HERCULES INC - 10-Q Quarterly Report

Hercules Incorporated

TABLE OF CONTENTS

Part I - Financial Information..............................................................................................	3
Item 1. Consolidated Financial Statements.......................................................................	3
Consolidated Statements of Operations........................................................................	3
Consolidated Balance Sheets.......................................................................................	4
Consolidated Statements of Cash Flows.......................................................................	5
Consolidated Statements of Comprehensive Income.....................................................	6
Notes to Consolidated Financial Statements..................................................................	7
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.......................................................................................................	27
Overview...................................................................................................................	27
Critical Accounting Estimates......................................................................................	28
Results of Operations.................................................................................................	30
Financial Condition.....................................................................................................	32
Risk Factors...............................................................................................................	33
Indemnifications.........................................................................................................	35
Recent Accounting Pronouncements...........................................................................	35
Forward-Looking Statements......................................................................................	35
Item 3. Quantitative and Qualitative Disclosures About Market Risk.................................	35
Item 4. Controls and Procedures....................................................................................	36
Part II - Other Information..................................................................................................	37
Item 1. Legal Proceedings.............................................................................................	37
Item 6. Exhibits and Reports on Form 8-K......................................................................	37
Signature.......................................................................................................................	38
Exhibit Index..................................................................................................................	39

PART I – FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
HERCULES INCORPORATED
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in millions, except per share)		(Unaudited)
		Three Months Ended
		March 31,
		2004			2003

Net sales	$	475		$	447
Cost of sales (Note 6)		305			284
Selling, general and administrative expenses (Note 6)		98			91
Research and development		11			10
Intangible asset amortization (Note 4)		2			2
Other operating expense (income), net (Note 7)		13			(1	)

Profit from operations		46			61
Interest and debt expense		30			34
Other (income) expense, net (Note 8)		(9	)		4

Income before income taxes and equity income		25			23
(Benefit) provision for income taxes		(1	)		9

Income before equity income		26			14
Equity income (loss) of affiliated companies, net of tax		-			-

Net income before cumulative effect of changes in accounting principle		26			14
Cumulative effect of changes in accounting principle, net of tax		-			(28	)

Net income (loss)	$	26		$	(14	)
Basic and diluted earnings (loss) per share (Note 5)
Continuing operations	$	0.24		$	0.13
Cumulative effect of changes in accounting principle	$	-		$	(0.26	)
Net earnings (loss)	$	0.24		$	(0.13	)
Weighted-average number of shares - basic (millions)		107.0			106.8
Weighted-average number of shares - diluted (millions)		108.2			107.0








See accompanying notes to consolidated financial statements.

HERCULES INCORPORATED
CONSOLIDATED BALANCE SHEETS
(Dollars in millions)		(Unaudited)
		March 31,			December 31,
		2004			2003
ASSETS
Current assets
Cash and cash equivalents	$	67		$	125
Accounts and notes receivable (net of allowance for doubtful
accounts of $8 million and $5 million, respectively)		395			415
Inventories
Finished products		101			100
Raw materials, work-in-process and supplies		91			87
Deferred income taxes		109			93
Total current assets		763			820
Property, plant, and equipment		2,009			2,039
Accumulated depreciation and amortization		(1,352	)		(1,362	)
Net property, plant, and equipment		657			677
Intangible assets, net (Note 4)		185			187
Goodwill, net (Note 4)		514			518
Deferred income taxes		27			27
Other assets		524			530
Total assets	$	2,670		$	2,759

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable	$	192		$	192
Accrued expenses		225			243
Current maturities of long-term debt (Note 10)		22			22
Total current liabilities		439			457

Long-term debt (Note 10)		1,287			1,326
Deferred income taxes		77			78
Pension liability (Note 12)		218			249
Other postretirement benefits (Note 12)		93			96
Deferred credits and other liabilities		478			494
Commitments and contingencies (Note 14)

Stockholders' equity
Series preferred stock		-			-
Common stock, $25/48 par value (shares issued and outstanding:
2004 - 159,984,444; 2003 - 159,984,444)		83			83
Additional paid-in capital		579			603
Unearned compensation		(88	)		(87	)
Accumulated other comprehensive losses		(329	)		(317	)
Retained earnings		1,569			1,543
		1,814			1,825
Reacquired stock, at cost (shares: 2004 - 48,160,762;
2003 - 48,992,628)		1,736			1,766
Total stockholders' equity		78			59
Total liabilities and stockholders' equity	$	2,670		$	2,759
See accompanying notes to consolidated financial statements.

