership interest in the SPE's receivables, and is available to the conduit to pay certain fees or expenses due to the conduit, and to absorb credit losses incurred on any of the SPE's receivables in the event of termination. However, the company believes that the risk of credit loss is very low since its bad-debt experience has historically been insignificant. The company retains servicing responsibilities and receives a servicing fee of 1.07% of the receivables sold for the period of time outstanding, generally 60 to 120 days. No recourse obligations were recorded since the company has no obligations for any recourse actions on the sold receivables. The company also holds preference stock in the special-purpose entity equal to 3.5% of the receivables sold. The preference stock is essentially a retained deposit to provide further credit enhancements, if needed, but otherwise recoverable by the company at the end of the program.


  
  - 17 -  

 

The program includes a ratings downgrade trigger in the event Kerr-McGee's corporate senior unsecured debt rating falls below BBB- by S&P or Baa3 by Moody's, or in the event such rating has been suspended or withdrawn by S&P or Moody's. The result of the downgrade trigger is an increase in the cost of the program, along with other program modifications. In addition, the program includes a ratings downgrade termination event, upon which the program effectively liquidates over time and the third-party multi-seller commercial paper conduit is repaid by the collections on accounts receivable sold by the SPE. The ratings downgrade termination event is triggered if Kerr-McGee's corporate senior unsecured debt (i) is rated less than BBB- by S&P and Baa3 by Moody's, (ii) is rated less than BB+ by S&P or Ba1 by Moody's or (iii) is withdrawn or suspended by S&P or Moody's.

The company sold $297 million and $287.6 million of its pigment receivables during the third quarter of 2004 and 2003, respectively and $837.9 million and $600.1 million during the first nine months of 2004 and 2003, respectively. Losses, though not material, are recorded on the receivable sales equal to the difference in the book value of the receivables sold and the total of cash and the fair value of the deposit retained by the special-purpose entity. The outstanding balance on receivables sold, net of the company's retained interest in receivables serving as over-collateralization, totaled $165 million at both September 30, 2004 and December 31, 2003.


L. Work Force Reduction, Restructuring Provisions and Exit Activities

In September 2004, the company shut down sulfate and gypsum production at its Savannah, Georgia facility. During the third quarter of 2004, the company recognized a pretax charge of $104.6 million for costs associated with the shutdown. Of the total, $68.3 million related to accelerated depreciation of plant assets (of which $12.7 million related to an asset retirement obligation recognized during the third quarter of 2004), $15.6 million for inventory revaluation, $7.4 million for impairment of intangible assets, $6.7 million for severance and benefit plan curtailment costs, and $6.6 million for other closure costs. The severance provision of $4.2 million is included in the restructuring reserve table below. See Note O for additional discussion regarding the asset retirement obligation. The shutdown will result in the elimination of 105 positions, the last of which will occur in early 2005. In addition, a $17.9 million charge was recognized in the third quarter of 2004 for accelerated depreciation of other plant assets at the Savannah facility that are no longer in service.

In connection with the Westport merger, the company recognized liabilities of $18.9 million associated with severance and relocation costs for certain former Westport employees. Terminations of 23 employees occurred in June 2004 and 44 employees remaining for transitional purposes will be terminated no later than June 25, 2005. Of the $18.9 million accrual, $18.1 million has been paid through the third quarter of 2004, with $.8 million remaining in the accrual at September 30, 2004.

In September 2003, the company announced a program to reduce its U.S. nonbargaining work force through both voluntary retirements and involuntary terminations. As a result of the program, the company’s eligible U.S. nonbargaining work force was reduced by approximately 9%, or 271 employees. Qualifying employees terminated under this program became eligible for enhanced benefits under the company's pension and postretirement plans, along with severance payments. The program was substantially completed by the end of 2003, with certain retiring employees staying into 2004 for transition purposes. In connection with the work force reduction, the company recognized a pretax charge of $56.4 million during the latter half of 2003, of which $16.7 million was recognized in the third quarter of 2003. The total charge included $34.2 million for curtailment and special termination benefits associated with the company’s retirement plans and $22.2 million for severance-related costs. The remaining provision for severance-related costs is included in the restructuring reserve balance below. Of the $22.2 million severance-related provision, $20.6 million has been paid through the third quarter of 2004, with $1.6 million remaining in the accrual at September 30, 2004.

