Ferro Corp. 10-K
Table of Contents

 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
 
 
Form 10-K
 
     
(Mark One)    
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the fiscal year ended December 31, 2005
or
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the transition period from           to          
 
Commission file number 1-584
FERRO CORPORATION
(Exact name of registrant as specified in its charter)
 
     
Ohio
  34-0217820
(State of Corporation)   (IRS Employer Identification No.)
     
1000 Lakeside Avenue
Cleveland, OH
(Address of principal executive offices)
  44114
(Zip Code)
 
Registrant’s telephone number, including area code: 216-641-8580
 
Securities Registered Pursuant to section 12(b) of the Act:
 
     
Title of Each Class
 
Name of Each Exchange on Which Registered
 
Common Stock, par value $1.00
  New York Stock Exchange
Common Stock Purchase Rights   New York Stock Exchange
 
Securities Registered Pursuant to Section 12(g) of the Act:
91/8% Senior Notes due January 1, 2009
75/8% Debentures due May 1, 2013 (repaid August 2006)
73/8% Debentures due November 1, 2015 (repaid July 2006)
8% Debentures due June 15, 2025 (repaid July 2006)
71/8% Debentures due April 1, 2028 (repaid July 2006)
Series A ESOP Convertible Preferred Stock, without Par Value
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  YES o     NO þ
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  YES o     NO þ
 
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 o     NO þ
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained here, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  YES o     NO þ
 
The aggregate market value of Ferro Common Stock, par value $1.00, held by non-affiliates (based on the closing sale price) as of June 30, 2005, was approximately $804,791,000.
 
On August 31, 2006, there were 42,747,117 shares of Ferro Common Stock, par value $1.00 outstanding.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
None.
 


 

 
TABLE OF CONTENTS
 
             
  Business   Page 3
  Risk Factors   Page 6
  Unresolved Staff Comments   Page 9
  Properties   Page 9
  Legal Proceedings   Page 10
  Submission of Matters to a Vote of Security Holders   Page 11
 
  Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities   Page 13
  Selected Financial Data   Page 13
  Management’s Discussion and Analysis of Financial Condition and Results of Operations   Page 14
  Quantitative and Qualitative Disclosures about Market Risk   Page 32
  Financial Statements and Supplementary Data   Page 34
  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   Page 75
  Controls and Procedures   Page 77
  Other Information   Page 82
 
  Directors and Executive Officers of the Registrant   Page 83
  Executive Compensation   Page 86
  Security Ownership of Certain Beneficial Owners and Management, and Related Shareholder Matters   Page 94
  Certain Relationships and Related Transactions   Page 98
  Principal Accountant Fees and Services   Page 98
 
  Exhibits and Financial Statement Schedules and Reports on Form 8-K   Page 99
 EX-10.D
 EX-10.I
 EX-12
 EX-21
 EX-23.1
 EX-23.2
 EX-31.1
 EX-31.2
 EX-32.1
 EX-32.2


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PART I
 
Item 1 — Business
 
Ferro Corporation (“Ferro” or the “Company”), incorporated under the laws of Ohio in 1919, is a leading global producer of a diverse array of performance materials sold to a broad range of manufacturers in approximately 30 markets throughout the world. The Company applies certain core scientific expertise in organic chemistry, inorganic chemistry, polymer science and material science to develop coatings for ceramics and metal; materials for passive electronic components; pigments; enamels, pastes and additives for the glass market; glazes and decorating colors for the dinnerware market; specialty plastic compounds and colors; polymer additives; specialty chemicals for the pharmaceuticals and electronics markets; and active ingredients and high purity carbohydrates for pharmaceutical formulations. Ferro’s products are classified as performance materials, rather than commodities, because they are formulated to perform specific and important functions both in the manufacturing processes and in the finished products of its customers. The Company’s performance materials require a high degree of technical service on an individual customer basis. The value of these performance materials stems from the results and performance they achieve in actual use.
 
Ferro’s products are traditionally used in markets such as appliances, automotive, building and renovation, electronics, household furnishings, industrial products, pharmaceuticals, telecommunications and transportation. The Company’s leading customers include major chemical companies, pharmaceutical companies, producers of multi-layer ceramic capacitors, and manufacturers of tile, appliances, building materials and automobiles. Many customers, particularly in the appliance and automotive markets, purchase materials from more than one of the Company’s business units. Ferro’s customer base is also well-diversified both geographically and by end market.
 
For information about recent acquisitions and divestitures, see the discussion in Selected Financial Data under Item 6 of this Form 10-K.
 
Raw Materials
 
Raw materials widely used in Ferro’s operations include polypropylene, titanium, zircon, phthalic anhydride, zinc oxide, cobalt oxide, toluene, boron, bismuth, soybean oil, silica, aluminum oxide, feldspar, chrome, nickel, unsaturated polyester, polystyrene, lead oxide, tallow, and lithium. Other important raw materials include silver, nickel, copper, gold, palladium, platinum and other precious metals, butanol, and fiberglass. Raw materials make up a large portion of the product cost in certain of the Company’s product lines and fluctuations in the cost of raw materials may have a significant impact on the financial performance of those businesses. The Company attempts to pass through to customers raw material cost fluctuations, including those related to precious metals.
 
The Company has a broad supplier base and, in many instances, alternative sources of raw materials are available if problems arise with a particular supplier. Ferro maintains many comprehensive supplier agreements for its strategic and critical raw materials. In addition, the magnitude of the Company’s purchases provides for leverage in negotiating favorable conditions for supplier contracts. The raw materials essential to Ferro’s operations both in the United States and overseas are in most cases obtainable from multiple sources worldwide. Ferro did not encounter raw material shortages in 2005 but is aware of potential future shortages in the world market for certain commodities such as zircon. Ferro does not expect to be affected by such shortages, other than by cost increases for such products.
 
Patents, Trademarks and Licenses
 
Ferro owns a substantial number of patents and patent applications relating to its various products and their uses. While these patents are of importance to Ferro, management does not believe that the invalidity or expiration of any single patent or group of patents would have a material adverse effect on its business. Ferro’s patents and patents that may issue from pending applications will expire at various dates through the year 2024. Ferro also uses a number of trademarks that are important to its business as a whole or to a particular segment. Ferro believes that these trademarks are adequately protected.


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Customers
 
None of the Company’s reportable segments is dependent on any single customer or group of customers.
 
Backlog of Orders; Seasonality
 
In general, no significant lead-time between order and delivery exists in any of Ferro’s business segments. As a result, Ferro does not consider that the dollar amount of backlog orders believed to be firm as of any particular date is material for an understanding of its business. Ferro does not regard any material part of its business to be seasonal, however the second quarter is normally the strongest quarter of the year in terms of sales and operating profit, because customer demands tend to be higher in the second quarter.
 
Competition
 
In most of its markets, Ferro has a substantial number of competitors, none of which is dominant. Due to the diverse nature of Ferro’s product lines, no single company competes across all product lines in any of the Company’s segments. Competition varies by product and by region and is based primarily on price, product quality and performance, customer service and technical support.
 
The Company is a worldwide leader in the production of glass enamels, porcelain enamels, ceramic glaze coatings and passive electronic materials, and believes it is currently the only merchant manufacturer of all primary components (electrodes, dielectrics, and termination pastes) of multi-layer capacitors. Strong local competition for ceramic glaze and color exists in the markets of Italy and Spain. The Company is one of the largest producers of polymer additives in the United States and has several large competitors. The Company is also one of the largest plastics compounders in the United States.
 
Research and Development
 
Ferro is involved worldwide in research and development activities relating to new and existing products, services and techniques required by the ever-changing markets of its customers. The Company’s research and development resources are organized into centers of excellence that support its regional and worldwide major business units. These centers are augmented by local laboratories, which provide technical service and support to meet customer and market needs of particular geographic areas.
 
Expenditures for research and development activities relating to the development or significant improvement of new and/or existing products, services and techniques for continuing operations were approximately $38.4 million in 2005, $42.4 million in 2004, and $40.2 million in 2003. Expenditures for individual customer requests for research and development were not material. During 2006, Ferro expects to spend approximately $46.3 million on research and development activities, an increase of 21% over 2005 due to reorganization of personnel within the Company.
 
Environmental Matters
 
Ferro’s manufacturing facilities, like those of the industry generally, are subject to numerous laws and regulations implemented to protect the environment, particularly with respect to plant wastes and emissions. The Company anticipates that stringent laws and regulations will continue to be placed on Ferro and the industry in general. Ferro believes that it is in compliance with the environmental regulations to which its operations are subject and that, to the extent Ferro may not be in compliance with such regulations, non-compliance has not had a materially adverse effect on Ferro’s results of operations or financial position.
 
The Company’s policy is to operate its plants and facilities in a manner that protects the environment and the health and safety of its employees and the public. The Company intends to continue to make expenditures for environmental protection and improvements in a timely manner consistent with available technology. Capital expenditures for environmental control were $3.3 million in 2005, $7.1 million in 2004, and $9.6 million in 2003. These amounts pertain primarily to costs associated with environmental protection equipment. Although the Company cannot precisely predict future environmental capital spending, the Company does not expect such costs to have a material impact on the Company’s results of operations or financial position.


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The Company expenses recurring costs associated with control and disposal of hazardous materials in current operations. Accruals for environmental remediation and other contingent liabilities, including those relating to ongoing, pending or threatened litigation, are recorded when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. The amount accrued for environmental remediation reflects the Company’s assumptions about remediation requirements at the contaminated site, the nature of the remedy, the outcome of discussions with regulatory agencies and other potentially responsible parties at multi-party sites, and the number and financial viability of other potentially responsible parties. Estimated costs are not discounted due to the uncertainty with respect to the timing of related payments. The Company actively monitors the status of sites, and as assessments and cleanups proceed, accruals are reviewed periodically and adjusted, if necessary, as additional information becomes available. Changes in the estimates on which the accruals are based, unanticipated government enforcement actions, or changes in health, safety, environmental regulation, and testing requirements could result in higher or lower costs.
 
As of December 31, 2005, the Company had accrued liabilities of $6.6 million for environmental remediation costs, of which $1.2 million related to Superfund sites. As of December 31, 2004, the Company had accrued liabilities of $6.4 million, of which $0.6 million related to Superfund sites.
 
Employees
 
At December 31, 2005, Ferro, in its continuing business operations, employed 6,839 full-time employees, including 4,386 employees in its foreign consolidated subsidiaries and 2,453 in the United States. Total employment decreased by 164 full time employees from December 31, 2004, due to continuing restructuring and cost control programs.
 
Approximately 21% of the United States workforce is covered by labor agreements, and approximately 9% is affected by labor agreements that expire in 2006. The Company expects to complete renewals of these agreements with no significant disruption to the related businesses during 2006.
 
Domestic and Foreign Operations
 
Financial information about Ferro’s domestic and foreign operations by segment is included herein in Note 15 to the consolidated financial statements under Item 8 of this Form 10-K.
 
Ferro’s products are produced and distributed in domestic as well as foreign markets. Ferro commenced its international operations in 1927.
 
Wholly-owned subsidiaries operate manufacturing facilities in Argentina, Australia, Belgium, Brazil, China, France, Germany, Italy, Japan, Mexico, the Netherlands, Portugal, Spain, Thailand and the United Kingdom. Partially-owned subsidiaries and affiliates manufacture in China, Ecuador, Indonesia, Italy, Spain, South Korea, Thailand and Venezuela.
 
Ferro receives technical service fees and/or royalties from many of its foreign subsidiaries. Historically, as a matter of corporate policy, the foreign subsidiaries have been expected to remit a portion of their annual earnings to the parent as dividends. To the extent earnings of foreign subsidiaries are not remitted to Ferro, those earnings are indefinitely re-invested in those subsidiaries.
 
Available Information
 
The Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K, including any amendments, will be made available free of charge on the Company’s web site, www.ferro.com, as soon as reasonably practicable, following the filing of the reports with the Securities and Exchange Commission.
 
Forward-looking Statements
 
Certain statements contained here and in future filings with the Securities and Exchange Commission reflect the Company’s expectations with respect to future performance and constitute “forward-looking statements” within


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the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These statements are subject to a variety of uncertainties, unknown risks and other factors concerning the Company’s operations and business environment, which are difficult to predict and are beyond the control of the Company.
 
Item 1A — Risk Factors
 
Important factors that could cause actual results to differ materially from those suggested by these forward-looking statements, and that could adversely affect the Company’s future financial performance, include the following:
 
The Company depends on reliable sources of raw materials and other supplies at a reasonable cost, but availability to such materials and supplies could be interrupted and/or the prices charged for them could escalate and adversely affect the Company’s sales and profitability.
 
The Company purchases many raw materials and supplies that are used in the manufacture of its products. Changes in the availability or price of these items could affect the Company’s ability to manufacture an adequate volume of products to meet customers’ demands or to manufacture products profitably. The Company tries to maintain multiple sources of raw materials and supplies where practical, but this may not prevent unanticipated changes in the availability or cost of the supplies purchased. Significant disruptions in availability or cost escalations could adversely affect the Company’s manufacturing volume or costs, which could have a related negative effect on product sales or profitability of the Company’s operations.
 
The markets in which the Company participates are highly competitive and subject to intense price competition, which could adversely affect the Company’s sales and earnings performance.
 
Customers choose to buy the Company’s products in a competitive environment where there are typically multiple suppliers. If the Company is unwilling or unable to provide products at competitive prices, and if other factors, such as product performance and value-added services do not provide an offsetting competitive advantage, customers may reduce, discontinue, or fail to initiate purchases of the Company’s products. If the Company could not secure alternate customers for lost business, the Company’s sales and earnings performance could be adversely affected.
 
The Company is striving to improve operating margins through price increases, productivity gains and improved purchasing techniques, but it may not be successful in achieving the desired improvements.
 
The Company is working to improve operating profit margins through a number of activities such as price increases, improvements to manufacturing processes and adoption of purchasing techniques that lower costs or provide increased cost predictability. However, these activities depend on a combination of improved product design and engineering, effective manufacturing process control initiatives and other efforts that may or may not be successful to the extent anticipated. The success of price increases is dependent not only on the Company’s actions but also the strength of customer demand and competitors’ pricing responses, which are not fully predictable. Failure to successfully implement actions to improve operating margins could adversely affect the Company’s financial performance.
 
The Company’s products are sold into industries that are heavily influenced by consumer spending or otherwise have proven to be unpredictable and cyclical.
 
The Company’s products are sold to a wide variety of customers who supply many different market segments. Many of these market segments, such as construction, appliances and automotive, have been in the past, and are expected to be in the future, cyclical or are closely tied to consumer demand, which is difficult to predict. Incorrect forecasts of demand or unforeseen reductions in demand can adversely affect costs and profitability due to factors such as underused manufacturing capacity, excess inventory, or working capital needs. These factors can result in lower profitability or reduced financial performance.


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The global scope of the Company’s operations exposes the Company to risks related to currency conversion rates and changing economic, social and political conditions around the world.
 
In order to support global customers, access regional markets and compete effectively, the Company engages in global operations. As a result, there is added complexity in the Company’s operations and the consequent risks associated with managing such complexity, including currency conversion effects and the impact of changing economic, social and political conditions. While the Company attempts to anticipate these changes and manage its business appropriately, these changes are often beyond the Company’s control and difficult to forecast. The consequences of these risks may have significant adverse effects on the Company’s results of operations or financial position.
 
The Company has a growing presence in the Asia/Pacific region where it can be difficult for an American company, such as Ferro, to compete lawfully with local competitors.
 
Many of the Company’s most promising growth opportunities are in the Asia/Pacific region, especially the People’s Republic of China. Although the Company has been able to compete successfully in those markets to date, local laws and customs can make it difficult for an American-based company to compete on a “level playing field” with local competitors without engaging in conduct that would be illegal under U.S. law. The Company’s strict policy of observing the highest standards of legal and ethical conduct may cause the Company to lose, in some cases, otherwise attractive business opportunities to local competition in the region.
 
Regulatory authorities in the U.S., European Union and elsewhere are taking a much more aggressive approach to regulating hazardous materials and those regulations could affect sales of the Company’s products.
 
Some of the Company’s products are subject to restrictions resulting from listing of materials under laws such as California Proposition 65 or from classification under the European Union’s hazardous substances directive. The proposed EU “REACH” registration system, for example, could affect the Company’s ability to sell certain products. Moreover, hazardous material legislation and regulations can restrict the sale of products and/or increase the cost of producing them. In light of these factors, customers will sometimes “deselect” a product in favor of perceived “greener” or less hazardous alternatives. All of these factors can adversely affect the Company’s sales and operating profits.
 
The Company’s operations are subject to stringent environmental, health and safety regulations and compliance with those regulations could require the Company to make significant investments.
 
The Company strives to conduct its manufacturing operations in a manner that is safe and in compliance with all applicable environmental, health and safety regulations. At times, compliance with changing regulations may require the Company to make significant capital investments, incur training costs, make changes in manufacturing processes or product formulations, or otherwise incur costs that could adversely affect the Company’s profitability. These costs may not affect competitors in an equivalent way due to differences in product formulations, manufacturing locations or other factors, and as such the Company may be disadvantaged, which may adversely affect financial performance.
 
The Company depends on external financial resources and any interruption in access to capital markets or borrowings could adversely affect the Company’s financial condition.
 
As of December 31, 2005, the Company had approximately $555 million of debt with varying maturities. These borrowings have allowed the Company to make investments in growth opportunities and fund working capital requirements. Continued access to capital markets is essential to meet the Company’s current obligations as well as to fund the Company’s strategic initiatives. An interruption in the access to external financial resources could adversely affect the Company’s business prospects and financial condition. See further information regarding the Company’s liquidity in Note 3 to the consolidated financial statements included under Item 8 of this Form 10-K.


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Interest rates on some of the Company’s external borrowings are variable and the Company’s borrowing costs could be affected adversely by interest rate increases.
 
Portions of the Company’s debt obligations have interest rates that are variable in nature. Generally, when interest rates rise, as they have over the last year, the Company’s cost of borrowings increases. The Company estimates, based on the debt obligations outstanding at December 31, 2005, that a one percent increase in interest rates would cause interest expense to increase by approximately $1.9 million annually. While the Company can take actions to mitigate the effect of rising interest rates, continued increases could adversely affect the cost of borrowings and the Company’s financial performance. See further information regarding the Company’s liquidity in Note 3 to the consolidated financial statements included under Item 8 of this Form 10-K.
 
Many of the Company’s assets are encumbered by liens that have been granted to lenders and those liens affect the Company’s flexibility in making timely dispositions of property and businesses.
 
The Company’s debt obligations are secured by substantially all of the Company’s assets. The granting of this security interest is described in more detail in Note 3 to the Company’s consolidated financial statements under Item 8 of this Form 10-K. These liens could affect the Company’s flexibility in making timely dispositions of property and businesses, as these liens must be cleared or waived by the lenders prior to completing any disposition.
 
The Company is subject to a number of restrictive covenants in its credit facilities and those covenants could affect the Company’s flexibility in making investments and acquisitions.
 
The Company’s credit facilities contain a number of restrictive covenants as described in more detail in Management’s Discussion and Analysis under Item 7 of this Form 10-K. These covenants include, among others, customary operating restrictions that limit the Company’s ability to engage in certain activities, including limitations on additional loans and investments; prepayments, redemptions and repurchases of debt; and mergers, acquisitions and asset sales. The Company is also subject to customary financial covenants including a leverage ratio and a fixed charge coverage ratio. These covenants restrict, among other things, the amount of the Company’s borrowings, reducing the Company’s flexibility in making investments and acquisitions. Breaches of these covenants could become events of default under the Company’s credit facilities and cause the acceleration of the maturity of debt beyond the Company’s ability to pay.
 
The Company has deferred tax assets and its ability to utilize those assets will depend on the Company’s future performance.
 
To fully realize the value of its deferred tax assets, the Company will have to generate adequate taxable profits in various tax jurisdictions. As of December 31, 2005, the Company had $87.3 million of net deferred tax assets. If the Company does not generate adequate profits within the time periods required by the applicable tax statutes, the value of the tax assets will not be realized. In addition, if it becomes unlikely that the deferred tax assets will be used, the value of the assets may need to be reduced in the Company’s financial statements, adversely affecting the results of operations. (See further information in Note 14 to the Company’s consolidated financial statements under Item 8 of this Form 10-K.)
 
The Company is a defendant in several lawsuits that could have, unless successfully resolved, an adverse effect on the Company’s financial condition and/or financial performance.
 
The Company is routinely involved in litigation brought by suppliers, customers, employees, governmental agencies and others. The most significant pending litigation is described in Item 3 — Legal Proceedings of this Form 10-K. Litigation is an inherently unpredictable process and unanticipated negative outcomes are possible.
 
The Company’s businesses depend on a continuous stream of new products and failure to introduce new products could affect the Company’s sales and profitability.
 
One way that the Company remains competitive in its markets is by developing and introducing new and improved products on an ongoing basis. These products are continually evaluated by customers in relation to products offered by the Company’s competitors. A failure to introduce new products in a timely manner that are


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price competitive and that provide the features and performance required by customers could adversely affect the Company’s sales, or could require the Company to compensate by lowering prices. This could result in lower sales and/or lower profitability.
 
Employee benefit costs, especially post-retirement costs, constitute a significant element of the Company’s annual expenses, and the funding of these costs could adversely affect the Company’s financial condition.
 
Employee benefit costs are a significant element of the Company’s cost structure. Certain expenses, particularly post-retirement costs under defined benefits pension plans and healthcare costs for employees and retirees, may increase significantly at a rate that is difficult to forecast and may adversely affect the Company’s financial results or financial condition.
 
The Company has signed a definitive agreement to sell its Specialty Plastics business, but there is no assurance that the sale will be successfully completed.
 
On August 21, 2006, the Company announced that it had signed a definitive agreement to sell its Specialty Plastics business to Wind Point Partners, a private equity investment firm. The sale was originally scheduled to close in the third quarter of 2006, but is now scheduled to close on October 31, 2006. The Company intends to use the proceeds of the sale to pay down debt. If the sale is not consummated, the Company will not be able to pay down debt as originally planned.
 
The Company is exposed to risks associated with acts of God, terrorists and others, as well as fires, explosions, wars, riots, accidents, embargos, natural disasters, strikes and other work stoppages, quarantines and other governmental actions, and other events or circumstances that are beyond the Company’s reasonable control.
 
The Company is exposed to risks from various events that are beyond its control, which may have significant effects on its results of operations. While the Company attempts to mitigate these risks through appropriate insurance, contingency planning and other means, it is not assured that all the risks can be reasonably or cost-effectively managed, or that all risks can be anticipated. As a result, the Company’s results of operations could be adversely affected by such circumstances or events in ways that are significant and/or long lasting.
 
The risks and uncertainties identified above are not the only risks the Company faces. Additional risks and uncertainties not presently known to the Company or that it currently believes to be immaterial also may adversely affect the Company. Should any known or unknown risks and uncertainties develop into actual events, these developments could have material adverse effects on the Company’s financial position, results of operations, and cash flows.
 
Item 1B — Unresolved Staff Comments
 
None.
 
Item 2 — Properties
 
The Company’s corporate headquarters offices are located at 1000 Lakeside Avenue, Cleveland, Ohio. The Company also owns other corporate facilities, located in Independence, Ohio. Principal manufacturing plants owned by the Company range in size from 17,000 sq. ft. to over 500,000 sq. ft. Plants with more than 250,000 sq. ft. are located in Germany; Spain; Niagara Falls, New York; Penn Yan, New York; Fort Worth, Texas; and France. The locations of these principal manufacturing plants by business segment are as follows:
 
Performance Coatings — U.S.: Cleveland, Ohio. Outside the U.S.: Argentina, Australia, China, France, Indonesia, Italy, Mexico, the Netherlands, Spain, Taiwan, Thailand and Venezuela.
 
Electronic Materials — U.S.: Penn Yan, New York; South Plainfield, New Jersey; and Niagara Falls, New York. Outside the U.S.: the Netherlands.


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Color and Glass Performance Materials — U.S.: Toccoa, Georgia; Orrville, Ohio; and Washington, Pennsylvania. Outside the U.S.: Australia, China, France, Germany, Mexico, Taiwan, United Kingdom and Venezuela.
 
Polymer Additives — U.S.: Bridgeport, New Jersey; Cleveland, Ohio; Walton Hills, Ohio; and Fort Worth, Texas.
 
Specialty Plastics — U.S.: Evansville, Indiana; Plymouth, Indiana; Edison, New Jersey; and Stryker, Ohio. Outside the U.S.: the Netherlands and Spain.
 
Other — U.S.: Waukegan, Illinois; Baton Rouge, Louisiana. Outside the U.S.: China
 
In October 2005, the Dutch government placed a lien on one of the Company’s facilities in the Netherlands as collateral for any future payment relating to an unresolved environmental claim. In March 2006, as a result of a credit rating downgrade, lenders of the Company’s revolving credit facility, senior notes and debentures become entitled to security interests in the Company’s and its domestic material subsidiaries’ real estate. This lien grant was substantially completed in April 2006.
 
In addition, Ferro leases manufacturing facilities for the Performance Coatings segment in Brazil and Italy; for the Electronic Materials segment in Vista, California, Germany and Japan; for the Color and Glass Performance Materials segment in Japan and Portugal; for the Polymer Additives segment in Belgium and the United Kingdom; and for the Specialty Plastics segment in Carpentersville, Illinois. In some instances, the manufacturing facilities are used for two or more business segments. Leased facilities range in size from 23,000 sq. ft. to over 300,000 sq. ft. at a plant located in Portugal.
 