HERCULES INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in millions)		(Unaudited)
		Three Months Ended March 31,
		2004			2003
Cash Flows from Operating Activities:
Net income (loss)	$	26		$	(14	)
Adjustments to reconcile net income to net cash (used in) provided by operations:
Depreciation		19			17
Amortization		7			7
Provision for deferred income taxes		5			4
Nonoperating gain on disposals		(26	)		(1	)
Impairment charges		7			-
Other non-cash charges and credits		2			1
Accruals and deferrals of cash receipts and payments:
Accounts and notes receivable		15			(6	)
Inventories		(7	)		(7	)
Accounts payable and accrued expenses		(9	)		(40	)
Income taxes payable		(25	)		(6	)
Pension and postretirement benefits		(35	)		5
Asbestos payments		(12	)		(1	)
Non-current assets and liabilities		(4	)		57
Net cash (used in) provided by operating activities	$	(37	)	$	16

Cash Flow from Investing Activities:
Capital expenditures		(10	)		(8	)
Proceeds from sale of minority interest in CP Kelco ApS		27			-
Proceeds of investment and fixed asset disposals		-			3
Other, net		-			1
Net cash provided by (used in) investing activities		17			(4	)

Cash Flow from Financing Activities:
Long-term debt repayments		(39	)		(5	)
Change in short-term debt		-			(1	)
Treasury stock issued		1			1
Net cash used in financing activities		(38	)		(5	)

Effect of exchange rate changes on cash		-			2

Net (decrease) increase in cash and cash equivalents		(58	)		9
Cash and cash equivalents - beginning of period		125			209
Cash and cash equivalents - end of period	$	67		$	218

Supplemental Disclosures of Cash Flow Information:
Cash paid during the period for:
Interest and debt expense	$	21		$	20
Income taxes		19			5
Non-cash investing and financing activities:
Incentive and other employee benefit stock plan issuances		11			5

See accompanying notes to consolidated financial statements.

HERCULES INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1. Basis of Presentation

The interim condensed consolidated financial statements and the notes to the condensed consolidated financial statements of Hercules Incorporated ("Hercules" or the "Company") are unaudited as of and for the three months ended March 31, 2004 and 2003, but in the opinion of management include all adjustments (consisting only of normal recurring adjustments) necessary for a fair statement of Hercules' financial position and results of operations for the interim periods. These condensed consolidated financial statements should be read in conjunction with the accounting policies, financial statements and notes included in Hercules' Annual Report on Form 10-K for the year ended December 31, 2003. Certain prior period amounts have been reclassified to conform to the current period presentation.

2. Stock-based Compensation

The Company has adopted Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), as amended by Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" ("SFAS 148"), effective January 1, 2003. SFAS 148 amends SFAS 123 by providing alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation and requiring enhanced disclosure regarding stock-based compensation. The Company elected to apply the fair value recognition provisions of SFAS 123 on a prospective basis to all employee awards granted, modified or settled after January 1, 2003. Therefore, the cost related to stock-based employee compensation included in the determination of net income is less than that which would have been recognized if the fair value based method had been applied to all awards since the original effective date of SFAS 123. The Company did not grant any stock options pursuant to SFAS 123, as amended by SFAS 148, to employees in 2003 or 2004. The Company made grants of restricted stock to employees and non-employee directors in 2003 and 2004. Restricted stock awards under the Hercules Long-term Incentive Compensation Plan are valued at the quoted market price (fair value) of the Company's stock on the grant date (measurement date). Stock acquired through the Employee Stock Purchase Plan and "above target" restricted stock awarded under the Hercules Management Incentive Compensation Plan ("MICP") for awards paid prior to 2004 is discounted 15% from market price as permitted by IRS regulations and the provisions of the Company's incentive compensation plans. "Above target" awards under the MICP for the 2003 plan year were paid in cash and "above target" awards, if any, for the 2004 plan year will be paid in either cash or restricted stock at fair market value. The value of the award and the discount, if any, is amortized into compensation expense over the applicable vesting period. Forfeitures are recorded as incurred. The Company recognized expense of $1 million during the three months ended March 31, 2004 in connection with restricted stock awards.