During 2003, the company’s chemical - pigment operating unit provided $60.8 million pretax for costs associated with the closure of its synthetic rutile plant in Mobile, Alabama. Included in the $60.8 million were $14.1 million for the cumulative effect of change in accounting principle related to the recognition of an asset retirement obligation, $15.2 million for accelerated depreciation, $14.9 million for other shut-down related costs, $10.5 million for severance benefits and $6.1 million for benefit plan curtailment costs. The provision for severance benefits is included in the restructuring reserve table below (see Note O for a discussion of the asset retirement obligation). Of the total $10.5 million severance accrual, $8.6 million has been paid through the third quarter of 2004. Approximately 135 employees will ultimately be terminated in connection with this plant closure, of which 117 had been terminated as of September 30, 2004. Payments are expected to continue through the end of 2007.


 
  - 18 -  

 

During 2002, the company’s chemical - other operating unit provided $16.5 million for costs associated with its plans to exit the forest products business. The company provided an additional $5.1 million in 2003 for severance benefits associated with exiting the forest products business, all of which was recorded during the first nine months of 2003. During the first nine months of 2004, the company provided an additional $1.8 million for dismantlement and closure costs. These costs are reflected in costs and operating expenses in the Consolidated Statement of Income. Included in the total provision of $23.4 million were $17.3 million for dismantlement and closure costs, and $6.1 million for severance costs. Of the total provision, $15.7 million has been paid through the 2004 third quarter and $7.1 million remained in the accrual at September 30, 2004. Payments related to the plant closures are expected to continue for several years in connection with dismantlement and clean up efforts; however, payments for severance should be complete by February 2005. As a result of this exit plan, approximately 226 employees will be terminated, of which 216 had been terminated as of September 30, 2004.

In 2001, the company’s chemical - pigment operating unit provided $31.8 million pretax related to the closure of a plant in Antwerp, Belgium. Of this total accrual, $27.2 million had been paid through the 2004 third quarter and $4.3 million remained in the accrual at September 30, 2004. As a result of this plant closure, 121 employees were terminated. Payments are expected to continue through the end of 2015.

The provisions, payments, adjustments and restructuring reserve balances for the nine-month period ended September 30, 2004, are included in the table below.
 
 
           
Dismantlement
 
       
Personnel
 
And
 
(Millions of dollars)
 
Total
 
Costs
 
Closure
 
   
 
 
 
     
December 31, 2003
 
$
39.1
 
$
26.5
 
$
12.6
 
Westport severance/relocation
   
18.9
   
18.9
   
-
 
Provisions
   
6.0
   
4.2
   
1.8
 
Payments
   
(43.0
)
 
(37.2
)
 
(5.8
)
Adjustments
   
.3
   
-
   
.3
 
September 30, 2004
 
$
21.3
 
$
12.4
 
$
8.9
 


M. Condensed Consolidating Financial Information

On October 3, 2001, Kerr-McGee Corporation issued $1.5 billion of long-term notes in a public offering and on July 1, 2004, Kerr-McGee Corporation issued an additional $650 million of long-term notes. These notes are general, unsecured obligations of the company and rank in parity with all of the company's other unsecured and unsubordinated indebtedness. Kerr-McGee Chemical Worldwide LLC and Kerr-McGee Rocky Mountain Corporation have guaranteed the notes. Additionally, Kerr-McGee Corporation has guaranteed all indebtedness of its subsidiaries, including the indebtedness assumed in the purchase of HS Resources. As a result of these guarantee arrangements, the company is required to present condensed consolidating financial information. The top holding company is Kerr-McGee Corporation. The guarantor subsidiaries include Kerr-McGee Chemical Worldwide LLC and Kerr-McGee Rocky Mountain Corporation.


  
  - 19 -  

 

The following tables present condensed consolidating financial information for (a) Kerr-McGee Corporation, the parent company, (b) the guarantor subsidiaries, and (c) the non-guarantor subsidiaries on a consolidated basis.