Item 3 — Legal Proceedings
 
In February 2003, the Company was requested to produce documents in connection with an investigation by the United States Department of Justice into possible antitrust violations in the heat stabilizer industry. In April 2006, the Company was notified by the Department of Justice that the Government had closed its investigation and that the Company was relieved of any obligation to retain documents that were responsive to the Government’s earlier document request. Before closing its investigation, the Department of Justice took no action against the Company or any current or former employee of the Company. The Company was previously named as a defendant in several lawsuits alleging civil damages and requesting injunctive relief relating to the conduct the Government was investigating. The Company is vigorously defending itself in those actions, and management does not expect these lawsuits to have a material effect on the consolidated financial position, results of operations, or cash flows of the Company.
 
In a July 23, 2004, press release, Ferro announced that its Polymer Additives business performance in the second quarter fell short of expectations and that its Audit Committee would investigate possible inappropriate accounting entries in Ferro’s Polymer Additives business. A consolidated putative securities class action lawsuit arising from and related to the July 23, 2004, announcement is currently pending in the United States District Court for the Northern District of Ohio against Ferro, its deceased former Chief Executive Officer, its Chief Financial Officer, and a former operating Vice President of Ferro. This claim is based on alleged violations of Federal securities laws. Ferro and the named executives consider these allegations to be unfounded, are vigorously defending this action and have notified Ferro’s directors and officers liability insurer of the claim. Because this action is in its preliminary stage, the outcome of this litigation cannot be determined at this time.
 
Also, following the July 23, 2004, announcement, two derivative lawsuits were commenced in the United States District Court for the Northern District of Ohio on behalf of Ferro against Ferro’s Directors, its deceased former Chief Executive Officer, and Chief Financial Officer. Two other derivative actions were subsequently filed in the Court of Common Pleas for Cuyahoga County, Ohio. The state court actions were removed to the United States District Court for the Northern District of Ohio and all of the derivative lawsuits were then consolidated into a single action. The derivative lawsuits alleged breach of fiduciary duties and mismanagement-related claims. On March 21, 2006, the Court dismissed the consolidated derivative action without prejudice. On April 8, 2006, plaintiffs filed a motion seeking relief from the judgment dismissing the derivative lawsuit and seeking to further amend their complaint following discovery, which was denied. On April 13, 2006, plaintiffs also filed a Notice of Appeal to the Sixth Circuit Court of Appeals. The Directors and named executives consider the allegations


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contained in the derivative actions to be unfounded, have vigorously defended this action and will defend against the new filings. The Company has notified Ferro’s directors and officers liability insurer of the claim. Because this appeal is in the preliminary stage, the outcome of this litigation cannot be determined at this time.
 
On June 10, 2005, a putative class action lawsuit was filed against Ferro, and certain former and current employees alleging breach of fiduciary duty with respect to ERISA plans. The Company considers these allegations to be unfounded, is vigorously defending this action, and has notified Ferro’s fiduciary liability insurer of the claim. Because this action is in the preliminary stage, the ultimate outcome of this litigation cannot be determined at this time. However, management does not expect the ultimate outcome of the lawsuit to have a material effect on the financial position, results of operations or cash flows of the Company.
 
On October 15, 2004, the Belgian Ministry of Economic Affairs’ Commercial Policy Division (the “Ministry”) served on Ferro’s Belgian subsidiary a mandate requiring the production of certain documents related to an alleged cartel among producers of butyl benzyl phthalate (“BBP”) from 1983 to 2002. Subsequently, German and Hungarian authorities initiated their own national investigations in relation to the same allegations. Ferro’s Belgian subsidiary acquired its BBP business from Solutia Europe S.A./N.V. (“SOLBR”) in August 2000. Ferro promptly notified SOLBR of the Ministry’s actions and requested SOLBR to indemnify and defend Ferro and its Belgian subsidiary with respect to these investigations. In response to Ferro’s notice, SOLBR exercised its right under the 2000 acquisition agreement to take over the defense and settlement of these matters, subject to reservation of rights. In December 2005, the Hungarian authorities imposed a de minimus fine on Ferro’s Belgian subsidiary, and the Company expects the German and Belgian authorities also to assess fines for the alleged conduct. Management cannot predict the amount of fines that will ultimately be assessed and cannot predict the degree to which SOLBR will indemnify Ferro’s Belgian subsidiary for such fines.
 
In October 2005, the Company performed a routine environmental, health and safety audit of its Bridgeport, New Jersey facility. In the course of this audit, internal environmental, health and safety auditors assessed the Company’s compliance with the New Jersey Department of Environmental Protection’s (“NJDEP”) laws and regulations regarding water discharge requirements pursuant to the New Jersey Water Pollution Control Act (“WPCA”). On October 31, 2005, the Company disclosed to the NJDEP that it had identified potential violations of the WPCA and the Company commenced an investigation and committed to report any violations and to undertake any necessary remedial actions. In September 2006, the Company entered into an agreement with the NJDEP under which the Company paid the State of New Jersey a civil administration penalty of $0.2 million in full settlement of the violations.
 
There are various other lawsuits and claims pending against the Company and its consolidated subsidiaries. In the opinion of management, the ultimate liabilities, if any, and expenses resulting from such lawsuits and claims will not materially affect the consolidated financial position, results of operations, or cash flows of the Company.
 
Item 4 — Submission of Matters to a Vote of Security Holders
 
No matters were submitted to a vote of Ferro’s security holders during the first, second, third, or fourth quarter of the fiscal year covered by this report.
 
Executive Officers of the Registrant
 
Below are set forth the name, age and positions held by each individual serving as an executive officer of the Company as of September 29, 2006, as well as their business experience during the past five years. Years indicate the year the individual was named to or held the indicated position. There is no family relationship between any of Ferro’s executive officers.


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James F. Kirsch — 49
President and Chief Executive Officer, 2005
President and Chief Operating Officer, 2004
President, Premix Inc., and President, Quantum Composites Inc., manufacturers of thermoset molding compounds, parts and sub-assemblies for the automotive, aerospace, electrical and HVAC industries, 2002
President and Director, Ballard Generation Systems Inc., a producer of hydrogen proton exchange membrane (PEM) fuel cells and component systems; Vice President, Ballard Power Systems Inc., a subsidiary of Ballard Generation Systems Inc., 1999
 
James C. Bays — 57
Vice President and General Counsel, 2001
 
Thomas M. Gannon — 57
Vice President and Chief Financial Officer, 2003
Chief Operating Officer, Riverwood International Corporation, a global supplier of paperboard packaging products, 2001
 
Ann E. Killian — 52
Vice President, Human Resources, 2005
Vice President, Human Resources, W. W. Holdings, LLC, a manufacturer and distributor of doors, frames and hardware products for the commercial construction industry, 2003
Vice President, Compensation & Benefits, TRW Inc., a provider of advanced technology products and services for the global automotive, aerospace and information systems markets, 1999
 
Celeste Beeks Mastin — 38
Vice President, Growth and Development, 2006
Vice President, Color and Glass Performance Materials, 2004
World Wide Business Director, Performance Pigments and Colors, 2003
Vice President and General Manager, Bostik Findley, Inc., Nonwovens Division, a global producer of adhesives, 2001
General Manager, Nitta Findley Co., Ltd., a distributor of adhesive products in Japan, 2001
 
Michael J. Murry — 55
Vice President, Performance Coatings and Color & Glass Performance Materials, 2006
Vice President, Performance Coatings, 2005
President, Chief Executive Officer, and Director, Catalytica Energy Systems, Inc., a provider of products that reduce nitrogen oxides (NOx) emissions for the transportation and power generation industries, 2003
Vice President and General Manager, Ballard Power Systems Inc., a producer of hydrogen proton exchange membrane (PEM) fuel cells and component systems, 2001
 
Barry D. Russell — 42
Vice President, Electronic Material Systems, 2006
Group Vice President and General Manager, Electronic Materials, Honeywell International, a provider of aerospace products and services; control technologies for buildings, homes, and industry; turbo chargers; automotive products; and specialty materials, 2004
Business Director and General Manager, Specialty Additives, Honeywell International, 2002
Business Director and General Manager, Performance Chemicals, Honeywell International, 2001
 
Peter T. Thomas — 51
Vice President, Pharmaceuticals and Fine Chemicals and Polymer Additives, 2004
Vice President, Pharmaceuticals and Fine Chemicals, 2003
Worldwide Business Director, Pharmaceuticals and Fine Chemicals, 2002
Commercial Director, Performance and Fine Chemicals, 2001


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PART II
 
Item 5 — Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities
 
Quarterly Data
 
The quarterly high and low intra-day sales prices and dividends declared per share for the Company’s common stock during 2005 and 2004 are presented below:
 
                                                 
    2005     2004  
    High     Low     Dividends     High     Low     Dividends  
 
First Quarter
  $ 23.55       18.36       0.145     $ 27.62       24.21       0.145  
Second Quarter
  $ 21.22       16.77       0.145     $ 27.40       24.08       0.145  
Third Quarter
  $ 23.22       16.91       0.145     $ 26.50       18.47       0.145  
Fourth Quarter
  $ 20.71       16.27       0.145     $ 23.51       20.18       0.145  
 
The common stock of the Company is listed on the New York Stock Exchange under the ticker symbol FOE. At August 31, 2006, the Company had 1,691 shareholders of record for its common stock. The closing price of the common stock on August 31, 2006, was $17.08 per share.
 
The Company intends to continue to declare quarterly dividends on its common stock, however, no assurances can be made as to the amount of future dividends, since such dividends are subject to the Company’s cash flow from operations, earnings, financial condition, capital requirements, and other matters concerning liquidity included in Management’s Discussion and Analysis of Financial Condition and Results of Operations under Item 7 of this Form 10-K.
 
Item 6 — Selected Financial Data
 
The following table presents selected financial data for the last five years ended December 31:
 
                                         
    2005     2004     2003     2002     2001  
    (Dollars in millions, except per share data)  
 
Net sales
  $ 1,882.3       1,843.7       1,615.6       1,528.5       1,246.5  
Income from continuing operations
  $ 17.1       27.8       9.6       33.2       29.9  
Basic earnings per share from continuing operations
  $ 0.37       0.62       0.18       0.80       0.79  
Diluted earnings per share from continuing operations
  $ 0.37       0.62       0.18       0.80       0.79  
Cash dividends declared per common share
  $ 0.58       0.58       0.58       0.58       0.58  
Total assets
  $ 1,668.5       1,733.4       1,731.3       1,603.6       1,732.2  
Long-term debt, including current portion
  $ 547.9       498.8       525.3       444.4       831.4  
Total debt(a)
  $ 554.7       510.6       538.6       562.1       939.5  
 
 
(a) Total debt is comprised of long-term debt, including current portion, notes and loans payable, borrowings under asset securitization and leveraged lease programs. See further information in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, Liquidity and Capital Resources, for discussion on the asset securitization and leveraged lease programs.
 
The Company adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” (FAS No. 142) for business combinations consummated after June 30, 2001, as of July 1, 2001, and adopted FAS No. 142 in its entirety effective January 1, 2002. Accordingly, all goodwill and other intangible assets having indefinite useful lives are not amortized but instead are subject to impairment testing on at least an annual basis. Before the adoption of any provisions of FAS No. 142, goodwill and intangible assets having indefinite useful lives were amortized ratably over their estimated useful lives.


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In September 2001, the Company acquired from OM Group, Inc. certain businesses previously owned by dmc2 Degussa Metals Catalysts Cerdec AG (dmc2). See further information regarding the transaction in Note 8 to the Company’s consolidated financial statements included herein under Item 8.
 
On September 30, 2002, Ferro completed the sale of its Powder Coatings business unit. On June 30, 2003, the Company completed the sale of its Petroleum Additives business and its Specialty Ceramics business. For all periods presented, the Powder Coatings, Petroleum Additives and Specialty Ceramics businesses have been reported as discontinued operations. The divestiture of the Powder Coatings, Petroleum Additives and Specialty Ceramics businesses are further discussed in Note 10 to the Company’s consolidated financial statements included under Item 8 of this Form 10-K.
 
Quarterly information is set forth below:
 
                                         
                Net
    Per Common Share  
Quarter
  Net Sales     Cost of Sales     Income     Basic Earnings     Diluted Earnings  
    (Dollars in millions, except per share data)  
 
2004
                                       
1
  $ 461.6     $ 359.9     $ 9.0     $ 0.20     $ 0.20  
2
    482.6       375.5       11.8       0.27       0.27  
3
    451.6       358.9       5.9       0.13       0.13  
4
    447.9       367.2       (1.8 )     (0.05 )     (0.05 )
                                         
Total
  $ 1,843.7     $ 1,461.5     $ 24.9     $ 0.55     $ 0.55  
                                         
2005
                                       
1
  $ 461.7     $ 368.7     $ 0.5     $ 0.00     $ 0.00  
2
    496.6       392.2       7.9       0.18       0.18  
3
    466.1       371.7       6.9       0.15       0.15  
4
    457.9       368.8       1.0       0.01       0.01  
                                         
Total
  $ 1,882.3     $ 1,501.4     $ 16.3     $ 0.35     $ 0.35  
                                         
 
Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Overview
 
Market conditions in 2005 were mixed. Sales increased in all of the Company’s segments except Electronic Materials where there was weak demand in the first half of the year. Improved pricing and product mix contributed to increased revenues, but this was partially offset by weaker volume. Sales increased by approximately 3% in North America, 9% in Asia and 14% in Latin America. However, sales declined by approximately 3% in Europe. Consolidated sales rose by approximately 2%. Changes in foreign exchange rates did not materially affect the Company’s revenue growth rate in 2005.
 
Beyond fundamental product demand, the market factors that most affected 2005 results included the following:
 
  •  Increased raw material costs and the Company’s ability to raise selling prices,
 
  •  A weak primary market served by the Electronic Materials segment in the first half of 2005,
 
  •  Cost control initiatives, including restructuring programs, and
 
  •  Costs incurred for the accounting investigations and restatement process.
 
Raw material costs generally increased during the year; however, through improvements in pricing and the mix of products sold, the Company was largely able to recover the raw material cost increases as well as largely offsetting the negative effects of lower customer unit demand, particularly in Electronic Materials and Polymer Additives. Raw materials cost increases were the most significant in the Polymer Additives, Performance Coatings


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and Specialty Plastics segments. The Company was the most successful in improving pricing and product mix in the Polymer Additives segment, although price/mix also improved in Performance Coatings and Specialty Plastics.
 
Demand for electronic materials was weak in the first quarter of 2005. Following the weak beginning to the year, demand gradually improved through the rest of 2005. Customers’ inventory issues, which caused a sharp decline in sales in the first quarter, abated in the following quarters. Sales in the second quarter recovered somewhat, but were still below previous year levels. Sales recovered further in the third quarter and were slightly higher than the corresponding previous year period. Sales growth, compared to the prior year, increased in the fourth quarter.
 
Total segment income in 2005 increased to $118.0 million from $106.5 million in 2004, driven by increases in Polymer Additives, Specialty Plastics and Performance Coatings partially offset by declines in Electronic Materials. As a result of improved second quarter income in all segments except Specialty Plastics, including a partial recovery in the results within Electronic Materials, segment income increased by approximately 29% from the first quarter to the second quarter. Segment income declined in the third quarter, and again in the fourth quarter, as lower sales, particularly in the Performance Coatings and Color and Glass Performance Materials segments, adversely impacted income.
 
Income from continuing operations for the year declined to $17.1 million in 2005 from $27.8 million in 2004. Higher segment income, lower foreign currency losses and a gain on forward supply contracts were more than offset by higher expenses in connection with the accounting investigation and restatement, increased interest expense, and higher other expenses. Net income in 2005 was also lower than in 2004 due to a gain on the sale of assets in 2004 that did not recur in 2005.
 
During the year, accounts payable declined by approximately $23.9 million and led to an increase in working capital requirements, despite modest reductions in accounts receivable and inventories. In addition, during the fourth quarter, requirements increased for cash deposits on precious metal consignment arrangements, further consuming capital. Total debt, as defined in Item 6, increased by $44.1 million during the year.
 
Outlook
 
Due to the timing of the filing of this Form 10-K, it is not meaningful to provide an outlook for the calendar year 2006. Refer to Current Reports on Form 8-K filed with or furnished to the Securities and Exchange Commission by the Company during 2006.
 
Results of Operations
 
Comparison of the years ended December 31, 2005 and 2004
 
Sales from continuing operations for the year ended December 31, 2005, of $1,882.3 million were 2.1% higher than for the comparable 2004 period. Improved pricing and more favorable product mix in North America, Asia-Pacific and Latin America were the primary drivers for the revenue gain. Weakness in the market for multilayer capacitors depressed unit demand and revenues, particularly in the first half of 2005. On a consolidated basis, the impact of strengthening foreign currencies versus the U.S. dollar had only a minimal positive impact on revenues.
 
Gross margin (net sales less cost of sales) was 20.2% of sales in 2005, compared with 20.7% of sales in 2004. The reduced gross margin percentage was mainly due to a combination of higher raw materials costs and lower customer unit demand, partially offset by a more favorable price and mix of products sold. Also contributing to the decline in gross margins was an increase in restructuring costs as compared to the prior year. During 2005, restructuring charges of $3.5 million were included in cost of sales.
 
Selling, general and administrative (SG&A) expenses declined by $1.6 million to $310.9 million in 2005, from $312.4 million in 2004. As a percent of sales, SG&A expenses were 16.5% in 2005, compared to 16.9% in the prior-year period. The lower SG&A expense primarily was driven by ongoing cost reduction measures which resulted in a decline in spending for sales, technical service, research and development, partially offset by an increase in fees related to the accounting investigation and restatement. During 2005, the Company recorded $1.7 million in restructuring charges, in addition to $10.5 million in expenses relating to the accounting investigation and


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restatement of the 2003 and first quarter 2004 consolidated financial statements, as part of SG&A expenses. Restructuring expenses in SG&A were $2.5 million in 2004.
 
Interest expense increased to $46.9 million in 2005 from $42.0 million in 2004. The increase was due to the combined effect of higher interest rates on the Company’s variable-rate borrowings and increased borrowing levels. Long-term debt increased to $547.9 million on December 31, 2005, compared with $498.8 million on December 31, 2004. The increase was partially due to increased deposit requirements on precious metal consignment agreements in the fourth quarter of 2005. In addition, increased borrowings were made to support higher working capital requirements, primarily driven by a decline in accounts payable.
 
Net foreign currency losses were $1.3 million for the year, compared with $3.0 million for 2004. The Company uses certain foreign currency instruments to offset the effect of changing exchange rates on foreign subsidiary earnings and short-term transaction exposure. The carrying values of such contracts are adjusted to market value and resulting gains or losses are charged to income or expense in the period.
 
In 2004, $5.2 million was recognized as gain on sale of business and related to the sale of the Company’s interest in Tokan Material Technology Co. Limited, which was an unconsolidated affiliate. There were no divestitures made in 2005.
 
Net miscellaneous income from continuing operations was $1.6 million as compared to $0.4 million in 2004. During 2005, the Company recorded gains of $3.1 million associated with marked-to-market forward supply contracts, primarily for natural gas. During 2004, the Company recorded a loss of $1.7 million from marked-to-market supply contracts. Partially offsetting this 2005 increase were higher minority interest expenses, lower realized gains on investments designated to fund payments for a nonqualified benefit plan, and lower gains on sales of fixed assets in 2005.
 
Income tax as a percentage of pre-tax income from continuing operations for the year ended December 31, 2005, was 28.8% compared to 10.7% for the year ended December 31, 2004. The primary reason for the increase in 2005 was the Company’s 2004 reversal of valuation allowances due to utilization of net operating losses and management’s determination that, more likely than not, certain deferred tax assets would be realized. Also contributing to the higher effective tax rate in 2005 was a higher proportion of earnings in jurisdictions having higher effective tax rates.
 
Income from continuing operations for the year ended December 31, 2005, was $17.1 million compared with $27.8 million for the year ended December 31, 2004. Diluted earnings per share from continuing operations totaled $0.37 for the year ended December 31, 2005, compared with $0.62 in 2004.
 
There were no new businesses included as discontinued operations in the year ended December 31, 2005. The Company, however, recorded a loss of $0.9 million, net of taxes, in 2005 related to certain post-closing matters associated with businesses sold in prior periods. The loss from discontinued operations in 2004 was $2.9 million.
 
Net income for 2005 totaled $16.3 million, or $0.35 per diluted share versus $24.9 million, or $0.55 per diluted share for 2004.
 
Performance Coatings Segment Results.  For 2005, sales in the Performance Coatings segment increased 4.7% to $488.5 million compared to $466.5 million for 2004. The higher revenue was due to a favorable price and mix of products, as well as improved volumes. Growth was mainly within the Company’s tile coatings business, and was distributed across the Asia-Pacific, European and North American markets. Operating income for the segment was $31.6 million for the year ended December 31, 2005, compared with $23.9 million for 2004. The increase in segment income was driven primarily by increased volume and higher average selling prices, combined with lower segment SG&A expenses. These improvements more than offset higher raw materials costs.
 
Electronic Materials Segment Results.  For 2005, sales in the Electronic Materials segment declined 8.4% to $355.7 million compared to $388.3 million for 2004. The decline in revenue was largely due to weakness in the market for multilayer capacitors and resulting inventory corrections by the Company’s customers. These inventory corrections resulted in sharply lower volumes. Sales increased in Asia-Pacific, but not enough to offset declines in North America and Europe. Operating income for the segment was $13.5 million for the year ended December 31, 2005, compared with operating income of $33.2 million in the prior year. The decline in segment income reflects the


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lower volume of products sold, and the resulting negative impact of fixed manufacturing costs coupled with lower prices for the Company’s products.
 
Color and Glass Performance Materials Segment Results.  Sales in the Color and Glass Performance Materials segment were $359.6 million for 2005, an increase of 1.0% versus $355.9 million in the prior year. The increase in volume for the year was slightly larger than the decline in the combination of price and a less favorable product mix. Segment operating income increased by 4.8%, to $38.9 million, from $37.1 million in 2004. The higher segment income was due primarily to a combination of lower segment SG&A expenses and improvements in the average selling price of products sold. This improvement was partially offset by higher raw materials costs.
 
Polymer Additives Segment Results.  Sales in the Polymer Additives segment increased to $300.6 million for 2005, or 7.3%, from $280.2 million in 2004. The year-over-year increase in sales was primarily due to improved performance in North American end markets, including vinyl processing and construction. Increased pricing, particularly in the markets for polymer modifiers, more than offset a reduction in volumes across the Polymer Additives product lines. Segment operating income for 2005 was $18.5 million versus a loss of $0.9 million in 2004. The increased segment income was due to pricing increases coupled with lower SG&A spending.
 
Specialty Plastics Segment Results.  Sales in the Specialty Plastics segment were $279.1 million for 2005, an increase of 5.3% versus $265.0 million in the prior year. The year-over-year increase in sales was primarily due to improved demand for North American durable goods, including automobiles and appliances. These sales gains were partially offset by weakness in Europe, where sales declined by approximately 8%. Segment operating income increased to $13.4 million from $9.6 million in 2004. The higher segment income was due primarily to the margin benefits from improved average selling prices, partially offset by higher raw material costs and lower volumes.
 
Other Segment Results.  Sales in the Other segment increased to $98.8 million for 2005, from $87.8 million in the prior year. Segment operating income declined to $2.1 million from $3.6 million in 2004.
 
Geographic Sales.  Sales in the United States were $925.9 million for the year ended December 31, 2005, compared with sales of $900.0 million for the year ended December 31, 2004. The increase was primarily due to increased sales in the Polymer Additives, Performance Coatings and Specialty Plastics segments, partially offset by lower sales in Electronic Materials. International sales were $956.4 million in 2005 compared with $943.7 million in 2004. The majority of the international sales increase occurred in the Asia-Pacific region, largely within the Color and Glass Performance Materials and Electronic Materials segments. This growth was partially offset by a volume decline in Europe that was not fully offset by pricing and product mix improvements.
 
Cash Flows.  Net cash provided by operating activities of continuing operations for the year ended December 31, 2005, was $23.2 million, compared with $63.5 million for 2004. The difference between the two periods was driven primarily by changes in net income, working capital balances, and use of the asset securitization facility.
 
Cash used for investing activities was $35.8 million in 2005 compared with $19.4 million in 2004. Capital expenditures for continuing operations were $42.8 million in 2005 compared to $39.1 million in 2004.
 
Net cash provided by financing activities was $18.1 million in 2005 compared with $51.8 million used by financing activities in 2004. Cash provided in 2005 primarily reflects an increase in debt, partially offset by dividends paid to the Company’s shareholders.
 
Net cash used for operating activities of discontinued operations was $1.8 million in 2005 versus $1.6 million in 2004.
 
Related Party Transactions.  Transactions with unconsolidated affiliates included sales of $5.1 million and $19.4 million in 2005 and 2004, respectively, and purchases of $5.6 million and $6.4 million in 2005 and 2004, respectively. At December 31, 2005, the Company had outstanding a €2.4 million guarantee, which was terminated in May 2006, to support the borrowing of an unconsolidated affiliate, and also had $2.8 million due to an unconsolidated wholly-owned qualifying special purpose entity. A Ferro Director, Mr. Weisser, is the Chairman and Chief Executive Officer of Bunge Limited (“Bunge”) and another Ferro Director, Mr. Bulkin, also serves on the board of Bunge. Bunge has a controlling interest in Central Soya Company from which Ferro purchased raw


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materials totaling $11.2 million in 2005 and $14.3 million in 2004. In addition, Mr. Weisser is a member of the board of directors of International Paper Company from which Ferro purchased other items totaling $0.8 million in 2005. Payables related to these purchases were less than $0.1 million at December 31, 2005.
 