Pursuant to the disclosure requirements of SFAS 123, as amended by SFAS 148, the following table presents the pro forma effect on net income (loss) and income (loss) per share assuming the Company had applied the fair value recognition provisions of SFAS 123 to all stock-based employee compensation on a retroactive basis.

(Dollars in millions, except per share)	Three Months Ended March 31,

		2004		2003
Net income (loss), as reported	$	26	$	(14	)

Add: Total stock-based employee compensation expense recognized
in reported results		1		-

Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards, net of tax		2		2

Pro forma net income (loss)	$	25	$	(16	)
Income (loss) per share:
Basic - as reported	$	0.24	$	(0.13	)
Basic - pro forma	$	0.23	$	(0.15	)

Diluted - as reported	$	0.24	$	(0.13	)
Diluted - pro forma	$	0.23	$	(0.15	)

3. Recent Accounting Pronouncements

In January 2004, the FASB issued Staff Position FAS 106-1, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003" ("FSP 106-1"). FSP 106-1 permits a sponsor of a postretirement health care plan that provides a prescription drug benefit to make a one-time election to defer accounting for the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the "Medicare Act"). The Medicare Act, which was signed by the President on December 8, 2003, introduces a prescription drug benefit under Medicare (Medicare Part D) as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D.

The Company offers a drug benefit plan as part of its comprehensive health care plan and has elected to defer current recognition of the effects of the Act in the accounting for its plan pursuant to FSP 106-1 until authoritative guidance on the accounting for the federal subsidy is issued. As such, any measures of the accumulated projected benefit obligation or net periodic postretirement benefit cost in the financial statements or accompanying notes do not reflect the effects of the Medicare Act on the plan. Specific authoritative guidance on the accounting for the federal subsidy is still pending and it is possible that the guidance, when issued, could require the Company to change previously reported information.

4. Goodwill and Other Intangible Assets

The following table shows changes in the carrying amount of goodwill by operating segment for the three months ended March 31, 2004.

(Dollars in millions)		Performance Products		Engineered Materials & Additives		Total

Balance at December 31, 2003	$	433	$	85	$	518
Foreign currency translation		4		-		4

Balance at March 31, 2004	$	429	$	85	$	514

The following table provides information regarding the Company's other intangible assets with finite lives:

(Dollars in millions)	Customer Relationships		Trademarks & Tradenames		Other Intangibles		Total

Gross Carrying Amount
Balance, December 31, 2003		$ 89		$ 72		$ 72	$ 233
Balance, March 31, 2004		89		72		72	233

Accumulated Amortization
Balance, December 31, 2003		$ 12		$ 9		$ 25	$ 46
Balance, March 31, 2004		12		10		26	48

Total period amortization expense for other intangible assets was $2 million for each of the three months ended March 31, 2004 and 2003. Estimated amortization expense is $8 million for 2004 and $7 million per year for 2005 through 2008.

5. Earnings (Loss) Per Share

The following table shows the amounts used in computing earnings (loss) per share and the effect on net income (loss) and the weighted-average number of shares of dilutive potential common stock:

(Dollars in millions, except per share)		Three Months Ended March 31,
		2004				2003
									Earnings
				Earnings		Income			(loss)
		Income		per share		(loss)			per share
Basic and Diluted:
Continuing operations	$	26	$	0.24	$	14		$	0.13
Cumulative effect of changes in accounting principle	$	-	$	-	$	(28	)	$	(0.26	)
Net income (loss)	$	26	$	0.24	$	(14	)	$	(0.13	)

Weighted-average number of shares - basic (millions)		107.0				106.8
Weighted-average number of shares - diluted (millions)		108.2				107.0

For the three months ended March 31, 2004 and 2003, the Company had convertible subordinated debentures, stock options and restricted stock which were convertible into approximately 1.2 million and 0.2 million shares, respectively, of common stock. The related interest on the debentures has an immaterial impact on the earnings per share calculation. Diluted earnings per share for the three months ended March 31, 2004 and 2003 excludes 13.7 million and 18.3 million options to purchase shares of common stock, respectively, as their exercise price exceeds their current market value.

6. Depreciation Expense

Cost of sales and selling, general and administrative expenses include depreciation expense related to continuing operations totaling $19 million and $17 million for the three months ended March 31, 2004 and 2003, respectively.