Kerr-McGee Corporation and Subsidiary Companies
Condensed Consolidating Statement of Income
For the Three Months Ended September 30, 2004


   
 
Kerr-McGee
 
 
Guarantor
 
Non-Guarantor
         
(Millions of dollars)
 
Corporation
 
Subsidiaries
 
Subsidiaries
 
Eliminations
 
Consolidated
 
                       
Revenues
 
$
-
 
$
235.7
 
$
1,130.5
 
$
-
 
$
1,366.2
 
                                 
Costs and Expenses
                               
Costs and operating expenses
   
-
   
123.2
   
408.1
   
(.4
)
 
530.9
 
Selling, general and administrative expenses
   
.3
   
4.7
   
79.6
   
-
   
84.6
 
Shipping and handling expenses
   
-
   
2.3
   
41.1
   
-
   
43.4
 
Depreciation and depletion
   
-
   
30.0
   
332.8
   
-
   
362.8
 
Accretion expense
   
-
   
.7
   
7.5
   
-
   
8.2
 
Asset impairments
   
-
   
-
   
7.4
   
-
   
7.4
 
Gain associated with assets held for sale
   
-
   
-
   
(.1
)
 
-
   
(.1
)
Exploration, including dry holes and amortization of
   undeveloped leases
   
-
   
1.9
   
97.0
   
-
   
98.9
 
Taxes, other than income taxes
   
-
   
9.4
   
35.5
   
(.1
)
 
44.8
 
Provision for environmental remediation
                               
and restoration, net of reimbursements
   
-
   
50.7
   
23.6
   
-
   
74.3
 
Interest and debt expense
   
41.1
   
9.0
   
81.1
   
(63.3
)
 
67.9
 
Total Costs and Expenses
   
41.4
   
231.9
   
1,113.6
   
(63.8
)
 
1,323.1
 
                                 
     
(41.4
)
 
3.8
   
16.9
   
63.8
   
43.1
 
Other Income (Expense)
   
64.1
   
(136.7
)
 
21.0
   
31.2
   
(20.4
)
Income (Loss) before Income Taxes
   
22.7
   
(132.9
)
 
37.9
   
95.0
   
22.7
 
Benefit (Provision) for Income Taxes
   
(15.3
)
 
63.0
   
(46.1
)
 
(16.9
)
 
(15.3
)
Net Income (Loss)
 
$
7.4
 
$
(69.9
)
$
(8.2
)
$
78.1
 
$
7.4
 
                                 


  
  - 20 -  

 


Kerr-McGee Corporation and Subsidiary Companies
Condensed Consolidating Statement of Income
For the Three Months Ended September 30, 2003


   
 
Kerr-McGee
 
 
Guarantor
 
Non-Guarantor
         
(Millions of dollars)
 
Corporation
 
Subsidiaries
 
Subsidiaries
 
Eliminations
 
Consolidated
 
                       
Revenues
 
$
-
 
$
180.6
 
$
819.1
 
$
6.4
 
$
1,006.1
 
                                 
Costs and Expenses
                               
Costs and operating expenses
   
-
   
94.8
   
307.9
   
7.2
   
409.9
 
Selling, general and administrative expenses
   
-
   
2.4
   
95.9
   
-
   
98.3
 
Shipping and handling expenses
   
-
   
2.1
   
32.3
   
-
   
34.4
 
Depreciation and depletion
   
-
   
30.7
   
149.9
   
-
   
180.6
 
Accretion expense
   
-
   
.6
   
5.7
   
-
   
6.3
 
Asset impairments
   
-
   
-
   
6.8
   
-
   
6.8
 
Gain associated with assets held for sale
   
-
   
(.3
)
 
(10.9
)
 
-
   
(11.2
)
Exploration, including dry holes and
   
                         
amortization of undeveloped leases
   
-
   
5.0
   
74.8
   
-
   
79.8
 
Taxes, other than income taxes
   
-
   
7.9
   
15.6
   
-
   
23.5
 
Provision for environmental remediation
   
                         
and restoration, net of reimbursements
   
-
   
28.6
   
18.6
   
-
   
47.2
 
Interest and debt expense
   
29.3
   
9.4
   
65.1
   
(41.0
)
 
62.8
 
Total Costs and Expenses
   
29.3
   
181.2
   
761.7
   
(33.8
)
 
938.4
 
                                 
     
(29.3
)
 
(.6
)
 
57.4
   
40.2
   
67.7
 
Other Income (Expense)
   
79.2
   
(17.5
)
 
11.4
   
(90.6
)
 
(17.5
)
Income (Loss) from Continuing Operations