Comparison of the years ended December 31, 2004 and 2003
 
Sales from continuing operations for the year ended December 31, 2004, of $1,843.7 million were 14.1% higher than the $1,615.6 million of sales for the comparable 2003 period. Increased volumes in North America, Asia-Pacific and Latin America were the primary drivers for the revenue gain. Increased volumes were driven by improved economic conditions in North America, particularly in construction, automotive, appliance and vinyl processing end markets coupled with increased demand for electronic materials and continued volume gains in Asia for tile coatings products. Europe also recorded increased sales due to the year-over-year change in foreign currency exchange rates. On a consolidated basis, the impact of strengthening currencies, in particular the Euro, improved revenue by approximately $61 million.
 
Gross margin (net sales less cost of sales) was 20.7% of sales compared with 23.1% for the comparable 2003 period. The reduced gross margin compared with 2003 stemmed primarily from increased raw material and energy costs that were only partially recovered through price adjustments. Increased costs of many basic materials, including crude oil and related petrochemical feedstocks, base and precious metals, and agricultural based commodities, drove much of the raw material cost increases. In addition, tight supply positions and strong global demand for basic plastics, including polypropylene, polystyrene, and polyethylene, further pressured raw material costs.
 
Selling, general and administrative expenses from continuing operations were $312.4 million, or 16.9% of sales for 2004 compared to $315.9 million, or 19.6% of sales for 2003. The strength of foreign currencies, primarily the Euro, increased 2004 reported costs by approximately $11 million. Excluding the impact of foreign currencies, SG&A declined by approximately $14 million. Differences in restructuring charges were a primary driver for the decline. In 2004, the Company recorded in SG&A $2.5 million of restructuring charges compared to $10.1 million in 2003. Restructuring savings from the actions taken in 2003 and other expense reductions initiated during 2004 further contributed to the decline, offsetting $2.7 million in expenses incurred as a result of the accounting investigation coupled with other cost increases, including pensions and research and development.
 
Earnings for the year ended December 31, 2004, included total pre-tax charges of $9.3 million related primarily to restructuring activities and the investigation and restatement process. Earnings for the year ended December 31, 2003, included pre-tax charges of $14.2 million related primarily to restructuring costs, consisting principally of employee termination expenses related to facility rationalization, overhead reduction and lease buy-out costs. Of the $9.3 million of charges incurred in 2004, $2.6 million were recorded in cost of sales, $5.2 million in SG&A expenses, and $1.5 million in miscellaneous expense.
 
Interest expense from continuing operations declined from $43.1 million for 2003 to $42.0 million for 2004. This change was driven by a decline in interest expense relating to capitalized lease obligations. This decline was partially offset by increased interest on the Company’s credit facility driven by higher average interest rates and increases in credit facility fees offset partially by reduced average debt levels during 2004.
 
Net foreign currency loss for the year ended December 31, 2004, was $3.0 million as compared to $1.2 million for 2003. Fiscal 2004 includes a $1.0 million loss from the write-off of accumulated translation adjustments associated with the liquidation of a joint venture company. The Company uses certain foreign currency instruments to offset the effect of changing exchange rates on foreign subsidiary earnings and short-term transaction exposure. The carrying values of such contracts are adjusted to market value and resulting gains or losses are charged to income or expense in the period.
 
A pre-tax gain of $5.2 million was recognized in 2004 for the sale of the Company’s interest in Tokan Material Technology Co. Limited, an unconsolidated affiliate. There were no similar gains or losses in 2003.
 
Net miscellaneous income for the year was $0.4 million as compared to expense of $1.8 million in 2003. The majority of the increase in net miscellaneous income resulted from gains associated with an asset sale. The Company recorded a $1.7 million pre-tax gain on the sale of a manufacturing facility. This asset related gain was


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partially offset by costs incurred to recognize unrealized losses on natural gas contracts. In 2004 the Company recorded a loss of $0.9 million for the marked-to-market valuation of gas contracts versus a $0.6 million gain in 2003.
 
Income tax as a percentage of pre-tax income from continuing operations for the year ended December 31, 2004, was 10.7% compared to 19.8% for the year ended December 31, 2003. Contributing to the decline in the effective tax rate were several positive adjustments to the Company’s tax provision, primarily in the fourth quarter, the largest of which was due to a reduction in a valuation allowance for a deferred tax asset associated with a net operating loss carryforward that is expected to be realized. The positive effect of the tax adjustments recorded in the fourth quarter of 2004 was approximately $3.1 million.
 
Income from continuing operations for the year ended December 31, 2004, was $27.8 million compared with $9.6 million for the year ended December 31, 2003. Diluted earnings per share from continuing operations totaled $0.62 for the year ended December 31, 2004, compared with $0.18 in 2003.
 
There were no businesses reported as discontinued operations in the year ended December 31, 2004. The Company, however, recorded a loss of $2.9 million, net of taxes, in 2004 related to certain post-closing matters associated with businesses sold in prior periods, including Powder Coatings and Specialty Ceramics. The loss from discontinued operations in 2003 was $0.9 million. The 2003 results include the Petroleum Additives and Specialty Ceramics business units, which were divested in June 2003. The disposal of the Petroleum Additives and Specialty Ceramics business units resulted in a gain, net of income taxes, of $3.1 million in the year ended December 31, 2003. In addition, certain post-closing matters increased the previously recorded gain on the 2002 sale of Powder Coatings business by $2.2 million. Diluted earnings per share from discontinued operations totaled a loss of $0.07 for December 31, 2004, compared to a $0.11 gain for the year ended December 31, 2003.
 
Net income for the year ended December 31, 2004, totaled $24.9 million, or $0.55 per diluted share versus $14.1 million, or $0.29 per diluted share for the year ended December 31, 2003.
 
Performance Coatings Segment Results.  For 2004, sales in the Performance Coatings segment increased 9.7% to $466.5 million compared to $425.1 million for 2003. The higher revenue was primarily due to improved economic conditions in North America, resulting in increased sales to the appliance market, increased demand for tile coatings products, principally driven by increased market demand in Asia, and the favorable impact of foreign currency exchange rates. These gains were partially offset by volume declines related to key European end markets for tile coatings and a slightly lower average selling price. Operating income for the segment was $23.9 million for the year ended December 31, 2004, compared with operating income of $26.2 million in 2003. The decline in segment income was driven primarily by higher raw material costs partially offset by slightly lower SG&A costs.
 
Electronic Materials Segment Results.  For 2004, sales in the Electronic Materials segment increased 14.8% to $388.3 million compared to $338.3 million for 2003. The higher revenue was primarily due to volume growth to support global electronic industry demand. Segment revenues also benefited from the favorable impact of foreign currency exchange rates. Operating income for the segment was $33.2 million for the year ended December 31, 2004, compared with operating income of $21.0 million in 2003. The increase in segment income reflects the increased demand from the electronics industry and higher operating rates, partially offset by increased SG&A costs, primarily due to increased research and development spending. While the Electronic Materials segment results were favorable for 2004, operating results declined substantially late in the year. Following a very strong first eight months of 2004, demand in the electronics market slowed as a result of customers’ inventory corrections which caused a substantial sales decline in the fourth quarter, compared to the previous three quarters of 2004.
 
Color and Glass Performance Materials Segment Results.  Sales in the Color and Glass Performance Materials segment were $355.9 million for 2004, an increase of 16.5% versus $305.4 million in 2003. Both increased volumes and a higher average selling price drove the year-over-year sales increase. Demand for products serving construction and container glass markets were major contributors to the increased volume, partially offset by a decline in sales to the dinnerware market. Appreciating foreign currency exchange rates relative to the U.S. dollar also added to the increase. Segment operating income decreased to $37.1 million from $41.7 million in 2003. The lower segment income was due primarily to higher raw material costs that the Company was unable to recover through pricing initiatives and increased SG&A expenditures.


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Polymer Additives Segment Results.  Sales in the Polymer Additives segment were $280.2 million for 2004, an increase of 16.6% versus $240.4 million in 2003. The year-over-year increase in sales was primarily due to improved demand from the North American end markets, including vinyl processing and construction. Increased pricing and appreciating foreign currency exchange rates relative to the U.S. dollar also added to the increase. These sales gains were partially offset by weakness in Europe, excluding the effect of foreign currency. Segment operating income for 2004 was a loss of $0.9 million versus income of $2.5 million in 2003. The lower segment income was due primarily to higher raw material cost that the Company was unable to recover through pricing initiatives, coupled with increased SG&A spending.
 
Specialty Plastics Segment Results.  Sales in the Specialty Plastics segment were $265.0 million for 2004, an increase of 12.3% versus $236.0 million in 2003. The year-over-year increase in sales was primarily due to improved demand for North American durable goods, including automobiles and appliances. Increased pricing coupled with appreciating foreign currency exchange rates relative to the U.S. dollar also added to the increase. These sales gains were partially offset by weakness in Europe, where volumes declined by approximately 7%. Segment operating income decreased to $9.6 million from $12.8 million in 2003. The lower segment income was due primarily to higher raw material cost that the Company was unable to recover through pricing initiatives, partially offset by lower SG&A spending.
 
Other Segment Results.  Sales in the Other segment were $87.8 million for 2004, an increase of 24.7% versus $70.4 million in 2003. Operating income improved to $3.6 million from $3.1 million in 2003.
 
Geographic Sales.  Sales in the United States were $900.0 million for the year ended December 31, 2004, compared with sales of $776.4 for the year ended December 31, 2003. The increase was primarily due to increased volumes sold to the electronics industry coupled with improved demand in construction, automotive, appliance, and vinyl processing end markets. International sales were $943.7 million in 2004 compared with $839.2 million in 2003. The majority of the international sales increase occurred in Europe due to the strengthening of the Euro against the dollar and in the Asia-Pacific region due to volume growth.
 
Cash Flows.  Net cash provided by operating activities of continuing operations for the year ended December 31, 2004, was $63.5 million, compared with $4.6 million for 2003. The difference between the two periods was driven primarily by changes in net income, working capital balances, and use of the asset securitization facility.
 
Cash used for investing activities was $19.4 million in 2004 compared with $49.7 million in 2003. Capital expenditures for continuing operations were $39.1 million in 2004 compared to $36.1 million in 2003. Cash used for investing activities in 2003 included a $25.0 million buy out of an operating lease agreement, accounting for the majority of the change in cash used for investing activities between 2004 and 2003.
 
Net cash used for financing activities was $51.8 million in 2004 compared with a source of $53.6 million in 2003. Cash used in 2004 reflects primarily debt reduction and dividends paid to the Company’s shareholders. The Company increased debt in 2003 primarily to buy-out an operating lease arrangement.
 
Net cash used for operating activities of discontinued operations was $1.6 million in 2004 versus $1.1 million in 2003. Net cash provided by investing activities of discontinued operations was $19.3 million in 2003, including the proceeds from the sale of the Company’s Specialty Ceramics and Petroleum Additives businesses.
 
Related Party Transactions.  Transactions with unconsolidated affiliates included sales of $19.4 million and $5.5 million in 2004 and 2003, respectively, and purchases of $6.4 million and $2.2 million in 2004 and 2003, respectively. At December 31, 2004, the Company had outstanding a €2.4 million guarantee, which was terminated in May 2006, to support the borrowing of an unconsolidated affiliate, and also had $2.8 million due to an unconsolidated wholly-owned qualifying special purpose entity. In addition, Ferro purchased raw materials from a company whose controlling interest is held by a company whose Chief Executive Officer currently serves on the Company’s Board of Directors. These purchases amounted to $14.3 million in 2004 and $7.0 million in 2003. There were no payables outstanding relating to these purchases at December 31, 2004.


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Liquidity and Capital Resources
 
The Company’s liquidity requirements include primarily debt service, working capital requirements, capital investments, post-retirement obligations and dividend payments. Capital expenditures were $42.8 million and $39.1 million for the years ended December 31, 2005 and 2004, respectively. The Company expects to be able to meet its liquidity requirements from a variety of sources, including cash flow from operations and use of its credit facilities. At December 31, 2005, the Company had a $300 million revolving credit facility that was scheduled to expire in September 2006, as well as $200 million of senior notes and $155 million of debentures outstanding with varying maturities, the majority of which extended beyond 2010. The Company also had an accounts receivable securitization facility under which the Company could receive advances of up to $100 million, subject to the level of qualifying accounts receivable. The accounts receivable securitization facility was due to mature in June 2006.
 
Subsequent to December 31, 2005, the Company replaced and/or modified its existing facilities to secure future financial liquidity. The $300 million revolving credit facility was replaced by a $700 million credit facility, consisting of a $250 million multi-currency senior revolving credit facility expiring in 2011 and a $450 million senior delayed-draw term loan facility expiring in 2012. See further discussion under “Revolving Credit and Term Loan Facility” below. In addition, the Company extended its $100 million accounts receivable securitization facility for up to three additional years. See further discussion under “Off Balance Sheet Arrangements” below. For further information regarding the Company’s credit facilities refer to Note 3 to the Company’s consolidated financial statements under Item 8 herein.
 
At December 31, 2005, the Company’s senior credit rating was Ba1 by Moody’s Investor Service, Inc. (“Moody’s”) and BB by Standard & Poor’s Rating Group (“S&P”). In March 2006, Moody’s downgraded its rating to B1 and then withdrew its ratings, and S&P downgraded its rating to B+. The rating agencies may, at any time, based on various factors including changing market, political or economic conditions, reconsider the current rating of the Company’s outstanding debt. Based on rating agency disclosures, Ferro understands that ratings changes within the general industrial sector are evaluated based on quantitative, qualitative and legal analyses. Factors considered by the rating agencies include: industry characteristics, competitive position, management, financial policy, profitability, capital structure, cash flow production and financial flexibility. Moody’s and S&P have disclosed that the Company’s ability to improve earnings, reduce the Company’s level of indebtedness and strengthen cash flow protection measures, whether through asset sales, increased free cash flows from operations or otherwise, will be factors in their ratings determinations going forward.
 
Revolving Credit and Term Loan Facility
 
In March 2006, the Company accepted a commitment from a syndicate of lenders to underwrite a $700 million credit facility (the “New Credit Facility”) and, in June 2006, finalized the agreement. The New Credit Facility is comprised of a five year, $250 million multi-currency senior revolving credit facility and a six year, $450 million senior delayed-draw term loan facility. Under the terms of the New Credit Facility, the Company can request that the revolving credit facility be increased by $50 million at no additional fee.
 
The New Credit Facility was entered into to replace the prior revolving credit facility that was scheduled to expire in September 2006. In addition, the financing, through the term loan facility, provided capital resources sufficient to refinance the $200 million of senior notes and $155 million of debentures that could have become immediately due and payable due to defaults associated with the Company’s delayed SEC financial filings for 2005. Because one of the purposes of the term loan facility is to fund the potential acceleration of the senior notes and debentures, the term facility contains certain restrictions including, but not limited to, the following:
 
  •  $355 million of the facility is reserved to repay the senior notes and debentures;
 
  •  $95 million of the facility is immediately available for refunding indebtedness other than the senior notes and debentures;
 
  •  The Company may access up to $55 million of the $355 million reserved to repay the senior notes and debentures if these obligations have not already been paid in full and no event of default for these obligations exists and is continuing; and


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  •  The Company may draw on the delayed-draw facility for up to one year with any unused commitment under the term facility terminating on June 6, 2007.
 
At the close of the New Credit Facility in June 2006, the Company drew $95 million of the term loan facility to partially repay the old revolving credit facility. In addition, during the third quarter of 2006, the Company drew down another $155 million of the term loan facility to repay $155 million of outstanding debentures, as bondholders accelerated payment on these obligations due to the previously mentioned 2005 SEC financial reporting delays. See further discussion under “Senior Notes and Debentures” below.
 
The New Credit Facility is secured by substantially all of the Company’s assets, including the assets and 100% of the shares of the Company’s material domestic subsidiaries and 65% of the shares of the Company’s “first tier” foreign subsidiaries, but excluding trade receivables sold pursuant to the Company’s accounts receivable sales programs (see below). These liens are shared with the holders of the Company’s senior notes, as required under the respective indenture. The New Credit Facility contains customary operating covenants that limit the Company’s ability to engage in certain activities, including limitations on additional loans and investments; creation of additional liens; prepayments, redemptions and repurchases of debt; and mergers, acquisitions and asset sales. The Company is also subject to customary financial covenants including a leverage ratio and a fixed charge coverage ratio. Additional covenants of the New Credit Facility require the Company to file its 2005 Form 10-K by November 15, 2006, and its 2006 Forms 10-Q by the earlier of three months after the 2005 Form 10-K is filed or January 15, 2007. Failure to satisfy certain of these covenants, either immediately or after a brief period allowing the company to satisfy the covenant, would result in an event of default. If any event of default should occur and be continuing and a waiver not have been obtained, the obligations under the New Credit Facility may become immediately due and payable at the option of providers of more than 50% of the credit facility commitment.
 
Senior Notes and Debentures
 
The indentures under which the senior notes and the debentures were issued contain operating covenants that limit the Company’s ability to engage in certain activities including limitations on consolidations, mergers, and transfers of assets; and sale and leaseback transactions. The indentures contain cross-default provisions with other debt obligations that exceed $10 million of principal outstanding. In addition, the terms of the indentures require, among other things, the Company to file with the Trustee copies of its annual reports on Form 10-K, quarterly reports on Form 10-Q and an Officers’ Certificate relating to the Company’s compliance with the terms of the indenture within 120 days after the end of its fiscal year. The Company has been in default on these reporting requirements since it delayed filing its Form 10-Q for the second quarter of 2004 due to the restatement of its 2003 and first quarter 2004 results. As the Company anticipated and planned for, in March and April 2006, the Company received notices of default from a holder and the Trustee of the senior notes and debentures of which $355 million was outstanding. The notices of default related only to reporting requirements and the related Officers’ Certificate. Under the terms of the indentures, the Company had 90 days from the notices of default to cure the deficiencies identified in the notices of default or obtain waivers, or events of default would have occurred and the holders or the Trustee of the senior notes or debentures could declare the principal immediately due and payable. At the end of these periods, the deficiencies had not been cured and waivers had not been obtained. During July and August 2006, the bondholders accelerated the payment of the principal amount of the debentures, of which $155 million was outstanding, and the Company financed the accelerated repayments by use of the aforementioned $450 million term loan facility.
 
As of the date of this filing, the $200 million senior notes currently remain outstanding, although they could be declared immediately due and payable at any time. In the event the bondholders of the senior notes provide a notice of acceleration prior to the Company curing the existing reporting default, the Company believes it has sufficient liquidity resources, primarily through the term loan facility, to fully satisfy any potential acceleration. In addition, the senior notes are redeemable at the option of the Company at any time for the principal amount of the senior notes then outstanding plus the sum of any accrued but unpaid interest and the present value of any remaining scheduled interest payments. The senior notes are redeemable at the option of the holders only upon a change in control of the Company combined with a rating by either Moody’s or S&P below investment grade as defined in the indenture. Currently, the rating by S&P of the senior notes is below investment grade.


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Off Balance Sheet Arrangements
 
Asset Securitization Program.  The Company has a $100 million program to sell (securitize), on an ongoing basis, a pool of its trade accounts receivable. This program serves to accelerate cash collections of the Company’s trade accounts receivable at favorable financing costs and helps manage the Company’s liquidity requirements. In 2005, the Company amended the program to resolve issues related to a credit rating downgrade and delayed SEC filings and to extend the program through June 2006. In June 2006, the Company amended the program to extend it up to June 2, 2009, to cure a default resulting from a credit rating downgrade, and to modify the reporting requirements to more closely match those in the New Credit Facility. While the Company expects to maintain a satisfactory U.S. asset securitization program to help meet the Company’s liquidity requirements, factors beyond the Company’s control such as prevailing economic, financial and market conditions may prevent the Company from doing so.
 
Under this program, certain of the Company’s receivables are sold to Ferro Finance Corporation (“FFC”), a wholly-owned unconsolidated qualified special purpose entity (“QSPE”), as defined by Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” (FAS No. 140). FFC finances its acquisition of trade accounts receivables assets by issuing financial interests to multi-seller receivables securitization companies (“commercial paper conduits”). At December 31, 2004, $3.6 million had been advanced to the Company, net of repayments, under this program. During the twelve months ended December 31, 2005, $946.2 million of accounts receivable were sold under this program and $948.8 million of receivables were collected and remitted to FFC and the commercial paper conduits, resulting in a net decrease in advances of $2.6 million and total advances outstanding at December 31, 2005, of $1.0 million.
 
The Company on behalf of FFC and the commercial paper conduits provides normal collection and administration services with respect to the receivables. In accordance with the criteria in FAS No. 140, no servicing asset or liability is reflected on the Company’s consolidated balance sheet. FFC and the commercial paper conduits have no recourse to the Company’s other assets for failure of debtors to pay when due as the assets transferred are legally isolated in accordance with the bankruptcy laws of the United States. Under FAS No. 140 and Financial Accounting Standards Board (“FASB”) Interpretation No. 46R, “Consolidation of Variable Interest Entities,” neither the amounts advanced nor the corresponding receivables sold are reflected in the Company’s consolidated balance sheets as the trade receivables have been de-recognized with an appropriate accounting loss recognized and included in interest expense in the Consolidated Statements of Income included under Item 8 of this Form 10-K.
 
The Company retains a beneficial interest in the receivables transferred to FFC or the conduits in the form of a note receivable to the extent that cash flows collected from receivables transferred exceed cash flows used by FFC to pay the commercial paper conduits. The note receivable balance was $111.9 million as of December 31, 2005, and $108.5 million as of December 31, 2004. The Company, on a monthly basis, measures the fair value of the retained interests using management’s best estimate of the undiscounted expected future cash collections on the transferred receivables. Actual cash collections may differ from these estimates and would directly affect the fair value of the retained interests.
 
Consignment Arrangements.  The Company consigns, from various financial institutions, precious metals (primarily silver, gold, platinum and palladium, collectively “metals”) used in the production of certain products for customers. Under these consignment arrangements, the financial institutions provide the Company with metals for a specified period of one year or less in duration, for which the Company pays a fee. Under these arrangements, the financial institutions own the metals, and accordingly, the Company does not report these consigned materials as part of its inventory on its consolidated balance sheet. These agreements are cancelable by either party at the end of each consignment period, however, because the Company has access to a number of consignment arrangements with available capacity, consignment needs can be shifted among the other participating institutions. In certain cases, these other participating institutions may require cash deposits to provide additional collateral beyond the underlying precious metals. In the fourth quarter of 2005, due to the Company’s delays in filing consolidated financial statements, certain financial institutions began to require the Company to make deposits. The Company had outstanding deposits of $19.0 million and $88.5 million at December 31, 2005, and August 31, 2006,


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respectively, which are included in other current assets in the Company’s Consolidated Balance Sheets. The Company anticipates that the majority of these cash deposits will be returned by December 31, 2006.
 
Cost of sales related to the consignment arrangements’ fees were $1.6 million for 2005 and $2.4 million for 2004. At December 31, 2005 and 2004, the Company had 5.9 million and 9.4 million troy ounces of metals (primarily silver) on consignment for periods of less than one year with market values of $99.3 million and $106.4 million, respectively.
 
Other Financing Arrangements
 
In addition, the Company maintains other lines of credit and receivable sales programs to provide global flexibility for the Company’s liquidity requirements. Most of these facilities, including receivable sales programs, are uncommitted lines for the Company’s international operations. At December 31, 2005, the unused portions of these lines provided approximately $15.0 million of additional liquidity. The receivable sales are generally without recourse. At December 31, 2005, the amount of outstanding receivables sold under these international receivable sales programs was less than $20 million. The Company had a €2.4 million guarantee, which was outstanding at December 31, 2005, and was terminated in May 2006, to support the borrowing facilities of an unconsolidated affiliate.
 
In June 2003, the Company bought out its $25.0 million leveraged lease program under which the Company leased certain land, buildings, machinery and equipment. The assets had a net carrying value of $24.0 million and an appraised value of $22.6 million. A loss of $1.4 million was recognized in cost of sales in 2003 as a result of the buyout. The program was accounted for as an operating lease.
 
Liquidity
 
Ferro’s level of debt and debt service requirements could have important consequences to its business operations and uses of cash flows. In addition, a reduction in overall demand for the Company’s products, as well as the potential requirement to repay the senior notes due to the Company’s delayed SEC filings, could adversely affect cash flows. Despite these potential constraints on cash flows, the Company maintains considerable resources. At December 31, 2005, the Company had a $300.0 million revolving credit facility of which $113.9 million was available. This liquidity, along with the liquidity from the Company’s asset securitization program of which $99.0 million was available as of December 31, 2005, other financing arrangements, available cash flows from operations, asset sales, and the New Credit Facility, should allow the Company to meet its funding requirements and other commitments. However, factors beyond the Company’s control such as prevailing economic, financial and market conditions may prevent the Company from doing so. As of August 31, 2006, the Company had borrowed $165.5 million against its $250 million revolving credit facility and drawn $49.2 million on the $100 million asset securitization program. In addition, the Company had drawn $250 million on the $450 million term loan facility, although the $200 million remaining availability is reserved for the repayment of the 91/8% senior notes should they be accelerated by the bondholders.
 