7. Other Operating Expense (Income), Net

Other operating expense (income), net, for the three months ended March 31, 2004 includes $7 million for impairment charges associated with two production facilities, $2 million in shutdown costs related to the Company's former nitrocellulose facility, $2 million in severance charges, $1 million for special executive pension adjustments, and $1 million of costs associated with efforts made to acquire Meraklon S.p.A.

Other operating expense (income), net, for the three months ended March 31, 2003 includes a $3 million gain related to a favorable legal settlement, partially offset by $2 million of severance costs.

8. Other (Income) Expense, Net

Other (income) expense, net, for the three months ended March 31, 2004 includes a $26 million gain on the Company's sale of its minority interest in CP Kelco ApS. The gain was partially offset by a $6 million legal settlement, $2 million of asbestos-related litigation costs, $1 million of legal and other costs associated with previously divested businesses, a $7 million loss recognized on the repurchase of debt, and a $1 million write-off of related unamortized debt issuance costs.

Other (income) expense, net, for the three months ended March 31, 2003 includes $1 million in net charges for asbestos-related litigation costs, $1 million in bank charges, $1 million of interest income and $3 million of other charges.

9. Severance and Other Exit Costs

The consolidated balance sheets reflect liabilities for employee severance benefits and other costs of $6 million at both March 31, 2004 and December 31, 2003. During 2001 and continuing through March 31, 2003, management authorized and committed to various plans to reduce the workforce as part of a comprehensive cost reduction and work process redesign program. During that period, the Company incurred $78 million in employee severance benefits, exit costs and contract terminations. During 2003, the Company recognized an additional $5 million for employee termination benefits in accordance with Statement of Financial Accounting Standards No. 112, "Employer's Accounting for Post-Employment Benefits" ("SFAS 112") under its Dismissal Salary and Dismissal Wage Plans ("Dismissal Plans").

During the three months ended March 31, 2004, the Company recognized an additional $2 million charge for employee termination benefits under the Dismissal Plans in accordance with SFAS 112, identifying an additional 47 employees to receive these benefits upon leaving the Company. As of March 31, 2004, under all plans, approximately 1,446 employees have left or will leave the Company by September 30, 2004, of which 1,397 employees were terminated pursuant to these plans through March 31, 2004. Approximately 10 employees were terminated during the three months ended March 31, 2004.

Cash payments during the three months ended March 31, 2004 were $2 million, including $1 million for severance under the 2001 plan and $1 million for severance liabilities recognized under the Dismissal Plans.

A reconciliation of activity with respect to the liabilities for these plans is as follows:

(Dollars in millions)
Balance at December 31, 2003	$	6
Additional termination costs		2
Cash payments		(2	)
Balance at March 31, 2004	$	6

The balance at March 31, 2004 represents severance benefits and other exit costs of which $2 million pertains to the continuing benefit payment streams under the 2001 restructuring plan and $4 million pertains to other severance benefits accounted for under the Company's Dismissal Plans.

Effective January 1, 2003, the Company adopted Statement of Financial Accounting Standards No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" ("SFAS 146"). The Company did not recognize any costs associated with exit or disposal activities pursuant to SFAS 146.

10. Debt

(Dollars in millions)		March 31,		December 31,
		2004		2003
Long-term:
6.60% notes due 2027	$	100	$	100
11.125% senior notes due 2007		343		376
8% convertible subordinated debentures due 2010		3		3
Term notes at various rates from 2.97% to 7.90% due in
varying amounts through 2006		40		42
Term B loan due 2007		198		198
9.42% junior subordinated deferrable interest debentures due 2029		363		363
6.5% junior subordinated deferrable interest debentures due 2029		262		262
Other		-		4
		1,309		1,348
Less: Current maturities of long-term debt		22		22
Net long-term debt	$	1,287	$	1,326

On April 8, 2004, the Company completed the refinancing of its old Senior Credit Facility with a new $400 million term loan (the "Term Loan Facility") and a new $150 million committed revolving credit facility (the "Revolving Facility"). The Company also has the ability under this facility, subject to lender approval, to borrow an additional $250 million in the form of an incremental term note. The Term Loan Facility matures October 8, 2010 and the Revolving Facility matures April 9, 2009. Borrowings under the Term Loan Facility initially will bear interest at LIBOR + 2.25% (initially 3.48%) with the Company holding the option to reset interest rates for one, two, three or six month periods. The new Senior Credit Facility is secured by liens on the Company's assets (including real, personal and intellectual properties) and is guaranteed by substantially all of the Company's current and future wholly owned domestic subsidiaries. The Company also completed the private offering of $250 million aggregate principal amount of 6 3/4% senior subordinated notes due 2029.