The Company’s aggregate amount of obligations for the next five years and thereafter is set forth below:
 
                                                         
    2006     2007     2008     2009     2010     Thereafter     Totals  
    (Dollars in thousands)  
 
Maturities of notes and debentures
  $ 655     $ 347     $ 169     $ 200,112     $ 118     $ 155,159     $ 356,560  
Revolving credit facility
                                  186,100       186,100  
Accounts receivable securitization facility
                      1,000                   1,000  
Obligations under capital leases
    1,628       1,424       1,222       1,115       1,109       5,385       11,883  
Obligations under operating leases
    11,516       8,004       5,070       3,133       2,195       9,656       39,574  
Purchase commitments
    15,099       665                               15,764  
Nonqualified retirement plan obligations
    2,747       413       406       416       401       2,566       6,949  
                                                         
    $ 31,645     $ 10,853     $ 6,867     $ 205,776     $ 3,823     $ 358,866     $ 617,830  
                                                         


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Interest payments are not included in the above table due to changes in the debt structure which increased the level of floating-rate debt, as discussed above and in Quantitative and Qualitative Disclosures about Market Risk under Item 7A of this Form 10-K. Further, the nonqualified retirement plan obligations are net of $9.2 million of investments designated to fund the plan benefits. The Company expects to contribute approximately $43.9 million to its pension and other post-retirement benefit plans in 2006.
 
Derivative Financial Instruments
 
Commodity Price Risk Management.  The Company purchases portions of its natural gas requirements under fixed price contracts, which in certain circumstances, although unlikely because committed quantities are below expected usage, could result in the Company settling its obligations under these contracts in cash at prevailing market prices. In compliance with FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities,” (FAS No. 133), as amended by Statement No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” (FAS No. 149), the Company marked these contracts to fair value and recognized the resulting gains or losses as miscellaneous income or expense, respectively. The fair value of the contracts for natural gas was $2.1 million and $(0.9) million at December 31, 2005 and 2004, respectively.
 
The Company also hedges a portion of its exposure to changes in the pricing of certain nickel and zinc commodities using derivative financial instruments. Nickel and zinc are raw materials used in the Company’s tile, porcelain enamel, and color and glass product lines. The hedges are accomplished principally through swap arrangements that allow the Company to fix the pricing of the commodities for future purchases. While hedged quantities are below expected usage, these swap arrangements, unlike the natural gas contracts, do not provide for physical delivery of the commodity but require the Company to settle its obligations in cash at the maturity of the contracts. In compliance with FAS No. 133 and FAS No. 149, the Company marks these contracts to fair value and recognizes the resulting gains or losses as other comprehensive income. After the contracts mature and the materials are sold, the gains and losses are recognized as a part of cost of goods sold. The fair value of the nickel and zinc contracts was $0.1 million at December 31, 2005. There were no such contracts at December 31, 2004.
 
Consignment Arrangements.  The Company consigns, from various financial institutions, precious metals (primarily silver, gold, platinum and palladium, collectively “metals”) used in the production of certain products for customers. Under these consignment arrangements, the financial institutions provide the Company with metals for a specified period of one year or less in duration, for which the Company pays a fee. Under these arrangements, the financial institutions own the metals, and accordingly, the Company does not report these consigned materials as part of its inventory on its consolidated balance sheet. These agreements are cancelable by either party at the end of each consignment period, however, because the Company has access to a number of consignment arrangements with available capacity, consignment needs can be shifted among the other participating institutions. In certain cases, these other participating institutions may require cash deposits to provide additional collateral beyond the underlying precious metals. In the fourth quarter of 2005, due to the Company’s delays in filing consolidated financial statements, certain financial institutions began to require the Company to make deposits. At August 31, 2006, and December 31, 2005, the Company had outstanding deposits of $88.5 million and $19.0 million, respectively, which are included in other current assets in the Company’s consolidated balance sheets. The Company anticipates that the majority of these cash deposits will be returned by December 31, 2006. The fair value of the Company’s rights and obligations under these arrangements at December 31, 2005 and 2004 was not material.
 
Costs of sales related to the consignment arrangements’ fees were $1.6 million for 2005, $2.4 million for 2004, and $1.6 million for 2003. At December 31, 2005 and 2004, the Company had 5.9 million and 9.4 million troy ounces of metals (primarily silver) on consignment for periods of less than one year with market values of $99.3 million and $106.4 million, respectively.
 
The consignment arrangements allow for the Company to replace the metals used in the manufacturing process by obtaining replacement quantities on the spot market and to charge the customer for the cost of the replacement quantities (i.e., the price charged to the customer is largely a pass-through). In certain circumstances, customers request at the time an order is placed, a fixed price for the metals cost pass-through. In these instances, the Company will enter into a fixed price sales contract to establish the cost for the customer at the estimated future delivery date. At the same time, the Company enters into a forward purchase arrangement with a metal supplier to completely


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cover the value of the fixed price sales contract. At December 31, 2005 and 2004, the Company had 3,000 and 599,000 troy ounces of metals (primarily silver) with market values of $0.1 million and $1.7 million, respectively, under fixed price contracts for future metal consignment replenishments. In accordance with FAS No. 133, the market value of these fixed price contracts is analyzed quarterly. Due to the short duration of the contracts (generally three months or less), the difference between the contract values and market values at any financial reporting date is not material.
 
Impact of Newly Issued Accounting Pronouncements
 
The FASB’s Emerging Issues Task Force (the “EITF”) ratified Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” in March 2004. The issue provided guidance for evaluating whether an investment is other-than-temporarily impaired and was effective for other- than-temporary impairment evaluations made in reporting periods beginning after June 15, 2004. However, the guidance contained in paragraphs 10-20 was delayed by FASB Staff Position (“FSP”) EITF Issue No. 03-1-1, “Effective Date of Paragraphs 10 — 20 of EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” in September 2004; the delay of that effective date will be superseded concurrent with the final issuance of FSP EITF Issue No. 03-1-a. The adoption of EITF Issue No. 03-1 is not expected to have a material impact on the Company’s results of operations or financial position.
 
The FASB issued Statement No. 151, “Inventory Costs,” (FAS No. 151) in November 2004. FAS No. 151 is effective for fiscal years beginning after June 15, 2005, and amends the guidance of ARB No. 43 to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage). FAS No. 151 requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” The adoption of FAS No. 151 as of January 1, 2006, is not expected to have a material impact on the results of operations or financial position of the Company.
 
In December 2004, the FASB issued Statement No. 123R, “Share-Based Payment,” (FAS No. 123R) that requires public entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which the employee is required to provide services in exchange for the award. FAS No. 123R is effective for interim and annual periods beginning after June 15, 2005, and applies to all outstanding and unvested share-based payment awards as of the adoption date. In April 2005, the Securities and Exchange Commission published a rule allowing public companies with calendar year ends to delay the quarter in which they begin to expense stock options to first quarter 2006 from third quarter 2005. The Company plans to adopt FAS No. 123R beginning January 1, 2006, using the modified prospective method and expects to incur pre-tax charges of approximately $3 million to $4 million for 2006.
 
In May 2005, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections — a replacement of APB Opinion No. 20 and FASB Statement No. 3,” (FAS No. 154). This Statement requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change or unless specific transition provisions are proscribed in the accounting pronouncements. FAS No. 154 does not change the accounting guidance for reporting a correction of an error in previously issued financial statements or a change in accounting estimate. FAS No. 154 is effective for accounting changes and error corrections made after December 31, 2005. The Company will apply this standard prospectively.
 
In September 2005, the EITF reached a consensus on Issue No. 04-13, “Accounting for Purchase and Sales of Inventory with the Same Counterparty,” that requires companies to recognize an exchange of finished goods for raw materials or work-in-progress within the same line of business at fair value. All other exchanges of inventory should be reflected at the recorded amount. This consensus is effective for transactions completed after March 31, 2006, and is not expected to have a material impact on the results of operations or financial position of the Company.
 
In March 2006, the FASB issued Statement No. 156 “Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140,” (FAS No. 156). This statement requires an entity to recognize at fair value, if practicable, a servicing asset or liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations primarily relating to off-balance sheet arrangements. Entities


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may chose between two subsequent measurement methods for each class of separately recognized servicing assets and servicing liabilities. FAS No. 156 is effective for fiscal years beginning after September 15, 2006. The provisions of FAS No. 156 are to be applied prospectively to transactions entered into after its adoption. The Company will adopt FAS No. 156 as of January 1, 2007, as permitted, and is currently evaluating the implementation options; at this time, the Company is uncertain as to the impact on the Company’s results of operations and financial position.
 
The FASB published Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (Interpretation No. 48) in June 2006. This interpretation requires companies to determine whether it is more likely than not that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit can be recorded in the financial statements. Interpretation No. 48 also provides guidance on derecognition, classification, accounting in interim periods, and disclosure requirements for tax contingencies. This interpretation is effective for fiscal years beginning after December 15, 2006. The Company is currently assessing the impact that Interpretation No. 48 will have on the Company’s 2007 results of operations and financial position.
 
In September 2006, the FASB published Staff Position No. AUG AIR-1, “Accounting for Planned Maintenance Activities.” This staff position prohibits the use of the accrue-in-advance method of accounting for planned major maintenance activities. It is effective for fiscal years beginning after December 15, 2006, and is to be applied retrospectively. When adopted in fiscal 2007, the staff position will increase retained earnings as of the beginning of 2005 by approximately $1.6 million, increase 2005 income from continuing operations by approximately $0.4 million and increase 2005 net income by approximately by $0.3 million.
 
In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements,” (FAS No. 157). FAS No. 157 defines fair value, establishes a framework and gives guidance regarding the methods used for measuring fair value, and expands disclosures about fair value measurements. Accordingly, FAS No. 157 does not require any new fair value measurements, but will change current practice for some entities. FAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company will apply this standard prospectively.
 
In September 2006, the U.S. Securities and Exchange Commission (SEC) released Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” (SAB No. 108) which provides interpretive guidance on the SEC’s views regarding the process of quantifying materiality of financial statement misstatements. SAB No. 108 is effective for years ending after November 15, 2006, with early application for the first interim period ending after November 15, 2006. The Company does not believe that the application of SAB No. 108 will have a material effect on the Company’s results of operations or financial position.
 
Critical Accounting Policies
 
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. The policies discussed below are considered by management to be more critical than other policies because their application requires management’s most subjective or complex judgments, often a result of the need to make estimates about the effect of matters that are inherently uncertain. Management has discussed the development, selection and disclosure of these policies with the Audit Committee of the Board of Directors.
 
Environmental and Other Contingent Liabilities
 
The Company expenses recurring costs associated with control and disposal of hazardous materials in current operations. Accruals for environmental remediation and other contingent liabilities, including those relating to ongoing, pending or threatened litigation, are recorded when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. The amount accrued for environmental remediation reflects the Company’s assumptions about remediation requirements at the contaminated site, the nature of the remedy, the outcome of discussions with regulatory agencies and other potentially responsible parties at multi-party sites, and the number and financial viability of other potentially responsible parties. Estimated costs are not discounted due to


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the uncertainty with respect to the timing of related payments. The Company actively monitors the status of sites, and as assessments and cleanups proceed, accruals are reviewed periodically and adjusted, if necessary, as additional information becomes available. Changes in the estimates on which the accruals are based, unanticipated government enforcement actions, or changes in health, safety, environmental regulation, and testing requirements could result in higher or lower costs.
 
As of December 31, 2005, the Company had accrued liabilities of $6.6 million for environmental remediation costs, of which $1.2 million related to Superfund sites. As of December 31, 2004, the Company had accrued liabilities of $6.4 million of which $0.6 million related to Superfund sites.
 
Income Taxes
 
Deferred income taxes are provided to recognize the effect of temporary differences between financial and tax reporting. Deferred income taxes are not provided for undistributed earnings of foreign consolidated subsidiaries, to the extent such earnings are reinvested for an indefinite period of time. The Company has significant operations outside the United States, where substantial pre-tax earnings are derived, and in jurisdictions in which the statutory tax rate is lower than in the United States. The Company also has significant cash requirements in the United States to pay interest and principal on borrowings. As a result, significant tax and treasury planning and analysis of future operations are necessary to determine the proper amount of tax assets, liabilities and tax expense. The Company’s tax assets, liabilities and tax expense are supported by its best estimates and assumptions of its global cash requirements, planned dividend repatriations and expectations of future earnings. Expectations of future earnings, the scheduled reversal of deferred tax liabilities, the ability to carryback losses and credits to offset taxable income in a prior year, and tax planning strategies are the primary drivers underlying management’s evaluation of the valuation allowance on net deferred tax assets. However, the amounts recorded may materially differ from the amounts that are ultimately payable if management’s estimates of future earnings, cash flows and outcomes of tax planning strategies are ultimately inaccurate. Valuation allowances are recorded against deferred tax assets for which management believes realization is not more likely than not.
 
Pension and Other Postretirement Benefits
 
The Company sponsors defined benefit plans in the U.S. and many countries outside the U.S., and also sponsors retiree medical benefits for a segment of its salaried and hourly work force within the U.S. The assumptions used in actuarial calculations for these plans have a significant impact on benefit obligations and annual net periodic benefit costs. Ferro management meets with its actuaries annually to discuss key economic assumptions used to develop these benefit obligations and net periodic costs. The discount rate for the U.S. pension plans is determined based on a bond model. Using the Company’s projected pension cash flows, the bond model considers all possible bond portfolios (based on bonds with a quality rating of AA or better under either Moody’s or S&P) that produce matching cash flows and selects the optimal one with the highest possible yield. The discount rates for the non-U.S. plans are selected based on a yield curve method. Using AA-rated bonds applicable in respective capital markets, the duration of each plans’ liabilities is used to select the rate from the yield curve corresponding to the same duration. The resulting yield is rounded to the nearest 25 basis points. The expected return on assets at the beginning of the year for defined benefit plans is calculated as the weighted-average of the expected return for the target allocation of the principal asset classes held by each of the plans. In determining the expected returns, the Company considers both historical performance and an estimate of future long-term rates of return. The resulting expected returns are then rounded to the nearest 25 basis points. All other assumptions are reviewed periodically by the Company’s management and its actuaries and may be adjusted based on current trends and expectations as well as past experience in the plans.


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The following table provides the sensitivity of net annual periodic benefit costs for the Company’s pension plans, including a U.S. nonqualified retirement plan, and the retiree medical plan to a 25 basis point decrease in both the discount rate and asset return assumption:
 
                 
          25 Basis Point Decrease
 
    25 Basis Point Decrease
    in Asset Return
 
    in Discount Rate     Assumption  
    (Dollars in millions)  
 
U.S. Pension Plans
  $ 1.3     $ 0.6  
U.S. Retiree Medical Plan
    0.0       0.0  
Non-U.S. Pension Plans
    0.8       0.3  
                 
Total
  $ 2.1     $ 0.9  
                 
 
The discount rate used to determine the net periodic pension cost associated with U.S. pension and retiree medical purposes decreased from 6.25% for 2004 to 6.10% for 2005. The discount rate used to determine actuarial liabilities associated with U.S. pension and retiree medical plans decreased from 6.10% at December 31, 2004 to 5.90% at December 31, 2005. The Company also reduced the expected asset return assumption for the U.S. pension plans from 8.75% in 2004 to 8.50% in 2005. These decreases were due to generally falling bond and equity yields during 2004 and 2005. The weighted average discount rate and expected asset return assumption for the Company’s non-U.S. pension plans decreased from 5.26% and 5.41% in 2004 to 4.77% and 5.26% in 2005, respectively. The measurement dates used to determine pension and other postretirement benefit measurements are September 30 for the United States plans and December 31 for the international plans.
 
Amortization of unrecognized gains or losses is a component of net periodic cost. These gains or losses result from the difference between actual and assumed results and from changes in actuarial assumptions. At December 31, 2005, Ferro’s U.S. and non-U.S. pension plans, including the nonqualified retirement plan, had unrecognized losses of $148.1 million, while Ferro’s U.S. retiree medical plan currently had unrecognized gains of $4.9 million. These unrecognized gains and losses will be recognized in future net periodic costs.
 
During 2006, the Company entered into an agreement under which additional contributions (above those required by local statutory law) would be made into one international defined benefit plan in the event of the Company’s termination of participants in the plan without a transfer of the participants’ respective accrued benefits. The additional contributions would be required as follows should such events occur before December 31, 2012: 2006 $4.6 million, 2007 $4.2 million, 2008 $3.7 million, 2009 $3.2 million, 2010 $2.5 million, 2011 $1.8 million, and 2012 $1.0 million.
 
On April 1, 2006, the Company froze retirement benefit accumulations for its largest defined benefit pension plan, which covers certain salaried and hourly employees in the United States. The affected employees now receive benefits in the Company’s defined contribution plan that previously covered only U.S. salaried employees hired after June 30, 2003. The new plan supports a diverse and mobile workforce with a competitive, flexible and portable retirement benefit, while lowering and providing greater predictability to the Company’s cost structure. These changes do not affect current retirees or former employees.
 
Additionally, the Company limited eligibility for the retiree medical and life insurance coverage for all eligible nonunion employees. Only employees age 55 or older with 10 or more years of service as of December 31, 2006, will be eligible for post-retirement medical and life insurance benefits. Moreover, these benefits will be available only to those employees who retire by December 31, 2007, after having advised the Company of their retirement plans by March 31, 2007. These changes do not affect current retirees.
 
Ferro expects its overall net periodic cost (U.S. pension, U.S. retiree medical, and non-U.S. pension) to decrease approximately $5.2 million from 2005 to 2006, primarily due to $10.0 million in expense reductions relating to the aforementioned changes in the pension and retiree medical programs, offset by $4.2 million in charges primarily relating to a lump sum payment to the beneficiary of its deceased former Chief Executive Officer from the nonqualified defined benefit retirement plan.


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The Company expects to contribute approximately $28.1 million to its U.S. defined benefit pension plans in 2006. Over the four-year period from 2007 through 2010, an additional $58 million of contributions could be required. These cash contribution requirements were determined based on current ERISA and IRS guidelines and reflect the aforementioned recent pension plan changes. For significant non-U.S. plans, the Company expects to contribute $4.2 million in 2006 and an additional $15.5 million over the four-year period from 2007 through 2010. These funding amounts were determined based on the minimum contributions required under various applicable regulations in each respective country.
 
Inventories
 
The Company values inventory at the lower of cost or market, with cost being determined utilizing the first-in, first-out (FIFO) method, except for selected inventories where the last-in, first-out (LIFO) method is used. Inventory valuation is periodically evaluated primarily based upon the age of the inventory, but also considers assumptions of future demand and market conditions. As a result of the evaluation, the inventory may be written down to the lower of cost or realizable value. If actual circumstances are less favorable than those projected by management, additional write-downs may be required.
 
Restructuring and Cost Reduction Programs
 
Costs associated with exit and disposal activities are recognized when liabilities are incurred. Reserves are established for such activities by estimating employee termination costs utilizing detailed restructuring plans approved by management. Reserve calculations are based upon various factors including an employee’s length of service, contract provisions, salary level and health care benefit choices. The Company believes the estimates and assumptions used to calculate these restructuring provisions are appropriate, and although significant changes are not anticipated, actual costs could differ from the estimates should changes be made in the nature or timing of the restructuring plans.
 
The Company continued actions during 2005 associated with its cost reduction and integration programs. The programs affect all businesses across the Company, and generally will take no longer than twelve months to complete from the date of commencement unless certain legal or contractual restrictions on the Company’s ability to complete the program exist. The Company recorded $3.7 million of pre-tax charges during 2005, all of which related to severance benefits for employees affected by plant closings or capacity reduction, as well as various personnel in administrative or shared service functions. Termination benefits were based on various factors including length of service, contract provisions, local legal requirements and salary levels. Management estimated the charges based on these factors as well as projected final service dates.
 
Revenue Recognition
 
The Company recognizes revenue when persuasive evidence of an arrangement exists, the selling price is fixed and determinable, collection is reasonably assured, and title has passed to it customers. Provision is made for uncollectible accounts based on historical experience and specific circumstances, as appropriate. Accounts deemed to be uncollectible or to require excessive collection costs are written off against the allowance for doubtful accounts. Customer rebates are accrued over the rebate periods based upon estimated attainments of the provisions set forth in the rebate agreements and recorded as reductions of sales.
 
Valuation of Goodwill and Other Intangibles
 
The Company adopted FASB Statement No. 142, “Goodwill and Other Intangible Assets,” (FAS No. 142) for goodwill and intangible assets acquired after June 30, 2001 as of July 1, 2001. FAS No. 142 was adopted in its entirety as of January 1, 2002 and accordingly, the Company’s goodwill and intangible assets with indefinite useful lives are no longer being amortized.
 
Fair value is estimated using the discounted cash flow method. The Company uses projections of market growth, internal sales efforts, input cost movements, and cost reduction opportunities to project future cash flows.


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Certain corporate expenses and assets and liabilities are allocated to the business units in this process. Using a risk adjusted, weighted average cost-of-capital, the Company discounts the cash flow projections to the annual measurement date, October 31st. If the fair value of any of the units were determined to be less than its carrying value, the Company would proceed to the second step and obtain independent appraisals of its assets. In 2005 and 2004, the fair value exceeded the carrying value, and therefore, it was not necessary to obtain independent appraisals.
 
Assessment of Long-Lived Assets
 
The Company’s long-lived assets include property, plant, equipment, goodwill and other intangible assets. Property, plant and equipment are depreciated on a straight-line basis over their estimated useful lives.
 
Property, plant and equipment are reviewed for impairment whenever events or circumstances indicate that the undiscounted net cash flows to be generated by their use and eventual disposition is less than their recorded value. In the event of impairment, a loss is recognized for the excess of the recorded value over fair value. The long-term nature of these assets requires the estimation of cash inflows and outflows several years into the future and only takes into consideration technological advances known at the time of impairment.
 
Due to depressed conditions in the electronics industry in late 2004 and 2005, the Company specifically evaluated its electronics assets in Holland. The Company also evaluated its Italian tile and Belgian polymer additives manufacturing assets because of sluggish market conditions in these regions. In each situation, management concluded that the assets were not impaired.
 
Asset Retirement Obligations
 
FASB Statement No. 143, “Accounting for Asset Retirement Obligations,” (FAS No. 143) requires that the fair value of a liability for an asset retirement obligation (“ARO”) be recognized in the period in which it is incurred. FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations,” (Interpretation No. 47) clarifies the evaluation of conditional AROs. The Company adopted FAS No. 143 as of January 1, 2003, and recorded AROs of $0.1 million. The Company adopted Interpretation No. 47 as of January 1, 2005, and recorded additional conditional AROs of $0.9 million.
 
At December 31, 2005 and 2004, estimated liabilities for AROs were $1.0 million and $0.1 million, respectively. In determining the amounts recorded relating to conditional AROs, the Company utilizes an expected value technique whereby potential settlement dates and related probabilities are based upon management’s judgment, taking into consideration the Company’s historical practices, current business intentions, and other relevant information. Legal obligations exist in connection with the retirement of assets at many of the Company’s operating facilities that would be triggered upon closure of the facilities or abandonment of existing operations. If certain operating facilities were to be closed, for which there is no current intention to do so, changes to or settlements of the related conditional AROs could significantly affect the Company’s results of operations and cash flows at that time.
 
Derivative Financial Instruments
 
The Company employs derivative financial instruments, primarily foreign currency forward exchange contracts and foreign currency options, to hedge certain anticipated transactions, firm commitments, or assets and liabilities denominated in foreign currencies. Gains and losses on foreign currency forward exchange contracts and foreign currency options are recognized as foreign currency transaction gains and losses.
 
The Company purchases portions of its natural gas requirements under fixed price contracts, which in certain circumstances, although unlikely because committed quantities are below expected usage, could result in the Company settling its obligations under these contracts in cash at prevailing market prices. In compliance with FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities,” (FAS No. 133), as amended by Statement No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,”


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(FAS No. 149), the Company marked these contracts to fair value and recognized the resulting gains or losses as miscellaneous income or expense, respectively.
 
The Company also hedges a portion of its exposure to changes in the pricing of certain nickel and zinc commodities using derivative financial instruments. Nickel and zinc are raw materials used in the Company’s tile, porcelain enamel, and color and glass product lines. The hedges are accomplished principally through swap arrangements that allow the Company to fix the pricing of the commodities for future purchases. While hedged quantities are below expected usage, these swap arrangements, unlike the natural gas contracts, do not provide for physical delivery of the commodity but require the Company to settle its obligations in cash at the maturity of the contracts. In compliance with FAS No. 133 and FAS No. 149, the Company marks these contracts to fair value and recognizes the resulting gains or losses as other comprehensive income. After the contracts mature and the materials are sold, the gains and losses are recognized as a part of cost of goods sold.
 
The Company consigns, from various financial institutions, precious metals (primarily silver, gold, platinum and palladium, collectively “metals”) used in the production of certain products for customers. Under these consignment arrangements, the financial institutions provide the Company with metals for a specified period of one year or less in duration, for which the Company pays a fee. Under these arrangements, the financial institutions own the metals, and accordingly, the Company does not report these consigned materials as inventory on its consolidated balance sheet. These agreements are cancelable by either party at the end of each consignment period, however, because the Company has access to a number of consignment arrangements with available capacity, consignment needs can be shifted among the other participating institutions. Beginning in the fourth quarter of 2005, certain participating institutions required cash deposits to provide additional collateral beyond the underlying precious metals. At August 31, 2006, and December 31, 2005, the Company had outstanding deposits of $88.5 million and $19.0 million, respectively, which are included in other current assets in the Company’s consolidated balance sheets. Fees relating to these contracts are recorded as cost of sales.
 
Item 7A — Quantitative and Qualitative Disclosures about Market Risk
 
The Company’s exposure to market risks is primarily limited to fluctuations in interest rates, foreign currency exchange rates, and costs of raw materials and natural gas.
 
Ferro’s exposure to interest rate risk relates primarily to its debt portfolio including obligations under the accounts receivable securitization program. The Company’s interest rate risk management objective is to limit the negative effect of interest rate changes on earnings, cash flows and overall borrowing costs. In managing the percentage of fixed versus variable rate debt, consideration is given to the interest rate environment and forecasted cash flows. This policy limits exposure from rising interest rates and allows the Company to benefit during periods of falling rates. The Company’s interest rate exposure is generally limited to the amounts outstanding under the revolving credit facility and amounts outstanding under its asset securitization program. Based on the amount of variable-rate indebtedness outstanding at December 31, 2005 and 2004, a 1% increase or decrease in interest rates would have resulted in a $1.9 million and a $1.5 million corresponding change in interest expense, respectively. For 2006, the sensitivity to interest rate fluctuations is likely to be higher due to increased levels of variable rate debt. At December 31, 2005, the Company had $354.4 million carrying value of fixed rate debt outstanding with an average effective interest rate of 8.6%, substantially all maturing after 2008. The fair market value of these debt securities was approximately $354.8 million at December 31, 2005. During July and August 2006, the bondholders accelerated the payment of the principal amount of the Company’s fixed-rate debentures, of which $155 million was outstanding. The debentures were repaid through use of the term loan facility (see further information included under Liquidity and Capital Resources under Item 7 of this Form 10-K), which increased the level of floating-rate debt.
 
Ferro manages its currency risks principally by entering into forward contracts to mitigate the impact of currency fluctuations on transaction and other exposures. At December 31, 2005, the Company held forward contracts with a notional amount of $119.3 million and an aggregate fair value of $0.1 million. A 10% appreciation of the U.S. dollar would have resulted in a $0.4 million and a $0.8 million decrease in the fair value of these positions in the aggregate at December 31, 2005 and 2004, respectively. A 10% depreciation of the U.S. dollar


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would have resulted in a $0.5 million and a $1.0 million increase in the fair value of these positions in the aggregate at December 31, 2005 and 2004, respectively.
 
The Company is also subject to cost changes with respect to its raw materials and natural gas purchases. The Company attempts to mitigate raw materials cost increases with price increases to the Company’s customers. In addition, the Company purchases portions of its natural gas requirements under fixed price contracts, over short time periods, to reduce the volatility of this cost. Natural gas contracts at December 31, 2005, and 2004, respectively, for 1.2 million and 1.5 million MMBTU’s of natural gas had fair values of $2.1 million and $(0.9) million. A 10% increase or decrease in the forward prices of natural gas would have resulted in a $1.3 million and a $0.9 million corresponding change in the fair value of these contracts as of December 31, 2005 and 2004, respectively. The Company also hedges a portion of its exposure to changes in the pricing of certain nickel and zinc commodities using derivative financial instruments. The hedges are accomplished principally through swap arrangements that allow the Company to fix the pricing of the commodities for future purchases. Nickel and zinc contracts at December 31, 2005, for 3,092 metric tons had a fair value of $0.1 million. A 10% increase or decrease in the forward prices of these commodities would have resulted in a $0.7 million corresponding change in the fair market of these contracts as of December 31, 2005. There were no such contracts at December 31, 2004.


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Item 8 — Financial Statements and Supplementary Data
 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Board of Directors and Shareholders of
Ferro Corporation
Cleveland, Ohio
 
We have audited the accompanying consolidated balance sheets of Ferro Corporation and subsidiaries (the “Company”) as of December 31, 2005, and the related consolidated statements of income, shareholders’ equity and comprehensive income, and cash flows for the year ended December 31, 2005. Our audit also included the financial statement schedule listed in the index at Item 15.1(c) for the year ended December 31, 2005. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audit.
 
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
 
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Ferro Corporation and subsidiaries as of December 31, 2005, and the results of their operations and their cash flows for the year ended December 31, 2005, in conformity with accounting principles generally accepted in the United Sates of America. Also, in our opinion, such financial statement schedule for the year ended December 31, 2005, when considered in relation to the basic 2005 consolidated statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated September 29, 2006, expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an adverse opinion on the effectiveness of the Company’s internal control over financial reporting because of material weaknesses.
 
/s/  Deloitte & Touche LLP
 
Cleveland, Ohio
September 29, 2006


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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
The Board of Directors and Shareholders
Ferro Corporation:
 
We have audited the accompanying consolidated balance sheet of Ferro Corporation and subsidiaries as of December 31, 2004, and the related consolidated statements of income, shareholders’ equity and comprehensive income, and cash flows for each of the years in the two-year period ended December 31, 2004. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule listed in the index at Item 15(a) for the two-year period ended December 31, 2004. These consolidated financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Ferro Corporation and subsidiaries as of December 31, 2004, and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
 
The accompanying financial statements have been prepared assuming the Company will continue as a going concern. As discussed in note 3 to the financial statements, the Company faces certain liquidity uncertainties that raise substantial doubt about its ability to continue as a going concern. Management’s plan in regard to these matters are also described in note 3. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
 
As discussed in note 1 to the consolidated financial statements, effective January 1, 2003, the Company adopted the provisions of Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations; and effective January 1, 2002, the Company voluntarily early adopted the provisions of the Financial Accounting Standards Board’s Emerging Issues Tax Force Issue No. 04-06, Accounting for Stripping Costs Incurred During Production in the Mining Industry.
 
/s/  KPMG LLP
 
Cleveland, Ohio
March 31, 2006, except as to note 20,
  which is as of September 28, 2006.


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FERRO CORPORATION AND CONSOLIDATED SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF INCOME
 
                         
    Years Ended December 31,  
    2005     2004     2003  
    (Dollars in thousands, except per share data)  
 
Net sales
  $ 1,882,305     $ 1,843,721     $ 1,615,598  
Cost of sales
    1,501,355       1,461,514       1,242,414  
Selling, general and administrative expenses
    310,882       312,441       315,910  
Other expense (income):
                       
Interest expense
    46,919       41,993       43,106  
Interest earned
    (538 )     (887 )     (883 )
Foreign currency transactions, net
    1,284       3,035       1,199  
Gain on sale of businesses
    (69 )     (5,195 )      
Miscellaneous (income) expense, net
    (1,600 )     (372 )     1,836  
                         
Income before taxes
    24,072       31,192       12,016  
Income tax expense
    6,928       3,352       2,378  
                         
Income from continuing operations
    17,144       27,840       9,638  
Discontinued operations:
                       
Loss from discontinued operations, net of tax
                (903 )
(Loss) gain on disposal of discontinued operations, net of tax
    (868 )     (2,915 )     5,315  
                         
Net income
    16,276       24,925       14,050  
Dividends on preferred stock
    (1,490 )     (1,705 )     (2,088 )
                         
Net income available to common shareholders
  $ 14,786     $ 23,220     $ 11,962  
                         
Per common share data
                       
Basic earnings (loss):
                       
From continuing operations
  $ 0.37     $ 0.62     $ 0.18  
From discontinued operations
    (0.02 )     (0.07 )     0.11  
                         
    $ 0.35     $ 0.55     $ 0.29  
                         
Diluted earnings (loss):
                       
From continuing operations
  $ 0.37     $ 0.62     $ 0.18  
From discontinued operations
    (0.02 )     (0.07 )     0.11  
                         
    $ 0.35     $ 0.55     $ 0.29  
                         
 
See accompanying notes to consolidated financial statements.


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Table of Contents

FERRO CORPORATION AND CONSOLIDATED SUBSIDIARIES
 
CONSOLIDATED BALANCE SHEETS
 
                 
    December 31,  
    2005     2004  
    (Dollars in thousands)  
 
ASSETS
Current assets
               
Cash and cash equivalents
  $ 17,413     $ 13,939  
Accounts and trade notes receivable, net
    182,390       184,470  
Notes receivable
    112,744       114,030  
Inventories
    215,257       220,126  
Deferred income taxes
    40,732       45,647  
Other current assets
    42,183       34,137  
                 
Total current assets
    610,719       612,349  
Other assets
               
Property, plant and equipment, net
    531,139       598,719  
Intangibles, net
    410,666       412,507  
Deferred income taxes
    61,130       46,696  
Other non-current assets
    54,890       63,166  
                 
Total assets
  $ 1,668,544     $ 1,733,437  
                 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities
               
Loans payable and current portion of long-term debt
  $ 7,555     $ 9,674  
Accounts payable
    236,282       260,215  
Income taxes
    5,474       3,609  
Accrued payrolls
    25,112       31,468  
Accrued expenses and other current liabilities
    92,461       96,017  
                 
Total current liabilities
    366,884       400,983  
Other liabilities
               
Long-term debt, less current portion
    546,168       497,314  
Post-retirement and pension liabilities
    230,320       247,132  
Deferred income taxes
    14,002       15,304  
Other non-current liabilities
    22,611       27,610  
                 
Total liabilities
    1,179,985       1,188,343  
Series A convertible preferred stock
    20,468       22,829  
Shareholders’ equity
               
Common stock, par value $1 per share; 300,000,000 shares authorized; 52,323,053 shares issued
    52,323       52,323  
Paid-in capital
    163,074       162,912  
Retained earnings
    595,902       605,521  
Accumulated other comprehensive loss
    (115,990 )     (67,683 )
Other
    (6,123 )     (7,292 )
                 
      689,186       745,781  
Common shares in treasury, at cost
    (221,095 )     (223,516 )
                 
Total shareholders’ equity
    468,091       522,265  
                 
Total liabilities and shareholders’ equity
  $ 1,668,544     $ 1,733,437  
                 
 
See accompanying notes to consolidated financial statements.


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Table of Contents

FERRO CORPORATION AND CONSOLIDATED SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND
COMPREHENSIVE INCOME
 
                                                                 
                                  Accumulated
          Total
 
    Common Shares
                      Other
          Share-
 
    In Treasury     Common
    Paid-in
    Retained
    Comprehensive
          holders’
 
    Shares     Amount     Stock     Capital     Earnings     Income (Loss)(a)     Other     Equity(b)  
                (In thousands, except per share data)              
 
Balances at December 31, 2002
    11,807     $ (247,530 )     52,323       153,115       618,119       (131,183 )     (6,118 )   $ 438,726  
Net income
                                    14,050                       14,050  
Other comprehensive income (loss), net of tax:
                                                               
Foreign currency translation adjustment
                                            57,043               57,043  
Minimum pension liability adjustment(b)
                                            (9,426 )             (9,426 )
Other adjustments(b)
                                            270               270  
                                                                 
Total comprehensive income
                                                            61,937  
Cash dividends(c):
                                                               
Common
                                    (23,552 )                     (23,552 )
Preferred
                                    (2,088 )                     (2,088 )
Federal tax benefits(b)
                                    59                       59  
Transactions involving benefit plans(b)
    (941 )     13,879               6,047                       (797 )     19,129  
                                                                 
Balances at December 31, 2003
    10,866     $ (233,651 )     52,323       159,162       606,588       (83,296 )     (6,915 )   $ 494,211  
Net income
                                    24,925                       24,925  
Other comprehensive income (loss), net of tax:
                                                               
Foreign currency translation adjustment
                                            25,166               25,166  
Minimum pension liability adjustment(b)
                                            (9,778 )             (9,778 )
Other adjustments(b)
                                            225               225  
                                                                 
Total comprehensive income
                                                            40,538  
Cash dividends(c):
                                                               
Common
                                    (24,344 )                     (24,344 )
Preferred
                                    (1,705 )                     (1,705 )
Federal tax benefits(b)
                                    57                       57  
Transactions involving benefit plans(b)
    (681 )     10,135               3,750                       (377 )     13,508  
                                                                 
Balances at December 31, 2004
    10,185     $ (223,516 )     52,323       162,912       605,521       (67,683 )     (7,292 )   $ 522,265  
Net income
                                    16,276                       16,276  
Other comprehensive income (loss), net of tax:
                                                               
Foreign currency translation adjustment
                                            (38,769 )             (38,769 )
Minimum pension liability adjustment(b)
                                            (9,518 )             (9,518 )
Other adjustments(b)
                                            (20 )             (20 )
                                                                 
Total comprehensive loss
                                                            (32,031 )
Cash dividends(c):
                                                               
Common
                                    (24,447 )                     (24,447 )
Preferred
                                    (1,490 )                     (1,490 )
Federal tax benefits(b)
                                    42                       42  
Transactions involving benefit plans(b)
    (215 )     2,421               162                       1,169       3,752  
                                                                 
Balances at December 31, 2005
    9,970     $ (221,095 )     52,323       163,074       595,902       (115,990 )     (6,123 )   $ 468,091  
                                                                 
 
See accompanying notes to consolidated financial statements.
 
 
(a) Accumulated translation adjustments were $(37,125), $1,644, and $(23,522), and accumulated minimum pension liability adjustments were $(79,340), $(69,822), and $(60,044) at December 31, 2005, 2004, and 2003, respectively.
 
(b) Income tax benefits (expenses) in 2005, 2004, and 2003, respectively, related to minimum pension liability adjustments were $5,125, $6,371, and $5,123, related to other adjustments to other comprehensive income were $11, $(121), and $(145), related to dividends on performance shares were $42, $57, and $59, and related to exercised stock options were $181, $785, and $185.
 
(c) Dividends per share of common stock were $0.58 for 2005, 2004 and 2003. Dividends per share of convertible preferred stock were $3.25 for 2005, 2004 and 2003.


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FERRO CORPORATION AND CONSOLIDATED SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
 
                         
    Years Ended December 31,  
    2005     2004     2003  
    (Dollars in thousands)  
 
Cash flows from operating activities
                       
Net income
  $ 16,276     $ 24,925     $ 14,050  
Adjustments to reconcile net income to net cash provided by operating activities
                       
Loss from discontinued operations, net of tax
                903  
Loss (gain) on disposal of discontinued operations, net of tax
    868       2,915       (5,315 )
Gain on sale of business, net of tax
          (3,376 )      
Loss (gain) on sale of fixed assets
    948       (1,419 )     (454 )
Depreciation and amortization
    74,823       75,020       76,634  
Provision for allowance for doubtful accounts
    1,799       3,650       1,218  
Retirement benefits
    (20,345 )     16,186       6,282  
Deferred income taxes
    (9,125 )     (10,477 )     (8,226 )
Net (payments) proceeds from asset securitization
    (2,642 )     2,182       (84,238 )
Changes in current assets and liabilities, net of effects of acquisitions
                       
Accounts and trade notes receivable
    (7,357 )     5,354       (39,557 )
Inventories
    (343 )     (37,210 )     114  
Other current assets
    (5,400 )     (16,969 )     8,705  
Accounts payable
    (17,595 )     20,494       31,911  
Accrued expenses and other current liabilities
    (3,312 )     (26,384 )     (12,649 )
Other operating activities
    (5,428 )     8,595       15,198  
                         
Net cash provided by continuing operations
    23,167       63,486       4,576  
Net cash used for discontinued operations
    (1,786 )     (1,582 )     (1,068 )
                         
Net cash provided by operating activities
    21,381       61,904       3,508  
Cash flows from investing activities
                       
Capital expenditures for plant and equipment of continuing operations
    (42,825 )     (39,054 )     (36,055 )
Capital expenditures for plant and equipment of discontinued operations
                (381 )
Divestitures, net of cash, of discontinued operations
                19,685  
Acquisitions, net of cash acquired, of continuing operations
    (1,908 )     (2,533 )      
Cash adjustments to purchase price of prior acquisition
          8,505       (8,478 )
Proceeds from the sale of assets and businesses
    9,287       11,872       1,750  
Buy-out of operating lease
                (25,000 )
Other investing activities
    (368 )     1,826       (1,183 )
                         
Net cash used for investing activities
    (35,814 )     (19,384 )     (49,662 )
Cash flows from financing activities
                       
Net (repayments) borrowings under short-term facilities
    (2,119 )     (3,533 )     4,608  
Proceeds from revolving credit facility
    949,867       661,162       670,092  
Principal payments on revolving credit facility
    (901,482 )     (688,159 )     (598,514 )
Cash dividends paid
    (25,937 )     (26,049 )     (25,640 )
Other financing activities
    (2,192 )     4,777       3,094  
                         
Net cash provided by (used for) financing activities
    18,137       (51,802 )     53,640  
Effect of exchange rate changes on cash
    (230 )     (160 )     953  
                         
Increase (decrease) in cash and cash equivalents
    3,474       (9,442 )     8,439  
Cash and cash equivalents at beginning of period
    13,939       23,381       14,942  
                         
Cash and cash equivalents at end of period
  $ 17,413     $ 13,939     $ 23,381  
                         
Cash paid during the period for
                       
Interest
  $ 44,092     $ 39,900     $ 36,640  
Income taxes
  $ 9,487     $ 22,199     $ 11,871  
 
See accompanying notes to consolidated financial statements.


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Table of Contents

FERRO CORPORATION AND CONSOLIDATED SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2005, 2004 and 2003
 
1.   Summary of significant accounting policies
 
Nature of Operations
 
Ferro Corporation (“Company” or “Ferro”) is a worldwide producer of performance materials for manufacturers. Ferro produces a variety of coatings and performance chemicals by utilizing organic and inorganic chemistry. The Company’s materials are used extensively in the markets of building and renovation, automotive, major appliances, household furnishings, transportation, electronics and industrial products. Ferro’s products are sold principally in the United States and Europe; however, operations also extend to the Latin America and Asia Pacific regions.
 
Principles of Consolidation
 
The consolidated financial statements include the accounts of the Company and its majority owned and controlled subsidiaries. Intercompany accounts, transactions and profits have been eliminated. Minority interests in consolidated subsidiaries are classified as other non-current liabilities. Investments in affiliated companies, over which Ferro has significant influence, but does not have effective control, are accounted for using the equity method and classified in other non-current assets. Financial results for acquisitions are included in the Company’s consolidated financial statements from the date of acquisition.
 
Use of Estimates and Assumptions in the Preparation of Financial Statements
 
The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The more significant estimates and judgments pertain to environmental and other contingent liabilities, income taxes, pension and other postretirement benefits, inventories, restructuring and cost reduction programs, revenue recognition, valuation of goodwill and other intangibles, assessment of long-lived assets, asset retirement obligations, and derivative financial instruments. Actual results could differ from those estimates.
 
Currency Translation
 
Operations in non-U.S. subsidiaries are recorded in local currencies, which are in most cases also the functional currencies for financial reporting purposes. The results of operations for non-U.S. subsidiaries are translated from local currencies into U.S. dollars using the average exchange rate during each period, which approximates the results that would be obtained using actual exchange rates on the dates of individual transactions. Assets and liabilities are translated using exchange rates at the end of the period with translation adjustments recorded as a separate component of accumulated other comprehensive income (loss) in shareholders’ equity. Transaction gains and losses are recorded as incurred in foreign currency transactions, net, in the consolidated statements of income.
 
For the U.S. parent and for subsidiaries that also use the U.S. dollar as the functional currency, remeasurement and transaction gains and losses are reflected in net income.
 
Revenue Recognition
 
The Company recognizes revenue when persuasive evidence of an arrangement exists, the selling price is fixed and determinable, collection is reasonably assured, and title has passed to its customers. Provision is made for uncollectible accounts based on historical experience and specific circumstances, as appropriate. Accounts deemed to be uncollectible or to require excessive collection costs are written off against the provision for doubtful accounts. Customer rebates are accrued over the rebate periods based upon estimated attainments of the provisions in the rebate agreements using available information and recorded as reductions of sales.


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FERRO CORPORATION AND CONSOLIDATED SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
In 2000, the Emerging Issues Task Force reached consensus on Issue 00-10, “Accounting for Shipping and Handling Fees and Costs,” which required all amounts billed to customers related to shipping and handling fees to be classified as revenue with related costs being recorded in cost of sales. In 2004, the Company identified that shipping and handling fees were embedded in amounts billed to customers, and the related costs were being reported as a reduction of revenues. Such costs for 2005 and 2004 were $37.9 million and $36.8 million, respectively and are reported in cost of sales. Shipping and handling costs for 2003 are reported as a reduction of revenues because the amount, which management believes is not material to sales and cost of sales, could not be determined due to extensive financial systems implementations in that year.
 
Stock-based Compensation
 
The Company has stock-based employee compensation plans, which are more fully described in Note 4. The Company accounts for its stock-based compensation under the recognition and measurement principles of Accounting Principles Board Opinion No. 25 (APB No. 25) and related interpretations. Compensation costs, if any, for stock-based awards are recognized over the vesting periods of the awards. Substantially all stock options granted had an exercise price equal to the market value of the underlying common stock on the date of the grant and, therefore, had no compensation costs. Compensation costs for performance share awards are based on the quoted price of the Company’s common stock at the end of each period. The initial performance share costs are charged to unearned compensation in Shareholders’ Equity and amortized to expense over the term of the performance share plans.
 
The following table shows pro forma information regarding net income and earnings per share as if the Company had accounted for stock options based on the fair value at the grant date under the fair value recognition provisions of FASB Statement No. 123 “Accounting for Stock-Based Compensation.” The fair value for these options was estimated at the date of grant using a Black-Scholes option-pricing model.
 
                         
    2005     2004     2003  
    (Dollars in thousands,
 
    except per share data)  
 
Income available to common shareholders from continuing operations — as reported
  $ 15,654     $ 26,135     $ 7,550  
Add: Stock-based employee compensation expense included in reported income, net of tax
    175       143       143  
Deduct: Total stock-based employee compensation expense determined under fair value methods for all awards, net of tax
    (3,353 )     (3,490 )     (3,406 )
                         
Income available to common shareholders from continuing operations — pro forma
  $ 12,476     $ 22,788     $ 4,287  
                         
Basic earnings per share from continuing operations — as reported
  $ 0.37     $ 0.62     $ 0.18  
Basic earnings per share from continuing operations — pro forma
  $ 0.29     $ 0.54     $ 0.10  
Diluted earnings per share from continuing operations — as reported
  $ 0.37     $ 0.62     $ 0.18  
Diluted earnings per share from continuing operations — pro forma
  $ 0.29     $ 0.54     $ 0.10  
Weighted-average fair value of options granted
  $ 5.17     $ 6.65     $ 7.12  
Expected life of option in years
    6.80       6.80       7.35  
Risk-free interest rate
    3.80 %     3.30 %     4.02 %
Expected volatility
    29.93 %     28.07 %     28.90 %
Expected dividend yield
    2.97 %     2.40 %     2.43 %
 
There was no impact of the pro forma expense on discontinued operations for 2005, 2004, or 2003.


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FERRO CORPORATION AND CONSOLIDATED SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
Postretirement and Other Employee Benefits
 
Costs are recognized as employees render the services necessary to earn the related benefits.
 
Research and Development
 
The costs of research and development are charged as an expense in the period in which they are incurred.
 
Restructuring and Cost Reduction Programs
 
Costs associated with exit and disposal activities are recognized when liabilities are incurred. Reserves are established for such activities by estimating employee termination costs utilizing detailed restructuring plans approved by management. Reserve calculations are based upon various factors including an employee’s length of service, contract provisions, salary level and health care benefit choices. The Company believes the estimates and assumptions used to calculate these restructuring provisions are appropriate, and although significant changes are not anticipated, actual costs could differ from the estimates should changes be made in the nature or timing of the restructuring plans. The resulting changes in costs could have a material impact on the Company’s results of operations, financial position, or cash flows.
 
Income Taxes
 
Income taxes are determined using the liability method of accounting for income taxes in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (FAS No. 109). Under FAS No. 109, income tax expense includes U.S. and international income taxes plus the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested. Tax credits and other incentives reduce tax expense in the year the credits are claimed. Deferred tax assets are recognized if it is more likely than not that the assets will be realized in future years. Valuation allowances are recorded against net deferred tax assets for which management believes realization is not more likely than not.
 
Earnings per Share
 
Basic earnings per share is calculated by dividing net income available to common shareholders by the weighted average number of shares outstanding for the period. Diluted earnings per share is calculated by dividing net income available to common shareholders by the weighted average number of shares outstanding for the period, adjusted for the effect of the assumed exercise of all dilutive options outstanding at the end of the period.
 
Cash Equivalents
 
Cash equivalents consist of highly liquid instruments with original maturities of three months or less and are carried at cost, which approximates market value.
 
Allowance for Doubtful Accounts
 
Provision is made for uncollectible accounts based on historical experience and specific circumstances, as appropriate. Accounts deemed to be uncollectible or to require excessive collection costs are written off against the allowance for doubtful accounts. The allowance for possible losses in the collection of accounts and trade notes receivable totaled $7.5 million and $9.2 million at December 31, 2005 and 2004, respectively. Bad debt expense was $1.8 million, $3.7 million, and $1.2 million for 2005, 2004 and 2003, respectively.
 