Proceeds from the refinancing were used in part to fully repay the outstanding Term B loan. The Company has dissolved Hercules Trust I (the "Trust") and caused the Company's 9.42% junior subordinated deferrable interest debentures due 2029 to be distributed to the holders of the Trust's 9.42% trust preferred securities. The Company also caused a notice to be issued that the redemption of the debentures would be on May 10, 2004. Proceeds of $363 million from the refinancing have been placed in an escrow account to fully redeem the debentures. As a result of the redemption, the Company will recognize approximately $14 million of non-cash expense during the second quarter 2004 for the write-off of unamortized debt issuance costs.

The Board of Directors has authorized the Company, from time to time, subject to market conditions and provisions of the Company's credit agreement, to repurchase up to $200 million of its outstanding indebtedness. During the first quarter 2004, the Company repurchased $33 million (book value) of the 11.125% senior notes for $40 million recording a loss on the repurchase of $7 million, which is included in Other (income) expense, net. During April 2004, the Company repurchased an additional $15 million (book value) of the 11.125% senior notes for $18 million.

As of March 31, 2004, $48 million of the $125 million revolver under the old Senior Credit Facility was available for use. The Company had $77 million of outstanding letters of credit associated with the old Senior Credit Facility at March 31, 2004.

The Company's new Senior Credit Facility requires quarterly compliance with certain financial covenants, including a debt/EBITDA ratio ("leverage ratio") and an interest coverage ratio and established limitations on the permitted amount of annual capital expenditures.

11. Company-obligated Preferred Securities of Subsidiary Trusts

The Company has determined that (i) Hercules Trust I and Hercules Trust II (the "Trusts") are variable interest entities and (ii) the Company is not the primary beneficiary of the Trusts pursuant to the provisions of FASB Interpretation No. 46 (revised December 2003), "Consolidation of Variable Interest Entities" ("FIN 46R"). Accordingly, the Company has de-consolidated the Trusts effective December 31, 2003. Summarized below is the condensed financial information of the Trusts.

(Dollars in millions)	March 31, 2004		December 31, 2003

	Hercules Trust I	Hercules Trust II	Hercules Trust I	Hercules Trust II

Non-current assets	$ 363	$ 262	$ 363	$ 262
Non-current liabilities	363	262	363	262

The non-current assets for Hercules Trust I represent its investment in the 9.42% junior subordinated deferrable interest debentures of Hercules due March 31, 2029. The non-current assets for Hercules Trust II represents its investment in the 6.50% junior subordinated deferrable interest debentures of Hercules due June 30, 2029. As discussed in Note 10, the Company dissolved Hercules Trust I and caused a redemption notice to be issued to the holders of the debentures. The funds required for redemption have been placed into an escrow account with a redemption date of May 10, 2004.

12. Pension and Other Postretirement Benefits

The following table sets forth the consolidated net periodic pension and other postretirement benefit costs recognized for the three months ended March 31, 2004 and 2003.

(Dollars in millions)
	Pension Benefits						Other Postretirement Benefits

Net periodic benefit cost:	2004			2003			2004			2003

Service cost	$	5		$	4		$	-		$	-
Interest cost		24			25			3			3
Expected return on plan assets		(27	)		(28	)		-			-
Amortization and deferrals		1			1			(2	)		(2	)
Special benefits		1			-			-			-
Actuarial losses recognized		8			5			2			2

	$	12		$	7		$	3		$	3

The total expected contributions to be paid in 2004 to all plans globally is $45 million, including $40 million in voluntary contributions made to the U.S. defined benefit plan in January 2004.

13. Asset Retirement Obligations

The following table provides a reconciliation of the changes in the asset retirement obligations during the period.

(Dollars in millions)

Balance

HERCULES INCORPORATED
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Dollars in millions)	(Unaudited)
	Three Months Ended
	March 31,
		2004		2003

Net income (loss)	$	26	$	(14	)
Foreign currency translation		12		20
Comprehensive income	$	38	$	6






































See accompanying notes to consolidated financial statements.