Inventories
 
Inventories are valued at the lower of cost or market. Cost is determined utilizing the first-in, first-out (FIFO) method, except for selected inventories where the last-in, first-out (LIFO) method is used. Inventory valuation is


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periodically evaluated primarily based upon the age of the inventory, but also considers assumptions of future demand and market conditions. As a result of the evaluation, the inventory may be written down to the lower of cost or realizable value. If actual circumstances are less favorable than those projected by management, additional write-downs may be required.
 
Property, Plant and Equipment
 
Property, plant and equipment are capitalized at cost. Acquisitions, additions and betterments, either to provide necessary capacity, improve the efficiency of production units, modernize or replace older facilities or to install equipment for environmental protection are capitalized. The Company capitalizes interest costs incurred during the period of construction of plants and equipment. Repair and maintenance costs are charged against earnings as incurred, except for major planned maintenance activities. Such activities generally include relining smelter furnaces; related costs are accrued in advance of when the costs are expected to be incurred which normally ranges between 18 and 24 months.
 
Depreciation of plant and equipment is provided on a straight-line basis for financial reporting purposes, generally over the following estimated useful lives of the assets:
 
     
Buildings
  20 to 40 years
Machinery and equipment
  5 to 15 years
 
At December 31, 2005 and 2004, estimated liabilities for asset retirement obligations (“AROs”) were $1.0 million and $0.1 million, respectively. In determining the amounts recorded relating to conditional AROs, the Company utilizes an expected value technique whereby potential settlement dates and related probabilities are based upon management’s judgment, taking into consideration the Company’s historical practices, current business intentions, and other relevant information. Legal obligations exist in connection with the retirement of assets at many of the Company’s operating facilities that would be triggered upon closure of the facilities or abandonment of existing operations. If certain operating facilities were to be closed, for which there are no current intentions to do so, changes to or settlements of the related conditional AROs could significantly affect the Company’s results of operations and cash flows at that time.
 
Valuation of Goodwill and Other Intangibles
 
The Company adopted Financial Accounting Standards Board (“FASB”) Statement No. 142, “Goodwill and Other Intangible Assets,” (FAS No. 142) for goodwill and intangible assets acquired after June 30, 2001 as of July 1, 2001. FAS No. 142 was adopted in its entirety as of January 1, 2002 and accordingly, the Company’s goodwill and intangible assets with indefinite useful lives are no longer being amortized.
 
Fair value is estimated using the discounted cash flow method. The Company uses projections of market growth, internal sales efforts, input cost movements, and cost reduction opportunities to project future cash flows. Certain corporate expenses and assets and liabilities are allocated to the reporting units in this process. Using a risk adjusted, weighted average cost-of-capital, the Company discounts the cash flow projections to the annual measurement date, October 31st. If the fair value of any of the reporting units were determined to be less than its carrying value, the Company would proceed to the second step and obtain independent appraisals of its assets. In 2005 and 2004, the fair value exceeded the carrying value, and therefore, it was not necessary to obtain independent appraisals.
 
Assessment of Long-Lived Assets
 
The Company’s long-lived assets include property, plant, equipment, goodwill and other intangible assets. Property, plant and equipment are depreciated on a straight-line basis over their estimated useful lives.


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Property, plant and equipment are reviewed for impairment whenever events or circumstances indicate that the undiscounted net cash flows to be generated by their use and eventual disposition is less than their recorded value. In the event of impairment, a loss is recognized for the excess of the recorded value over fair value. The long-term nature of these assets requires the estimation of cash inflows and outflows several years into the future and only takes into consideration technological advances known at the time of review.
 
Due to depressed conditions in the electronics industry in late 2004 and 2005, the Company specifically evaluated its electronics assets in Holland. The Company also evaluated its Italian tile and Belgium polymer additives manufacturing assets because of sluggish market conditions in these regions. In each situation, management concluded that the assets were not impaired.
 
Asset Securitization
 
Certain of the Company’s receivables are sold to a wholly-owned unconsolidated qualified special purpose entity, Ferro Finance Corporation (“FFC”). FFC can sell, under certain conditions, an undivided fractional ownership interest in the pool of receivables to multi-seller receivables securitization companies (commercial paper conduits). Additionally, under this program, receivables of certain European subsidiaries were sold directly to other commercial paper conduits during 2003. The Company and certain European subsidiaries, on behalf of FFC and the commercial paper conduits, provide service, administration and collection of the receivables. In accordance with FASB Statement No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” neither amounts borrowed under the program nor servicing liabilities are recorded on the Company’s balance sheet.
 
The Company retains interest in the receivables transferred to FFC and the commercial paper conduits in the form of notes receivable to the extent that receivables transferred exceed advances. FFC and the commercial paper conduits have no recourse to the Company’s other assets for failure of debtors to pay when due. The Company and certain European subsidiaries, on a monthly basis, measure the fair value of the notes receivable based on management’s best estimate of the undiscounted expected future cash collections on the transferred receivables.
 
Environmental and Other Contingent Liabilities
 
The Company’s operations are subject to various hazards incidental to the production of some of its products, including the use, handling, processing, and storage of hazardous materials. The Company expenses recurring costs associated with control and disposal of hazardous materials in current operations. Accruals for environmental remediation and other contingent liabilities, including those relating to ongoing, pending or threatened litigation, are recorded if available information indicates it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. The amount accrued for environmental remediation reflects the Company’s assumptions about remediation requirements at the contaminated site, the nature of the remedy, existing technology, the outcome of discussions with regulatory agencies and other potentially responsible parties at multi-party sites, and the number and financial viability of other potentially responsible parties. Estimated costs are not discounted due to the uncertainty with respect to the timing of related payments. The Company actively monitors the status of sites, and as assessments and cleanups proceed, accruals are reviewed periodically and adjusted, if necessary, as additional information becomes available. If the loss is neither probable nor reasonably estimable, but is reasonably possible, the Company provides appropriate disclosure if the contingency is material. Changes in the estimates on which the accruals are based, unanticipated government enforcement actions, or changes in health, safety, environmental regulation, and testing requirements could result in higher or lower costs.
 
Derivative Financial Instruments
 
The Company employs derivative financial instruments, primarily foreign currency forward exchange contracts and foreign currency options, to hedge certain anticipated transactions, firm commitments, or assets


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

and liabilities denominated in foreign currencies. Gains and losses on foreign currency forward exchange contracts and foreign currency options are recognized as foreign currency transaction gains and losses.
 
The Company purchases portions of its natural gas requirements under fixed price contracts, which in certain circumstances, although unlikely because committed quantities are below expected usage, could result in the Company settling its obligations under these contracts in cash at prevailing market prices. In compliance with FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities,” (FAS No. 133), as amended by Statement No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” (FAS No. 149), the Company marked these contracts to fair value and recognized the resulting gains or losses as miscellaneous income or expense, respectively.
 
The Company consigns, from various financial institutions, precious metals (primarily silver, gold, platinum and palladium, collectively “metals”) used in the production of certain products for customers. Under these consignment arrangements, the financial institutions provide the Company with metals for a specified period of one year or less in duration, for which the Company pays a fee. Under these arrangements, the financial institutions own the metals, and accordingly, the Company does not report these consigned materials as inventory on its consolidated balance sheet. These agreements are cancelable by either party at the end of each consignment period, however, because the Company has access to a number of consignment arrangements with available capacity, consignment needs can be shifted among the other participating institutions. In certain cases, these other participating institutions may require cash deposits to provide additional collateral beyond the underlying precious metals. Fees for these contracts are recorded as cost of sales.
 
Reclassifications
 
Certain reclassifications have been made to prior year balances to conform to current year presentation.
 
Recently Adopted Accounting Pronouncements
 
In June 2001, the FASB issued Statement No. 143, “Accounting for Asset Retirement Obligations,” (FAS No. 143). FAS No. 143 requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. When a liability is initially recorded, the entity capitalizes a cost by increasing the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the liability, an entity either settles the obligation for its recorded amount or incurs a gain or loss upon settlement. The Company adopted FAS No. 143 as of January 1, 2003, and recognized asset retirement obligations of $0.1 million. The ongoing expense on an annual basis resulting from the adoption of FAS No. 143 is not material to the Company’s results of operations.
 
FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations,” (Interpretation No. 47) was issued in March 2005 and is effective for fiscal years ending after December 15, 2005. Interpretation No. 47 clarifies that the term “conditional asset retirement obligation” as used in FASB Statement No. 143, “Accounting for Asset Retirement Obligation,” refers to an unconditional legal obligation to perform an asset retirement activity in which the timing or method of settlement are conditional on a future event. This obligation should be recognized at its fair value, if that value can be reasonably estimated. The Company adopted Interpretation No. 47 as of January 1, 2005, and recorded additional conditional asset retirement obligations of $0.9 million; the effect of Interpretation No. 47 on the Company’s net income and earnings per share for the years ended December 31, 2003 and 2004, is not material.
 
In July 2002, the FASB issued Statement No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” (FAS No. 146). FAS No. 146 applies to costs from activities such as eliminating or reducing product lines, terminating employees and contracts, and relocating plant facilities or personnel. The Company adopted FAS No. 146 as of January 1, 2003, and accordingly, records exit or disposal costs when they are “incurred” and can


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be measured at fair value. The adoption of FAS No. 146 did not have an impact on the financial statements because the Company recorded restructuring and integration charges as summarized in Note 9 of the Company’s consolidated financial statements using the guidance under FASB Statement No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits” and FASB Statement No. 112, “Employers’ Accounting for Postemployment Benefits.”
 
The FASB published Interpretation No. 46, “Consolidation of Variable Interest Entities,” (Interpretation No. 46) in January 2003 and Interpretation No. 46R of the same name (Interpretation No. 46R) in December 2003. Interpretation No. 46 addresses consolidation by business enterprises of variable interest entities and requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risk among the parties involved. Interpretation No. 46R clarifies some of the provisions of FASB Interpretation No. 46 and exempts certain entities from its requirements. Under the transition provisions of Interpretation No. 46R, special effective dates apply to enterprises that have fully or partially applied Interpretation No. 46 prior to issuance of Interpretation No. 46R. The Company adopted Interpretation No. 46 as of October 1, 2003, and Interpretation No. 46R as of January 1, 2004. The adoption of these Interpretations did not have a material impact on the results of operations or financial position of the Company. In June 2003, the Company bought out its asset defeasance program that would have required consolidation under Interpretation No. 46.
 
In January 2004, the FASB issued FASB Staff Position (“FSP”) No. FAS 106-1, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003,” (FSP No. 106-1). FSP No. 106-1 was superseded by FSP No. 106-2 of the same name, issued in May 2004. It was effective for the first interim or annual period beginning after June 15, 2004, and applied only to sponsors of single-employer defined benefit postretirement health care plans for which a) the employer concluded that prescription drug benefits available under the plan to some or all participants for some or all future years are “actuarially equivalent” to Medicare Part D and thus qualify for the subsidy under the Medicare Prescription Drug Improvement and Modernization Act of 2003 and b) the expected subsidy offset or reduced the employer’s share of the cost of the underlying post-retirement prescription drug coverage on which the subsidy is based. The Company adopted FSP No. 106-2 as of July 1, 2004, and had a reduction of approximately $0.1 million in the Company’s net periodic postretirement pension cost in each of the third and fourth quarters of 2004, and a reduction of $0.2 million to the accumulated postretirement benefit obligation as of December 31, 2004.
 
In October 2004, the American Jobs Creation Act of 2004 (the “Act”) was signed into Federal law. The FASB issued two staff positions to address the accounting for income taxes in conjunction with the Act. The Act, when fully phased-in, includes a tax deduction of up to 9 percent of the lesser of (a) qualified production activities income or (b) taxable income, both as defined in the Act. FSP No. 109-1, “Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities provided by the American Jobs Creation Act of 2004,” (FSP No. 109-1) was effective upon its release in December 2004. FSP No. 109-1 requires companies to treat the tax deduction as a special deduction instead of a change in tax rate that would have impacted existing deferred tax balances. Adoption of FSP No. 109-1 did not have a material impact on the Company’s income tax provision.
 
In addition, the Act includes a special one-time tax deduction of 85 percent of certain foreign earnings that are repatriated no later than in the 2005 tax year. FSP No. FAS 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004,” (FSP No. 109-2) was issued in December 2004 and was effective upon issuance. FSP No. 109-2 established accounting and disclosure requirements for enterprises in the process of evaluating the repatriation provision of the Act. Based on the Company’s analysis, repatriation under the Act would not have provided significant additional benefits, and therefore, the application of FSP No. 109-2 did not affect income tax expense in the period of enactment or any related disclosures.
 
In December 2004, the FASB issued Statement No. 153, “Exchanges of Nonmonetary Assets,” (FAS No. 153). This statement, effective for fiscal periods beginning after June 15, 2005, amends APB Opinion No. 29 to eliminate


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The adoption of FAS No. 153 had no impact on the results of operations or the financial position of the Company.
 
Newly Issued Accounting Pronouncements
 
The FASB’s Emerging Issues Task Force (the “EITF”) ratified Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” in March 2004. The issue provided guidance for evaluating whether an investment is other-than-temporarily impaired and was effective for other- than-temporary impairment evaluations made in reporting periods beginning after June 15, 2004. However, the guidance contained in paragraphs 10-20 was delayed by FSP EITF Issue No. 03-1-1, “Effective Date of Paragraphs 10 — 20 of EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” in September 2004; the delay of that effective date will be superseded concurrent with the final issuance of FSP EITF Issue 03-1-a. The adoption of EITF Issue No. 03-1 is not expected to have a material impact on the Company’s results of operations or financial position.
 
The FASB issued Statement No. 151, “Inventory Costs,” (FAS No. 151) in November 2004. FAS No. 151 is effective for fiscal years beginning after June 15, 2005, and amends the guidance of ARB No. 43 to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage). FAS No. 151 requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” The adoption of FAS No. 151 as of January 1, 2006, is not expected to have a material impact on the results of operations or financial position of the Company.
 
In December 2004, the FASB issued Statement No. 123R, “Share-Based Payment,” (FAS No. 123R) that requires public entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which the employee is required to provide services in exchange for the award. FAS No. 123R is effective for interim and annual periods beginning after June 15, 2005, and applies to all outstanding and unvested share-based payment awards as of the adoption date. In April 2005, the Securities and Exchange Commission published a rule allowing public companies with calendar year ends to delay the quarter in which they begin to expense stock options to first quarter 2006 from third quarter 2005. The Company plans to adopt FAS No. 123R beginning January 1, 2006, using the modified prospective method and expects to incur pre-tax charges of approximately $3 million to $4 million for 2006.
 
In May 2005, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections — a replacement of APB Opinion No. 20 and FASB Statement No. 3,” (FAS No. 154). This Statement requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change or unless specific transition provisions are proscribed in the accounting pronouncements. FAS No. 154 does not change the accounting guidance for reporting a correction of an error in previously issued financial statements or a change in accounting estimate. FAS No. 154 is effective for accounting changes and error corrections made after December 31, 2005. The Company will apply this standard prospectively.
 
In September 2005, the EITF reached a consensus on Issue No. 04-13, “Accounting for Purchase and Sales of Inventory with the Same Counterparty,” that requires companies to recognize an exchange of finished goods for raw materials or work-in-progress within the same line of business at fair value. All other exchanges of inventory should be reflected at the recorded amount. This consensus is effective for transactions completed after March 31, 2006, and is not expected to have a material impact on the results of operations or financial position of the Company.
 
In March 2006, the FASB issued Statement No. 156 “Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140,” (FAS No. 156). This statement requires an entity to recognize at fair value, if practicable, a servicing asset or liability each time it undertakes an obligation to service a financial asset by


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entering into a servicing contract in certain situations primarily relating to off-balance sheet arrangements. Entities may chose between two subsequent measurement methods for each class of separately recognized servicing assets and servicing liabilities. FAS No. 156 is effective for fiscal years beginning after September 15, 2006. The provisions of FAS No. 156 are to be applied prospectively to transactions entered into after its adoption. The Company will adopt FAS No. 156 as of January 1, 2007, as permitted, and is currently evaluating the implementation options; at this time, the Company is uncertain as to the impact on the Company’s results of operations and financial position.
 
The FASB published Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (Interpretation No. 48) in June 2006. This interpretation requires companies to determine whether it is more likely than not that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit can be recorded in the financial statements. Interpretation No. 48 also provides guidance on derecognition, classification, accounting in interim periods, and disclosure requirements for tax contingencies. This interpretation is effective for fiscal years beginning after December 15, 2006. The Company is currently assessing the impact that Interpretation No. 48 will have on the Company’s results of operations and financial position.
 
In September 2006, the FASB published Staff Position No. AUG AIR-1, “Accounting for Planned Maintenance Activities.” This staff position prohibits the use of the accrue-in-advance method of accounting for planned major maintenance activities. It is effective for fiscal years beginning after December 15, 2006, and is to be applied retrospectively. When adopted in fiscal 2007, the staff position will increase retained earnings as of the beginning of 2005 by approximately $1.6 million, increase 2005 income from continuing operations by approximately $0.4 million and increase 2005 net income by approximately by $0.3 million.
 
In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements,” (FAS No. 157). FAS No. 157 defines fair value, establishes a framework and gives guidance regarding the methods used for measuring fair value, and expands disclosures about fair value measurements. Accordingly, FAS No. 157 does not require any new fair value measurements, but will change current practice for some entities. FAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company will apply this standard prospectively.
 
In September 2006, the U.S. Securities and Exchange Commission (SEC) released Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” (SAB No. 108) which provides interpretive guidance on the SEC’s views regarding the process of quantifying materiality of financial statement misstatements. SAB No. 108 is effective for years ending after November 15, 2006, with early application for the first interim period ending after November 15, 2006. The Company does not believe that the application of SAB No. 108 will have a material effect on the Company’s results of operations or financial position.
 
2.   Inventories
 
Inventories as of December 31 are comprised of the following:
 
                 
    2005     2004  
    (Dollars in thousands)  
 
Raw materials
  $ 62,488     $ 61,249  
Work in process
    34,122       35,091  
Finished goods
    133,060       135,541  
                 
FIFO cost (approximates replacement cost)
    229,670       231,881  
LIFO reserve
    (14,413 )     (11,755 )
                 
Total
  $ 215,257     $ 220,126  
                 


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
The portion of inventories valued by the LIFO method at December 31 is as follows:
 
                 
    2005     2004  
 
United States
    14.9%       14.9%  
Consolidated
    7.0%       6.7%  
 
The LIFO reserve increased by $2.7 million in 2005, compared with an increase of $2.2 million in 2004.
 
3.   Financing and short-term and long-term debt
 
Notes and loans payable at December 31 are as follows:
 
                 
    2005     2004  
    (Dollars in thousands)  
 
Loans payable to banks
  $ 5,866     $ 8,159  
Current portion of long-term debt
    1,689       1,515  
                 
Total
  $ 7,555     $ 9,674  
                 
 
Long-term debt at December 31 is as follows:
 
                 
    2005     2004  
    (Dollars in thousands)  
 
$200,000 Senior notes, 9.125%, due 2009*
  $ 198,909     $ 197,549  
$25,000 Debentures, 7.625%, due 2013*
    24,877       24,864  
$25,000 Debentures, 7.375%, due 2015*
    24,965       24,961  
$50,000 Debentures, 8.0%, due 2025*
    49,550       49,526  
$55,000 Debentures, 7.125%, due 2028*
    54,532       54,511  
Revolving credit agreement
    186,100       137,400  
Capitalized lease obligations (see Note 17)
    7,364       8,161  
Other notes
    1,560       1,857  
                 
      547,857       498,829  
Less: Current portion
    1,689       1,515  
                 
Total
  $ 546,168     $ 497,314  
                 
 
 
* Net of unamortized discounts
 
The aggregate maturities of long-term debt are as follows:
 
                                     
2006   2007   2008   2009   2010
(Dollars in thousands)
 
$ 1,689       1,243       933       200,839       905  
 
Revolving Credit and Term Loan Agreement
 
At December 31, 2005, the Company had borrowed $186.1 million under a $300 million revolving credit facility that was scheduled to expire in September 2006 (“Prior Revolving Credit Facility”). The average interest rates for borrowings against the prior revolving credit facility at December 31, 2005 and 2004, were 6.4% and 4.0%, respectively.
 
The Prior Revolving Credit Facility contained financial covenants relating to total debt, fixed charges and EBITDA, cross default provisions with other debt obligations, and customary operating covenants that limited its


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ability to engage in certain activities, including significant acquisitions. In addition, when the Company’s senior credit rating was downgraded below Ba2 by Moody’s in March 2006, the Company and its domestic material subsidiaries were required to grant security interests in their tangible and intangible assets (with the exception of the receivables sold as part of the Company’s asset securitization program), pledge 100% of the stock of domestic material subsidiaries and pledge 65% of the stock of foreign material subsidiaries, in each case, in favor of the lenders under the senior credit facility. This lien grant and pledge of stock was substantially completed in April 2006. Liens on principal domestic manufacturing properties and the stock of domestic subsidiaries were also granted to and shared with the holders of the Company’s senior notes and debentures, as required by their indentures.
 
In March 2006, the Company accepted a commitment from a syndicate of lenders to underwrite a $700 million credit facility (the “New Credit Facility”) and, in June 2006, finalized the agreement. The New Credit Facility is comprised of a five year, $250 million multi-currency senior revolving credit facility and a six year, $450 million senior delayed-draw term loan facility. Under the terms of the New Credit Facility, the Company can request that the revolving credit facility be increased by $50 million at no additional fee.
 
The New Credit Facility was entered into to replace the Prior Revolving Credit Facility that was scheduled to expire in September 2006. In addition, the financing, through the term loan facility, provided capital resources sufficient to refinance the $200 million of senior notes and $155 million of debentures that could have become immediately due and payable due to defaults associated with the Company’s delayed SEC financial filings for 2005. Because one of the purposes of the term loan facility is to fund the potential acceleration of the senior notes and debentures, the term facility contains certain restrictions including, but not limited to, the following:
 
  •  $355 million of the facility is reserved to repay the senior notes and debentures;
 
  •  $95 million of the facility is immediately available for refunding indebtedness other than the senior notes and debentures;
 
  •  The Company may access up to $55 million of the $355 million reserved to repay the senior notes and debentures if these obligations have not already been paid in full and no event of default for these obligations exists and is continuing; and
 
  •  The Company may draw on the delayed-draw facility for up to one year with any unused commitment under the term facility terminating on June 6, 2007.
 
At the close of the New Credit Facility in June 2006, the Company drew $95 million of the term loan facility to partially repay the old revolving credit facility. In addition, during the third quarter of 2006, the Company drew down another $155 million of the term loan facility to repay $155 million of outstanding debentures, as bondholders accelerated payment on these obligations due to the previously mentioned 2005 SEC financial reporting delays. See further discussion under “Senior Notes and Debentures” below.
 
The New Credit Facility bears interest at a rate equal to, at the Company’s option, either (1) LIBOR or (2) the Alternate Base Rate (“ABR”) which is the higher of the Prime Rate and the Federal Funds Effective Rate plus 0.5%; plus, in each case, applicable margins based on the Company’s index debt rating. The New Credit Facility is secured by substantially all of the Company’s assets, including the assets and 100% of the shares of the Company’s material domestic subsidiaries and 65% of the shares of the Company’s “first tier” foreign subsidiaries, but excluding trade receivables sold pursuant to the Company’s accounts receivable sales programs (see below). These liens are shared with the holders of the Company’s senior notes, as required under the respective indenture.
 
The New Credit Facility contains customary operating covenants that limit the Company’s ability to engage in certain activities, including limitations on additional loans and investments; creation of additional liens; prepayments, redemptions and repurchases of debt; and mergers, acquisitions and asset sales. The Company is also subject to customary financial covenants including a leverage ratio and a fixed charge coverage ratio. Additional covenants of the New Credit Facility require the Company to file its 2005 Form 10-K by November 15, 2006, and its 2006 Forms 10-Q by the earlier of three months after the 2005 Form 10-K is filed or January 15, 2007. Failure to satisfy


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certain of these covenants, either immediately or after a brief period allowing the company to satisfy the covenant, would result in an event of default. If any event of default should occur and be continuing and a waiver not have been obtained, the obligations under the New Credit Facility may become immediately due and payable at the option of providers of more than 50% of the credit facility commitment.
 
Senior Notes and Debentures
 
At December 31, 2005, the Company had $355.0 million principal amount outstanding under debentures and senior notes, which had an estimated fair market value of $353.2 million. At December 31, 2004, the Company had $355.0 million principal amount outstanding, with an estimated fair market value of $387.1 million. Fair market value represents a third party’s indicative bid prices for these obligations. The Company’s senior credit rating was Ba1 by Moody’s Investor Service, Inc. (“Moody’s”) and BB by Standard & Poor’s Rating Group (“S&P”) at December 31, 2005. In March 2006, Moody’s downgraded its rating to B1 and then withdrew its ratings, and S&P downgraded its rating to B+. See further information regarding this matter in Note 22.
 
The indentures under which the senior notes and the debentures were issued contain operating covenants that limit the Company’s ability to engage in certain activities, including limitations on consolidations, mergers, and transfers of assets; and sale and leaseback transactions. The indentures contain cross-default provisions with other debt obligations that exceed $10 million of principal outstanding. In addition, the terms of the indentures require, among other things, the Company to file with the Trustee copies of its annual reports on Form 10-K, quarterly reports on Form 10-Q and an Officers’ Certificate relating to the Company’s compliance with the terms of the indentures within 120 days after the end of its fiscal year. The Company has been in default on these reporting requirements since it delayed filing its Form 10-Q for the second quarter of 2004 due to the restatement of its 2003 and first quarter 2004 results. As the Company anticipated and planned for, in March and April 2006, the Company received notices of default from a holder and the Trustee of the senior notes and debentures of which $355 million was outstanding. The notices of default related only to reporting requirements and the related Officers’ Certificate. Under the terms of the indentures, the Company had 90 days from the notices of default in which to cure the deficiencies identified in the notices of default or obtain waivers, or events of default would have occurred and the holders of the senior notes or debentures or the Trustee could declare the principal immediately due and payable. At the end of these periods, the deficiencies had not been cured and waivers had not been obtained. During July and August 2006, the bondholders accelerated the payment of the principal amount of the debentures, of which $155 million was outstanding, and the Company financed the accelerated repayments by use of the aforementioned $450 million term loan facility.
 
As of the date of this filing, the $200 million senior notes currently remain outstanding, although they could be declared immediately due and payable at any time. In the event the bondholders of the senior notes provide a notice of acceleration prior to the Company curing the existing reporting default, the Company believes it has sufficient liquidity resources, primarily through the term loan facility, to fully satisfy any potential acceleration. In addition, the senior notes are redeemable at the option of the Company at any time for the principal amount of the senior notes then outstanding plus the sum of any accrued but unpaid interest and the present value of any remaining scheduled interest payments. The senior notes are redeemable at the option of the holders only upon a change in control of the Company combined with a rating by either Moody’s or S&P below investment grade as defined in the indenture. Currently, the rating by S&P of the senior notes is below investment grade.
 
Asset Securitization Program
 
The Company has a $100 million program to sell (securitize), on an ongoing basis, a pool of its U.S. trade accounts receivable. This program serves to accelerate cash collections of the Company’s trade accounts receivable at favorable financing costs and helps manage the Company’s liquidity requirements. In 2005, the Company amended the program to resolve issues related to a credit rating downgrade and delayed SEC filings and to extend the program through June 2006. In June 2006, the Company amended the program to extend it up to June 2, 2009, to cure a default resulting from a credit rating downgrade, and to modify the reporting requirements to more closely match those in the New Credit Facility. While the Company expects to maintain a satisfactory U.S. asset


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securitization program to help meet the Company’s liquidity requirements, factors beyond the Company’s control such as prevailing economic, financial and market conditions may prevent the Company from doing so.
 
Under this program, certain of the Company’s receivables are sold to Ferro Finance Corporation (“FFC”), a wholly-owned unconsolidated qualified special purpose entity (“QSPE”), as defined by Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” (FAS No. 140). FFC finances its acquisition of trade accounts receivable assets by issuing financial interests to multi-seller receivables securitization companies (“commercial paper conduits”). At December 31, 2004, $3.6 million had been advanced to the Company, net of repayments, under this program. During the twelve months ended December 31, 2005, $946.2 million of accounts receivable were sold under this program and $948.8 million of receivables were collected and remitted to FFC and the commercial paper conduits, resulting in a net decrease in advances of $2.6 million and total advances outstanding at December 31, 2005, of $1.0 million.
 
The Company on behalf of FFC and the commercial paper conduits provides normal collection and administration services with respect to the receivables. In accordance with FAS No. 140, no servicing asset or liability is reflected on the Company’s consolidated balance sheet. FFC and the commercial paper conduits have no recourse to the Company’s other assets for failure of debtors to pay when due as the assets transferred are legally isolated in accordance with the bankruptcy laws of the United States. Under FAS No. 140 and FASB Interpretation No. 46R, “Consolidation of Variable Interest Entities,” neither the amounts advanced nor the corresponding receivables sold are reflected in the Company’s consolidated balance sheet as the trade receivables have been de-recognized with an appropriate accounting loss recognized.
 
The Company retains a beneficial interest in the receivables transferred to FFC in the form of a note receivable to the extent that cash flows collected from receivables transferred exceed cash flows used by FFC to pay the commercial paper conduits. The note receivable balance was $111.9 million as of December 31, 2005, and $108.5 million as of December 31, 2004. The Company, on a monthly basis, measures the fair value of the retained interests using management’s best estimate of the undiscounted expected future cash collections on the transferred receivables. Actual cash collections may differ from these estimates and would directly affect the fair value of the retained interests.
 
Other Financing Arrangements
 
In addition, the Company maintains other lines of credit and receivable sales programs to provide global flexibility for the Company’s liquidity requirements. Most of these facilities, including receivable sales programs, are uncommitted lines for the Company’s international operations. At December 31, 2005, the unused portions of these lines provided approximately $15.0 million of additional liquidity. The receivable sales are generally without recourse. At December 31, 2005, the amount of outstanding receivables sold under these international receivable sales programs was less than $20 million. The Company had a €2.4 million guarantee, which was outstanding at December 31, 2005, and was terminated in May 2006, to support the borrowing facilities of an unconsolidated affiliate.
 
Liquidity
 
The Company’s level of debt and debt service requirements could have important consequences to its business operations and uses of cash flows. In addition, a reduction in overall demand for the Company’s products, as well as the potential requirement to repay the senior notes due to the Company’s delayed SEC filings, could adversely affect cash flows. At December 31, 2005, the Company had a $300.0 million revolving credit facility of which $113.9 million was available. This liquidity, along with the liquidity from the Company’s asset securitization program of which $99.0 million was available as of December 31, 2005, other financing arrangements, available cash flows from operations, asset sales, and the New Credit Facility, should allow the Company to meet its funding requirements and other commitments. As of August 31, 2006, the Company had borrowed $165.5 million against its $250 million revolving credit facility and drawn $49.2 million on the $100 million asset securitization program. In addition, the


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Company had drawn $250 million on the $450 million term loan facility, although the $200 million remaining availability is reserved for the repayment of the 91/8% senior notes should they be accelerated by the bondholders.
 
4.   Stock-based compensation plans
 
In April 2003, shareholders of the Company approved the 2003 Long-Term Incentive Compensation Plan (the “Plan”). The Plan authorizes several different types of long-term incentives. The available incentives include stock options, stock appreciation rights, restricted shares, performance shares and common stock awards. The shares of common stock to be issued under the Plan may be either authorized but unissued shares or shares held as treasury stock. The effective date of the Plan is January 1, 2003. The number of shares of common stock reserved for awards under the Plan is 3,250,000 shares. At December 31, 2005, there were 914,225 shares available for grant.
 
Previous Employee Stock Option Plans and a 1997 Performance Share Plan authorized different types of long-term incentives, including stock options, stock appreciation rights, performance shares and common stock awards. No further grants may be made under Ferro’s previous Employee Stock Option Plans or under Ferro’s 1997 Performance Share Plan. However, any outstanding awards or grants made under these plans will continue until the end of their specified term.
 
The Company maintains a performance share plan whereby awards, expressed as shares of common stock of the Company, are earned only if the Company meets specific performance targets over a three-year period. The Company pays 50% cash and 50% common stock for the value of any earned performance shares. Performance share awards in the amount of 127,900 shares at a weighted-average market price of $19.39 per share were granted in 2005 (119,100 shares at $26.26 in 2004 and 135,500 shares at $21.26 in 2003). The Company accrues amounts based on performance reflecting the fair value of cash and common stock, which is anticipated to be earned. The effects of the plan on the Company’s operations were expenses (credits) of $(0.5) million, $(0.6) million, and $1.2 million in 2005, 2004 and 2003, respectively.
 
Information pertaining to stock options is shown below:
 
                 
          Weighted-
 
          Average
 
    Number of
    Exercise
 
    Options     Price  
 
Outstanding at January 1, 2003
    3,814,182     $ 21.86  
Granted in 2003
    830,800       21.44  
Exercised in 2003
    (202,833 )     20.56  
Canceled in 2003
    (232,341 )     23.29  
                 
Outstanding at December 31, 2003
    4,209,808       21.75  
Granted in 2004
    831,250       25.49  
Exercised in 2004
    (340,367 )     19.41  
Canceled in 2004
    (160,560 )     23.37  
                 
Outstanding at December 31, 2004
    4,540,131       22.56  
Granted in 2005
    751,500       19.55  
Exercised in 2005
    (112,809 )     16.39  
Canceled in 2005
    (348,922 )     22.63  
                 
Outstanding at December 31, 2005
    4,829,900       22.23  
                 
Exercisable at December 31, 2003
    2,627,387     $ 21.06  
Exercisable at December 31, 2004
    2,836,687       21.60  
Exercisable at December 31, 2005
    3,712,869       22.26  


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
Significant option groups outstanding at December 31, 2005 and the related weighted-average price for the exercisable options and remaining life information are as follows:
 
                                         
Options Outstanding     Options Exercisable  
    Outstanding
    Weighted-Average
    Weighted-
    Exercisable
    Weighted-
 
    as of
    Remaining
    Average
    as of
    Average
 
Range of Exercise Prices
  12/31/2005     Contractual Life     Exercise Price     12/31/2005     Exercise Price  
 
$14.00-17.00
    150,585       0.1     $ 15.75       150,585     $ 15.75  
$17.01-22.00
    2,430,461       5.9       20.13       1,689,811       20.10  
$22.01-27.00
    2,145,408       5.7       24.76       1,769,402       24.51  
$27.01-30.00
    103,446       3.1       28.52       103,071       28.52  
                                         
Total options
    4,829,900       5.6       22.23       3,712,869       22.26  
                                         
 
Stock options have a term of 10 years and vest evenly over four years on the anniversary of the grant date. In the case of death, retirement, disability or change in control, the stock options become 100% vested and exercisable.
 
5.   Serial convertible preferred stock
 
The Company is authorized to issue up to 2,000,000 shares of serial convertible preferred stock without par value. In 1989, Ferro issued 1,520,215 shares of 7% Series A ESOP Convertible Preferred Stock (“Series A Preferred Stock”) to the Trustee of the Ferro Employee Stock Ownership Plan (“ESOP”). The Series A Preferred Stock was issued at a price of $46.375 per share for a total consideration of $70.5 million. As of December 31, 1999, all shares of the Series A Preferred Stock were allocated to participating individual employee accounts. The Trustee may redeem the Series A Preferred Stock to provide for distributions to participants or to satisfy an investment election provided to participants, or to provide loans to or withdrawals by participants. The Series A Preferred Stock is redeemable at the option of the Company, in whole or in part, at any time after July 1, 1999, and under certain other circumstances if the Company terminates the Plan or future contributions to the Plan, in the event of changes in Federal tax laws that would preclude the Company from claiming a tax deduction for dividends paid on the Series A Preferred Stock, or if the Plan is determined not to be a qualified plan within the meanings of Section 401(a) or 4975(e)(7) of the Internal Revenue Code. In any redemption other than plan termination or the termination of future contributions to the Plan, the redemption price is fixed at $46.375 per preferred share plus earned but unpaid dividends as of the date of redemption. In addition, the Trustee is entitled, at any time, to cause any or all shares of Series A Preferred Stock to be converted into shares of common stock at a fixed conversion rate of 2.5988 shares (adjusted for stock splits) of common stock for each one share of Series A Preferred Stock.
 
Each share of Series A Preferred Stock carries one vote, voting together with the common stock on most matters. The Series A Preferred Stock accrues dividends at an annual rate of 7% on shares outstanding. The dividends are cumulative from the date of issuance. To the extent the Company is legally permitted to pay dividends and the Board of Directors declares a dividend payable, the Company pays dividends on a quarterly basis. In the case of liquidation or dissolution of the Company, the holders of the Series A Preferred Stock are entitled to receive $46.375 per preferred share, or $25.00 per preferred share in the event of involuntary liquidation, plus earned but unpaid dividends, before any amount shall be paid or distributed to holders of the Company’s common stock.
 
There were 442,271 and 489,649 shares of Series A Preferred Stock outstanding at December 31, 2005 and 2004, respectively. During 2005, 2004 and 2003, respectively, 47,378 shares, 113,793 shares, and 101,060 shares were redeemed as permitted by the Plan.
 
6.   Common stock
 
The Company did not purchase common stock on the open market in 2005, 2004 or 2003. At December 31, 2005, the Company had remaining authorization to acquire 4,201,216 shares under its current treasury stock purchase program. Until the Company becomes current in its filings with the Securities and Exchange Commission,


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

the Company is prohibited from purchasing additional shares. In addition, the New Credit Facility limits the Company’s ability to purchase shares.
 
The Company maintained a Shareholder Rights Plan (the “Plan”) whereby, until the occurrence of certain events, each share of the outstanding common stock represented ownership of one right (“Right”). The Rights expired on April 8, 2006.
 
7.   Earnings per share computation
 
Information concerning the calculation of basic and diluted earnings per share is shown below:
 
                         
    2005     2004     2003  
    (In thousands, except per share amounts)  
 
Basic earnings per share computation:
                       
Net income available to common shareholders
  $ 14,786     $ 23,220     $ 11,962  
Less: Income (loss) from discontinued operations
    (868 )     (2,915 )     4,412  
                         
    $ 15,654     $ 26,135     $ 7,550  
                         
Weighted-average common shares outstanding
    42,309       41,981       40,903  
Basic earnings per share from continuing operations
  $ 0.37     $ 0.62     $ 0.18  
                         
Diluted earnings per share computation:
                       
Net income available to common shareholders
  $ 14,786     $ 23,220     $ 11,962  
Less: Income (loss) from discontinued operations
    (868 )     (2,915 )     4,412  
Plus: Convertible preferred stock
                 
                         
    $ 15,654     $ 26,135     $ 7,550  
                         
Weighted-average common shares outstanding
    42,309       41,981       40,903  
Assumed conversion of convertible preferred stock
                 
Assumed exercise of stock options
    36       254       184  
                         
Weighted-average diluted shares outstanding
    42,345       42,235       41,087  
                         
Diluted earnings per share from continuing operations
  $ 0.37     $ 0.62     $ 0.18  
                         
 
The convertible preferred shares were anti-dilutive for the years ended December 31, 2005, 2004 and 2003, and thus not included in the diluted shares outstanding.
 
8.   Acquisitions
 
In September 2001, the Company acquired from OM Group, Inc. certain businesses previously owned by dmc2 Degussa Metals Catalysts Cerdec AG (“dmc2”) pursuant to an agreement to purchase certain assets of dmc2, including shares of certain of its subsidiaries. In the first quarter of 2003, the Company paid $8.5 million in cash for certain purchase price settlements with dmc2. In the second quarter of 2004, the Company received approximately $8.5 million in cash from dmc2 as the final settlement of the purchase price, which was recorded as a reduction to goodwill.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
9.   Restructuring and cost reduction programs
 
The following table summarizes the activities relating to the Company’s reserves for restructuring and cost reduction programs:
 
                         
          Other
       
    Severance     Costs     Total  
    (Dollars in thousands)  
 
Balance, December 31, 2003
  $ 13,797     $ 181     $ 13,978  
Gross charges
    3,497       2,509       6,006  
Cash payments
    (12,397 )     (458 )     (12,855 )
Non-cash write-offs
          (1,256 )     (1,256 )
                         
Balance, December 31, 2004
    4,897       976       5,873  
Gross charges
    5,201             5,201  
Cash payments
    (6,342 )     (910 )     (7,252 )
Non-cash write-offs
    (1,524 )           (1,524 )
                         
Balance, December 31, 2005
  $ 2,232     $ 66     $ 2,298  
                         
 
Charges for 2005 and 2004 relate to the Company’s ongoing cost reduction and restructuring programs. These programs include employment cost reductions in response to a slowdown in general economic conditions. Total gross charges for the year ended December 31, 2005, were $5.2 million, of which $3.5 million and $1.7 million were included in cost of sales, and selling and general and administrative expenses, respectively. Total gross charges for the year ended December 31, 2004 were $6.0 million, of which $2.6 million, $2.5 million and $0.9 million were included in the cost of sales, selling and general and administrative expenses, and miscellaneous expense, respectively. Total gross charges for the year ended December 31, 2003, were $13.0 million, of which $2.4 million, $10.1 million and $0.5 million were included in cost of sales, selling and general and administrative expenses, and miscellaneous expense, respectively. No charges for discontinued operations were incurred in 2005, 2004 or 2003.
 
The remaining reserve balance for restructuring and cost reduction programs of $2.3 million at December 31, 2005, primarily represents future cash payments expected to be made during 2006 except where certain legal or contractual restrictions on the Company’s ability to complete the program exist. The Company will continue to evaluate further steps to reduce costs and improve efficiencies.
 
10.   Discontinued operations
 
On September 30, 2002, the Company completed the sale of its Powder Coatings business unit in separate transactions with Rohm and Haas Company and certain of its wholly-owned subsidiaries and certain wholly-owned subsidiaries of Akzo Nobel NV. On June 30, 2003, the Company completed the sale of its Petroleum Additives business to Dover Chemicals and its Specialty Ceramics business to CerCo LLC. For all periods presented, the Powder Coatings, Petroleum Additives and Specialty Ceramics businesses have been reported as discontinued operations.
 
There were no sales, income before taxes, or related tax expense from discontinued operations in 2005 or 2004. For the year ended December 31, 2003, sales from discontinued operations were $30.0 million, losses before tax from discontinued operations were $1.5 million, and the related tax benefits were $0.6 million. In connection with certain divestitures, the Company has continuing obligations with respect to environmental remediation. The Company accrued $3.1 million as of December 31, 2005 and 2004, for these matters. These amounts are based on management’s best estimate of the nature and extent of soil and/or groundwater contamination, as well as expected remedial actions as determined by agreements with relevant authorities, where applicable, and existing technologies. For 2003, the results of discontinued operations also include the operating earnings of the discontinued units prior to their sale, as well as interest expense, foreign currency gains and losses, other income or expenses and


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

income taxes directly related to, or allocated to, the discontinued operations. Interest was allocated to discontinued operations assuming debt levels approximating the estimated or actual debt reductions upon disposal of the operations and the Company’s actual weighted average interest rates for the respective years.
 
Disposal of discontinued operations resulted in pre-tax (losses) gains of $(1.4) million, $(3.8) million, and $7.7 million for the years ended December 31, 2005, 2004 and 2003, respectively. The related tax (benefits) expenses were $(0.5) million, $(0.9) million, and $2.4 million for the years ended December 31, 2005, 2004 and 2003, respectively. Selling prices are subject to certain post-closing adjustments with respect to assets sold to and liabilities assumed by the buyers. The gain (loss) on disposal of discontinued operations includes post-closing adjustments to the selling prices and ongoing legal costs and reserve adjustments directly related to discontinued operations.
 
11.   Contingent liabilities
 
In February 2003, the Company was requested to produce documents in connection with an investigation by the United States Department of Justice into possible antitrust violations in the heat stabilizer industry. In April 2006, the Company was notified by the Department of Justice that the Government had closed its investigation and that the Company was relieved of any obligation to retain documents that were responsive to the Government’s earlier document request. Before closing its investigation, the Department of Justice took no action against the Company or any current or former employee of the Company. The Company was previously named as a defendant in several lawsuits alleging civil damages and requesting injunctive relief relating to the conduct the Government was investigating. The Company is vigorously defending itself in those actions, and management does not expect these lawsuits to have a material effect on the consolidated financial position, results of operations, or cash flows of the Company.
 
In a July 23, 2004, press release, Ferro announced that its Polymer Additives business performance in the second quarter fell short of expectations and that its Audit Committee would investigate possible inappropriate accounting entries in Ferro’s Polymer Additives business. A consolidated putative securities class action lawsuit arising from and related to the July 23, 2004, announcement is currently pending in the United States District Court for the Northern District of Ohio against Ferro, its deceased former Chief Executive Officer, its Chief Financial Officer, and a former operating Vice President of Ferro. This claim is based on alleged violations of Federal securities laws. Ferro and the named executives consider these allegations to be unfounded, are vigorously defending this action and have notified Ferro’s directors and officers liability insurer of the claim. Because this action is in its preliminary stage, the outcome of this litigation cannot be determined at this time.
 
Also, following the July 23, 2004, announcement, two derivative lawsuits were commenced in the United States District Court for the Northern District of Ohio on behalf of Ferro against Ferro’s Directors, its deceased former Chief Executive Officer, and Chief Financial Officer. Two other derivative actions were subsequently filed in the Court of Common Pleas for Cuyahoga County, Ohio. The state court actions were removed to the United States District Court for the Northern District of Ohio and all of the derivative lawsuits were then consolidated into a single action. The derivative lawsuits alleged breach of fiduciary duties and mismanagement-related claims. On March 21, 2006, the Court dismissed the consolidated derivative action without prejudice. On April 8, 2006, plaintiffs filed a motion seeking relief from the judgment dismissing the derivative lawsuit and seeking to further amend their complaint following discovery, which was denied. On April 13, 2006, plaintiffs also filed a Notice of Appeal to the Sixth Circuit Court of Appeals. The Directors and named executives consider the allegations contained in the derivative actions to be unfounded, have vigorously defended this action and will defend against the new filings. The Company has notified Ferro’s directors and officers liability insurer of the claim. Because this appeal is in the preliminary stage, the outcome of this litigation cannot be determined at this time.
 
On June 10, 2005, a putative class action lawsuit was filed against Ferro, and certain former and current employees alleging breach of fiduciary duty with respect to ERISA plans. The Company considers these allegations


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

to be unfounded, is vigorously defending this action, and has notified Ferro’s fiduciary liability insurer of the claim. Because this action is in the preliminary stage, the ultimate outcome of this litigation cannot be determined at this time. However, management does not expect the ultimate outcome of the lawsuit to have a material effect on the financial position, results of operations or cash flows of the Company.
 
On October 15, 2004, the Belgian Ministry of Economic Affairs’ Commercial Policy Division (the “Ministry”) served on Ferro’s Belgian subsidiary a mandate requiring the production of certain documents related to an alleged cartel among producers of butyl benzyl phthalate (“BBP”) from 1983 to 2002. Subsequently, German and Hungarian authorities initiated their own national investigations in relation to the same allegations. Ferro’s Belgian subsidiary acquired its BBP business from Solutia Europe S.A./N.V. (“SOLBR”) in August 2000. Ferro promptly notified SOLBR of the Ministry’s actions and requested SOLBR to indemnify and defend Ferro and its Belgian subsidiary with respect to these investigations. In response to Ferro’s notice, SOLBR exercised its right under the 2000 acquisition agreement to take over the defense and settlement of these matters, subject to reservation of rights. In December 2005, the Hungarian authorities imposed a de minimus fine on Ferro’s Belgian subsidiary, and the Company expects the German and Belgian authorities also to assess fines for the alleged conduct. Management cannot predict the amount of fines that will ultimately be assessed and cannot predict the degree to which SOLBR will indemnify Ferro’s Belgian subsidiary for such fines.
 
In October 2005, the Company performed a routine environmental, health and safety audit of its Bridgeport, New Jersey facility. In the course of this audit, internal environmental, health and safety auditors assessed the Company’s compliance with the New Jersey Department of Environmental Protection’s (“NJDEP”) laws and regulations regarding water discharge requirements pursuant to the New Jersey Water Pollution Control Act (“WPCA”). On October 31, 2005, the Company disclosed to the NJDEP that it had identified potential violations of the WPCA and the Company commenced an investigation and committed to report any violations and to undertake any necessary remedial actions. In September 2006, the Company entered into an agreement with the NJDEP under which the Company paid the State of New Jersey a civil administrative penalty of $0.2 million in full settlement of the violations.
 
As of December 31, 2005, the Company had accrued liabilities of $6.6 million for environmental remediation costs, of which $1.2 million related to Superfund sites. As of December 31, 2004, the Company had accrued liabilities of $6.4 million of which $0.6 million related to Superfund sites.
 
There are various other lawsuits and claims pending against the Company and its consolidated subsidiaries. In the opinion of management, the ultimate liabilities, if any, and expenses resulting from such lawsuits and claims will not materially affect the consolidated financial position, results of operations, or cash flows of the Company.
 
12.   Research and development expense
 
Amounts expended for development or significant improvement of new and/or existing products, services and techniques for continuing operations were $38.4 million, $42.4 million, and $40.2 million in 2005, 2004 and 2003, respectively.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
13.   Retirement benefits
 
Information concerning the pension and other post-retirement benefit plans of the Company is as follows:
 
                                 
    Pension Benefits     Other Benefits  
    2005     2004     2005     2004  
    (Dollars in thousands)  
 
Change in benefit obligation:
                               
Benefit obligation at beginning of year
  $ 488,748     $ 436,667     $ 53,011     $ 56,283  
Service cost
    16,375       14,610       799       902  
Interest cost
    26,213       25,375       3,160       3,361  
Amendments
          126              
Effect of curtailment
          (137 )            
Effect of settlements
    (1,125 )     (902 )            
Plan participants’ contributions
    672       599              
Benefits paid
    (22,812 )     (23,052 )     (3,672 )     (3,518 )
Acquisitions
          (532 )            
Actuarial loss (gain)
    41,468       23,290       5,199       (4,017 )
Exchange rate effect
    (21,840 )     12,704              
                                 
Benefit obligation at end of year
  $ 527,699     $ 488,748     $ 58,497     $ 53,011  
                                 
                 
Accumulated benefit obligation at end of year
  $ 498,351     $ 460,854     $ 58,497     $ 53,011  
                 
Change in plan assets:
                               
Fair value of plan assets at beginning of year
  $ 312,107     $ 292,383     $     $  
Actual return on plan assets
    31,361       23,320              
Employer contributions
    40,856       11,492       3,672       3,518  
Plan participants’ contributions
    672       599              
Benefits paid
    (22,812 )     (23,052 )     (3,672 )     (3,518 )
Effect of settlements
    (1,125 )     (902 )            
Acquisitions
          (532 )            
Exchange rate effect
    (15,224 )     8,799              
                                 
Fair value of plan assets at end of year
  $ 345,835     $ 312,107     $     $  
                                 
Reconciliation of accrued costs:
                               
Funded status
  $ (181,864 )   $ (176,641 )   $ (58,497 )   $ (53,011 )
Unrecognized net actuarial loss (gain)
    140,483       123,636       (4,926 )     (8,796 )
Unrecognized prior service cost (benefit)
    7,619       1,968       (2,718 )     (4,839 )
                                 
Net amount recognized
  $ (33,762 )   $ (51,037 )   $ (66,141 )   $ (66,646 )
                                 
Amounts recognized in the balance sheet:
                               
Prepaid benefit cost
  $ 97     $ 17     $     $  
Accrued benefit liability
    (150,148 )     (151,535 )     (66,141 )     (66,646 )
Intangible assets
    1,405       1,635              
Accumulated other comprehensive income
    114,884       98,846              
                                 
Net amount recognized
  $ (33,762 )   $ (51,037 )   $ (66,141 )   $ (66,646 )
                                 
Weighted-average assumptions as of December 31:
                               
Discount rate
    5.38 %     5.63 %     5.90 %     6.10 %
Expected return on plan assets
    7.39 %     7.51 %     N/A       N/A  
Rate of compensation increase
    3.29 %     3.25 %     N/A       N/A  
 


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

                                 
          Pension Plans with
 
    Pension Plans with
    Accumulated Benefit
 
    Benefit Obligations in
    Obligations in
 
    Excess of Plan Assets     Excess of Plan Assets  
    2005     2004     2005     2004  
    (Dollars in thousands)  
 
Benefit obligations
  $ 525,189     $ 486,734     $ 483,305     $ 444,999  
Plan assets
    343,054       310,018       330,285       295,894  
 
For measurement purposes, the assumed increase in the cost of covered pre-Medicare health care benefits was 10.0% for 2005, gradually decreasing to 5.1% for 2013 and later years, and the assumed increase in the cost of covered post-Medicare health care benefits was 10.3% for 2005, gradually decreasing to 5.2% for 2013 and later years.
 
In December 2003 the new Medicare Prescription Drug, Improvement and Modernization Act became law and will provide a basic subsidy of 28% of certain retiree health care beneficiaries’ drug costs if the benefit is at least actuarially equivalent to the Medicare benefit. See Note 1 regarding impact of adoption during 2004.
 
                                                 
    Pension Benefits     Other Benefits  
    2005     2004     2003     2005     2004     2003  
    (Dollars in thousands)  
 
Components of net periodic cost:
                                               
Service cost
  $ 16,375     $ 14,610     $ 12,995     $ 799     $ 902     $ 888  
Interest cost
    26,213       25,375       24,105       3,160       3,361       3,979  
Expected return on plan assets
    (22,095 )     (21,810 )     (20,194 )                  
Amortization of prior service cost
    (86 )     80       28       (558 )     (558 )     (558 )
Net amortization and deferral
    6,825       6,130       4,594       (232 )     (97 )      
Curtailment and settlement effects
    (353 )     (66 )     1,684                    
                                                 
Net periodic benefit cost
  $ 26,879     $ 24,319     $ 23,212     $ 3,169     $ 3,608     $ 4,309  
                                                 
 
In connection with the Company’s divestment of the Petroleum Additives and Specialty Ceramics businesses during 2003, a curtailment expense of $0.7 million was recognized as part of the gain on disposal of discontinued operations. Additionally, as a result of a cost reduction and restructuring program implemented in 2003 at an international subsidiary, a $1.0 million expense was recorded for special termination benefits.
 
A one-percentage point change in the assumed health care cost trend rates would have the following effect:
 
                 
    1-Percentage
    1-Percentage
 
    Point Increase     Point Decrease  
    (Dollars in thousands)  
 
Effect on total of service and interest cost component
  $ 255     $ 215  
Effect on post-retirement benefit obligation
  $ 4,491     $ 3,796  
 
The Company expects to contribute approximately $43.9 million to its pension and other post-retirement benefit plans in 2006.
 
The expected return on assets at the beginning of the year is based on the weighted-average of the expected return for the target asset allocations of the principal asset categories held by each plan. In determining the expected return, the Company considers both historical performance and an estimate of future long-term rates of return. The Company consults with and considers the opinion of its actuaries in developing appropriate return assumptions.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
The measurement dates used to determine pension and other postretirement benefit measurements are September 30 for the United States plans and December 31 for the international plans. The weighted average asset allocations of the pension benefit plans at their measurement dates were:
 
                 
    2005     2004  
 
Debt Securities
    39 %     40 %
Equity Securities
    51       57  
Other
    10       3  
                 
Total
    100 %     100 %
                 
 
The Company establishes asset allocation ranges for each major category of plan assets. The risks inherent in the various asset categories are considered along with the benefit obligations, financial status and short-term liquidity needs of the fund. Listed below are the ranges of percentages for each asset category on a weighted-average basis:
 
                 
    Minimum     Maximum  
 
Debt securities
    21%       42%  
Equity securities
    12%       57%  
 
The Company’s pension plans held 424,651 and 424,651 shares of the Company’s common stock with a market value of $8.0 million and $9.8 million at December 31, 2005 and 2004, respectively, and received $0.2 million of dividends from the Company’s common stock in both 2005 and 2004.
 
At December 31, 2005, retiree benefit payments, which reflect expected future service, were anticipated to be paid as follows:
 
                         
          Other Benefits
    Other Benefits
 
    Pension
    Before
    After
 
    Benefits     Medicare Subsidy     Medicare Subsidy  
    (Dollars in thousands)  
 
2006
  $ 24,055     $ 4,724     $ 4,300  
2007
    25,446       4,769       4,320  
2008
    26,991       4,869       4,352  
2009
    28,461       4,884       4,348  
2010
    29,864       4,940       4,391  
2011-2015
    178,988       24,403       21,610  
 
The Company also sponsors unfunded nonqualified defined benefit retirement plans for certain employees and for these plans expensed $2.3 million, $2.1 million and $2.1 million in 2005, 2004 and 2003, respectively. For 2005, components of the expense were service cost of $0.2 million, interest cost of $1.0 million, amortization of prior service cost of $0.2 million, and amortization of net loss of $0.9 million. At December 31, 2005, the benefit obligation was $16.1 million, the unrecognized actuarial loss was $7.6 million, the accrued benefit liability was $15.6 million, and the accumulated other comprehensive loss was $7.2 million. At December 31, 2005, the Company held $9.2 million of investments designated to fund benefit payments. At December 31, 2005, benefit payments were expected to be paid as follows: $11.4 million in 2006 primarily related to a lump sum payment to the beneficiary of the Company’s deceased former Chief Executive Officer, $0.4 million in each of 2007 through 2010, and $3.1 million for the five year period of 2011-2015.
 
The parent company and certain subsidiaries have defined contribution retirement plans covering certain employees. The Company’s contributions are determined by the terms of the plans subject to the limitations that they shall not exceed the amounts deductible for income taxes. Generally, benefits under these plans vest gradually


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

over a period of five years from date of employment and are based on the employee’s contributions. The expense applicable to these plans was $5.6 million, $5.2 million, and $5.6 million in 2005, 2004 and 2003, respectively.
 
In February 2006, the Company announced changes to certain of its postretirement benefit plans. See additional information regarding this matter in Note 22.
 
14.   Income taxes
 
Income tax expense (benefit) from continuing operations is comprised of the following components:
 
                         
    2005     2004     2003  
    (Dollars in thousands)  
 
Current:
                       
U.S. federal
  $ (240 )   $ 2,151     $ (2,611 )
Foreign
    16,022       11,484       13,543  
State and local
    271       194       (328 )
                         
      16,053       13,829       10,604  
Deferred:
                       
U.S. federal
    (5,258 )     (3,650 )     (3,529 )
Foreign
    (2,948 )     (6,780 )     (4,157 )
State and local
    (919 )     (47 )     (540 )
                         
      (9,125 )     (10,477 )     (8,226 )
                         
Total income tax
  $ 6,928     $ 3,352     $ 2,378  
                         
 
In addition to the 2005 income tax expense of $6.9 million, certain net tax benefits of $5.4 million were allocated directly to shareholders’ equity.
 
The above taxes are based on earnings (losses) from continuing operations before income taxes. These earnings (losses) aggregated $(13.5) million, $(0.1) million, and $(14.7) million for domestic operations, and $37.6 million, $31.3 million, and $26.7 million for foreign operations in 2005, 2004 and 2003, respectively.
 
A reconciliation of the statutory federal income tax rate and the effective tax rate follows:
 
                         
    2005     2004     2003  
 
Statutory federal income tax rate
    35.0 %     35.0 %     35.0 %
U.S. tax cost of foreign dividends
    6.3       4.2       10.4  
Extraterritorial income exclusion
    (6.2 )     (4.4 )     (11.9 )
Net adjustment of prior year accrual
    (3.1 )     (6.6 )     (0.2 )
ESOP dividend tax benefit
    (3.0 )     (2.5 )     (8.0 )
Adjustment of valuation allowances
    1.0       (9.9 )     (14.2 )
Foreign tax rate difference
    0.9       (9.1 )     3.9  
Miscellaneous
    (2.1 )     4.0       4.8  
                         
Effective tax rate
    28.8 %     10.7 %     19.8 %
                         


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
The components of deferred tax assets and liabilities at December 31 were:
 
                 
    2005     2004  
    (Dollars in thousands)  
 
Deferred tax assets:
               
Pension and other benefit programs
  $ 79,712     $ 81,194  
Foreign tax credit carryforwards
    32,587       17,428  
Net operating loss carryforwards
    32,257       25,527  
Other credit carryforwards
    7,976       2,394  
Accrued liabilities
    7,699       8,212  
Reserve for doubtful accounts
    3,132       4,341  
Inventories
    2,907       3,525  
State and local
    962       3,287  
Other
    1,147       6,870  
                 
Total deferred tax assets
    168,379       152,778  
Deferred tax liabilities:
               
Property and equipment — depreciation and amortization
    70,949       69,327  
Other
    516        
                 
Total deferred tax liabilities
    71,465       69,327  
                 
Net deferred tax asset before valuation allowance
    96,914       83,451  
Valuation allowance
    (9,651 )     (8,163 )
                 
Net deferred tax assets
  $ 87,263     $ 75,288  
                 
 
At December 31, 2005, the Company had benefits from domestic federal and state operating loss carryforwards in the amount of $8.0 million and foreign operating loss carryforwards of $24.3 million for tax purposes, some of which can be carried forward indefinitely and others expire in one to twenty years. A valuation allowance of $9.7 million has been established due to the uncertainty of realizing certain state and foreign operating loss carryforwards. The $1.5 million increase in the valuation allowance was the result of an increase of $1.2 million relating to state net operating losses, combined with a net $0.3 million increase in the valuation reserve for certain foreign net operating losses. At December 31, 2005, $1.4 million of the valuation allowance relates to dmc2 pre-acquisition losses, and any future reduction of this portion of the valuation allowance will be recognized as a reduction of goodwill and other noncurrent intangibles, rather than as tax benefits in the statement of income.
 
At December 31, 2005, the Company had benefits from foreign tax credit carryforwards of $32.6 million for tax purposes. These can be carried forward for ten years. $3.2 million will expire in 2011, $7.3 million will expire in 2012, $6.8 million will expire in 2013, $4.3 million will expire in 2014 and $11.0 million will expire in 2015. In management’s opinion, it is more likely than not that the credits will be utilized before the expiration periods.
 
Of the total net deferred tax assets, $40.7 million and $45.6 million were classified as current assets, $61.1 million and $46.7 million as non-current assets, $0.5 million and $1.7 million as current liabilities, and $14.0 million and $15.3 million as non-current liabilities at December 31, 2005 and 2004, respectively.
 
Undistributed earnings of the Company’s foreign subsidiaries amounted to approximately $127.6 million at December 31, 2005. Deferred income taxes are not provided on these earnings as it is intended that these earnings be indefinitely invested in these entities.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
15.   Reporting for segments
 
Under the provisions of FASB’s Statement No. 131, “Disclosures about Segments of an Enterprise and Related Information,” (FAS No. 131), the Company has six reportable segments: Performance Coatings, Electronic Materials, Color and Glass Performance Materials, Polymer Additives, Specialty Plastics and Other, which is comprised of two business units, Pharmaceuticals and Fine Chemicals, which do not meet the quantitative thresholds for separate disclosure. The Company uses the criteria outlined in FAS No. 131 to identify segments which management has concluded are its seven major business units. Further, the Company has concluded that it is appropriate to aggregate its Tile and Porcelain Enamel business units into one reportable segment, Performance Coatings, based on their similar economic and operating characteristics.
 
The accounting policies of the segments are consistent with those described for the Company’s consolidated financial statements in the summary of significant accounting policies (see Note 1). The Company measures segment income for reporting purposes as net operating profit before interest and taxes. Net operating profit also excludes unallocated corporate expenses and charges associated with employment cost reduction programs and certain integration costs related to the acquisition of certain businesses of dmc2.
 
Net sales to external customers by segment (inter-segment sales are not material):
 
                         
    2005     2004     2003  
    (Dollars in millions)  
 
Performance Coatings
  $ 488.5     $ 466.5     $ 425.1  
Electronic Materials
    355.7       388.3       338.3  
Color and Glass Performance Materials
    359.6       355.9       305.4  
Polymer Additives
    300.6       280.2       240.4  
Specialty Plastics
    279.1       265.0       236.0  
Other
    98.8       87.8       70.4  
                         
Total consolidated sales
  $ 1,882.3     $ 1,843.7     $ 1,615.6  
                         
 
Income and reconciliation to income (loss) before taxes by segment:
 
                         
    2005     2004     2003  
    (Dollars in millions)  
 
Performance Coatings
  $ 31.6     $ 23.9     $ 26.2  
Electronic Materials
    13.5       33.2       21.0  
Color and Glass Performance Materials
    38.9       37.1       41.7  
Polymer Additives
    18.5       (.9 )     2.5  
Specialty Plastics
    13.4       9.6       12.8  
Other
    2.1       3.6       3.1  
                         
Total segment income
    118.0       106.5       107.3  
Unallocated expenses
    (47.9 )     (36.8 )     (50.1 )
Interest expense
    (46.9 )     (42.0 )     (43.1 )
Interest earned
    .5       .9       .9  
Foreign currency
    (1.3 )     (3.0 )     (1.2 )
Gain on sale of businesses
    .1       5.2        
Miscellaneous — net
    1.6       .4       (1.8 )
                         
Income before taxes from continuing operations
  $ 24.1     $ 31.2     $ 12.0  
                         


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
Depreciation and amortization by segment:
 
                         
    2005     2004     2003  
    (Dollars in millions)  
 
Performance Coatings
  $ 13.3     $ 13.3     $ 12.4  
Electronic Materials
    19.3       19.8       19.7  
Color and Glass Performance Materials
    10.4       11.5       11.2  
Polymer Additives
    10.6       10.6       8.9  
Specialty Plastics
    4.2       4.5       5.2  
Other
    7.3       5.1       5.4  
                         
Total segment depreciation and amortization
    65.1       64.8       62.8  
Other
    9.7       10.2       13.8  
                         
Total consolidated depreciation and amortization
  $ 74.8     $ 75.0     $ 76.6  
                         
 
Total assets at December 31 by segment:
 
                 
    2005     2004  
    (Dollars in millions)  
 
Performance Coatings
  $ 339.8     $ 347.7  
Electronic Materials
    382.9       400.9  
Color and Glass Performance Materials
    249.0       275.3  
Polymer Additives
    235.5       243.6  
Specialty Plastics
    98.6       105.9  
Other
    117.5       113.6  
                 
Total segment assets
    1,423.3       1,487.0  
Other assets
    245.2       246.4  
                 
Total consolidated assets
  $ 1,668.5     $ 1,733.4  
                 
 
Segment assets primarily consist of trade receivables, inventories, intangibles, and property, plant and equipment, net of applicable reserves. Other assets include cash, deferred taxes, pension assets, and other items.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
Intangible assets at December 31 by segment:
 
                 
    2005     2004  
    (Dollars in millions)  
 
Performance Coatings
               
Goodwill
  $ 46.5     $ 46.7  
Other intangibles
    .3       .3  
Accumulated amortization
    (.4 )     (.4 )
                 
Total Performance Coatings
    46.4       46.6  
Electronic Materials
               
Goodwill
    161.1       162.3  
Other intangibles
    21.9       21.9  
Accumulated amortization
    (16.3 )     (15.8 )
                 
Total Electronic Materials
    166.7       168.4  
Color and Glass Performance Materials
               
Goodwill
    65.6       65.0  
Other intangibles
    4.4       4.4  
Accumulated amortization
    (2.8 )     (2.4 )
                 
Total Color and Glass Performance Materials
    67.2       67.0  
Polymer Additives
               
Goodwill
    39.5       39.9  
Other intangibles
    42.4       42.4  
Accumulated amortization
    (9.0 )     (9.0 )
                 
Total Polymer Additives
    72.9       73.3  
Specialty Plastics
               
Goodwill
    20.7       20.8  
Other intangibles
           
Accumulated amortization
    (3.8 )     (3.8 )
                 
Total Specialty Plastics
    16.9       17.0  
Other
               
Goodwill
    42.3       41.4  
Other intangibles
           
Accumulated amortization
    (1.7 )     (1.2 )
                 
Total Other
    40.6       40.2  
                 
Total consolidated intangible assets, net
  $ 410.7     $ 412.5  
                 


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
Expenditures for long-lived assets (including acquisitions) by segment:
 
                         
    2005     2004     2003  
    (Dollars in millions)  
 
Performance Coatings
  $ 13.9     $ 12.9     $ 8.8  
Electronic Materials
    6.8       3.6       4.8  
Color and Glass Performance Materials
    4.6       4.8       7.5  
Polymer Additives
    3.7       4.7       5.1  
Specialty Plastics
    2.3       3.2       2.7  
Other
    9.4       9.9       4.9  
                         
Total segment expenditures for long-lived assets
    40.7       39.1       33.8  
Other
    2.1             2.3  
                         
Total consolidated expenditures for long-lived assets
  $ 42.8     $ 39.1     $ 36.1  
                         
 
Geographic revenues are based on the region in which the customer invoice is generated. The United States of America is the single largest country for customer sales. No other single country represents greater than 10% of the Company’s consolidated sales. Net sales by geographic region:
 
                         
    2005     2004     2003  
    (Dollars in millions)  
 
United States
  $ 925.9     $ 900.0     $ 776.4  
International
    956.4       943.7       839.2  
                         
Total
  $ 1,882.3     $ 1,843.7     $ 1,615.6  
                         
 
Except for the United States of America, no single country has greater than 10% of consolidated long-lived assets. Long-lived assets by geographic region at December 31:
 
                         
    2005     2004     2003  
    (Dollars in millions)  
 
United States
  $ 604.8     $ 626.8     $ 649.3  
International
    337.0       384.4       386.4  
                         
Total
  $ 941.8     $ 1,011.2     $ 1,035.7  
                         
 
16.   Financial instruments
 
The carrying amounts of cash and cash equivalents, trade receivables, other current assets, accounts payable and amounts included in investments and accruals meeting the definition of a financial instrument approximate fair value due to the short period to maturity of the instruments.
 
The Company manages currency risks principally by entering into forward contracts to mitigate the impact of currency fluctuations on transactions and other exposures. The maturity of such foreign currency forward contracts is consistent with the underlying exposure, generally less than one year. The Company does not engage in speculative transactions for trading purposes. The contracts are marked-to-market at the end of each reporting period, with the corresponding gain or loss included in the consolidated statement of income. At December 31, 2005, the notional amount and fair value of these forward contracts was $119.3 million and $0.1 million, respectively. At December 31, 2004, the notional amount and fair value of these forward contracts was $116.7 million and $(0.7) million, respectively. These forward contracts are executed with major reputable multinational financial institutions. Accordingly, the Company does not anticipate counter-party default.


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FERRO CORPORATION AND CONSOLIDATED SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
The Company purchases portions of its natural gas requirements under fixed price contracts, which in certain circumstances, although unlikely because committed quantities are below expected usage, could result in the Company settling its obligations under these contracts in cash at prevailing market prices. In compliance with FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities,” (FAS No. 133), as amended by Statement No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” (FAS No. 149), the Company marked these contracts to fair value and recognized the resulting gains or losses as miscellaneous income or expense, respectively. Natural gas contracts at December 31, 2005, and 2004, respectively, for 1.2 million and 1.5 million MMBTU’s of natural gas had fair values of $2.1 million and $(0.9) million. Purchase commitments at December 31, 2005, for natural gas were $10.6 million.
 
The Company also hedges a portion of its exposure to changes in the pricing of certain nickel and zinc commodities using derivative financial instruments. Nickel and zinc are raw materials used in the Company’s tile, porcelain enamel, and color and glass product lines. The hedges are accomplished principally through swap arrangements that allow the Company to fix the pricing of the commodities for future purchases. While hedged quantities are below expected usage, these swap arrangements, unlike the natural gas contracts, do not provide for physical delivery of the commodity but require the Company to settle its obligations in cash at the maturity of the contracts. In compliance with FAS No. 133 and FAS No. 149, the Company marks these contracts to fair value and recognizes the resulting gains or losses as other comprehensive income. After the contracts mature and the materials are sold, the gains and losses are recognized as a part of cost of goods sold. Nickel and zinc contracts at December 31, 2005, for 3,092 metric tons had a fair value of $0.1 million. There were no such contracts at December 31, 2004.
 
The Company consigns, from various financial institutions, precious metals (primarily silver, gold, platinum and palladium, collectively “metals”) used in the production of certain products for customers. Under these consignment arrangements, the financial institutions provide the Company with metals for a specified period of one year or less in duration, for which the Company pays a fee. Under these arrangements, the financial institutions own the metals, and accordingly, the Company does not report these consigned materials as part of its inventory on its consolidated balance sheet. These agreements are cancelable by either party at the end of each consignment period, however, because the Company has access to a number of consignment arrangements with available capacity, consignment needs can be shifted among the other participating institutions. In certain cases, these other participating institutions may require cash deposits to provide additional collateral beyond the underlying precious metals. In the fourth quarter of 2005, due to the Company’s delay in filing consolidated financial statements, certain financial institutions began to require the Company to make deposits. At December 31, 2005, the Company had outstanding deposits of $19.0 million, which are included in other current assets in the Company’s consolidated balance sheets. The fair value of the Company’s rights and obligations under these arrangements at December 31, 2005 and 2004 was not material.
 
Cost of sales related to the consignment arrangements’ fees were $1.6 million for 2005, $2.4 million for 2004, and $1.6 million for 2003. At December 31, 2005 and 2004, the Company had 5.9 million and 9.4 million troy ounces of metals (primarily silver) on consignment for periods of less than one year with market values of $99.3 million and $106.4 million, respectively.
 
The consignment arrangements allow for the Company to replace the metals used in the manufacturing process by obtaining replacement quantities on the spot market and to charge the customer for the cost of the replacement quantities. In certain circumstances, customers request, at the time an order is placed, a fixed price for the portion of the sales price relating to metals content in the finished goods. In these instances, the Company will enter into a fixed price sales contract to establish the cost for the customer at the estimated future delivery date. At the same time, the Company enters into a forward purchase arrangement with a metal supplier to completely cover the value of the fixed price sales contract. At December 31, 2005 and 2004, the Company had 3,000 and 599,000 troy ounces of metals (primarily silver) with market values of $0.1 million and $1.7 million, respectively, under fixed price contracts for future metal consignment replenishments. In accordance with FAS No. 133, the market value of these


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FERRO CORPORATION AND CONSOLIDATED SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

fixed price contracts is analyzed quarterly. Due to the short duration of the contracts (generally three months or less), the difference between the contract values and market values at any financial reporting date is not material.
 
17.   Leases
 
Rent expense for all operating leases was approximately $14.5 million in 2005, $13.9 million in 2004, and $10.7 million in 2003. Amortization of assets recorded under capital leases is recorded as depreciation expense.
 
The Company has a number of capital lease arrangements relating primarily to buildings and production equipment. Assets held under capitalized leases and included in property, plant and equipment at December 31 are as follows:
 
                 
    2005     2004  
    (Dollars in thousands)  
 
Gross amounts capitalized
               
Buildings
  $ 3,100     $ 3,100  
Equipment
    9,583       9,398  
                 
      12,683       12,498  
Accumulated amortization
               
Buildings
    (1,434 )     (1,356 )
Equipment
    (5,848 )     (4,915 )
                 
      (7,282 )     (6,271 )
                 
Net capital lease assets
  $ 5,401     $ 6,227  
                 
 
At December 31, 2005, future minimum lease payments under all non-cancelable leases are as follows:
 
                 
    Capitalized
    Operating
 
    Leases     Leases  
    (Dollars in thousands)  
 
2006
  $ 1,628     $ 11,516  
2007
    1,424       8,004  
2008
    1,222       5,070  
2009
    1,115       3,133  
2010
    1,109       2,195  
Thereafter
    5,385       9,656  
                 
Total minimum lease payments
    11,883     $ 39,574  
                 
Less amount representing executory costs
    23          
                 
Net minimum lease payments
    11,860          
Less amount representing imputed interest
    4,496     </