10-Q 1 tin3d10q2004.txt TEMPLE-INLAND 3D 2004 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 _____________________________________ FORM 10-Q (Mark One) [x] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Quarterly Period Ended October 2, 2004 OR [ ] 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: 001-08634 Temple-Inland Inc. (Exact name of registrant as specified in its charter) Delaware 75-1903917 (State or other jurisdiction of (I.R.S. Employer Identification incorporation or organization) Number) 1300 MoPac Expressway South, Austin, Texas 78746 (Address of Principal Executive Offices, including Zip code) (512) 434-5800 (Registrant's telephone number, including area code) Not Applicable (Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [x] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [x] No [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Number of common shares outstanding Class as of October 2, 2004 ------ --------------------- Common Stock (par value $1.00 55,991,644 per share) Page 1 of 47 The Exhibit Index is page 41. 2 CONTENTS Page ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements Parent company financial statements 3 Financial services financial statements 6 Consolidated financial statements 9 Notes to consolidated financial statements 13 Item 2. Management's Discussion and Analysis of 21 Financial Condition and Results of Operations Item 3. Quantitative and Qualitative Disclosures About 37 Market Risk Item 4. Controls and Procedures 38 PART II. OTHER INFORMATION 38 Item 1. Legal Proceedings 38 Item 2. Unregistered Sales of Equity Securities and Use 38 of Proceeds Item 3. Defaults Upon Senior Securities 38 Item 4. Submission of Matters to a Vote of Security 38 Holders Item 5. Other Information 39 Item 6. Exhibits and Reports on Form 8-K 39 SIGNATURES 40 3 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS SUMMARIZED STATEMENTS OF INCOME PARENT COMPANY (TEMPLE-INLAND INC.) Unaudited
Third First Nine Quarter Months ----------- ----------- 2004 2003 2004 2003 ---- ---- ---- ---- (In millions) NET REVENUES $ 955 $ 878 $ 2,788 $ 2,602 COSTS AND EXPENSES Cost of sales 804 799 2,408 2,398 Selling 25 28 76 85 General and administrative 41 40 128 130 Other operating (income) expense 4 15 28 45 ----- ----- ----- ----- 874 882 2,640 2,658 ----- ----- ----- ----- 81 (4) 148 (56) FINANCIAL SERVICES EARNINGS 16 48 128 129 ----- ----- ----- ----- OPERATING INCOME 97 44 276 73 Interest expense (31) (33) (97) (103) Other non-operating expense - (8) (2) (8) ----- ----- ----- ----- INCOME (LOSS) FROM CONTINUING 66 3 177 (38) OPERATIONS BEFORE TAXES Income tax (expense) benefit (26) (6) (69) 173 ----- ----- ----- ----- INCOME (LOSS) FROM CONTINUING 40 (3) 108 135 OPERATIONS Discontinued operations 1 - 2 1 ----- ----- ----- ----- INCOME (LOSS) BEFORE ACCOUNTING 41 (3) 110 136 CHANGE Effect of accounting change - - - (1) ----- ----- ----- ----- NET INCOME (LOSS) $ 41 $ (3) $ 110 $ 135 ===== ===== ===== =====
See the notes to consolidated financial statements. 4 SUMMARIZED BALANCE SHEETS PARENT COMPANY (TEMPLE-INLAND INC.) Unaudited
Third Quarter Year-End 2004 2003 ---- ---- (In millions) ASSETS Current Assets Cash and cash equivalents $ 15 $ 20 Receivables, net of allowances of $15 445 359 in 2004 and $14 in 2003 Inventories: Work in process and finished goods 99 83 Raw materials and supplies 273 247 ----- ----- Total inventories 372 330 Prepaid expenses and other 67 69 ----- ----- Total current assets 899 778 Investment in financial services 1,129 1,123 Timber and timberlands 497 497 Property and equipment: Land and buildings 592 600 Machinery and equipment 3,474 3,454 Construction in progress 47 59 Less allowances for depreciation (2,366) (2,259) ----- ----- Total property and equipment 1,747 1,854 Goodwill 235 237 Assets of discontinued operations 28 50 Other assets 111 99 ----- ----- TOTAL ASSETS $ 4,646 $ 4,638 ===== ===== LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Accounts payable $ 211 $ 218 Employee compensation and benefits 73 72 Accrued interest 25 27 Accrued property taxes 30 23 Other accrued expenses 150 141 Liabilities of discontinued operations 23 22 Current portion of long-term debt 3 4 ----- ----- Total current liabilities 515 507 Long-term debt 1,457 1,611 Deferred income taxes 80 25 Postretirement benefits 144 146 Pension liability 285 250 Other long-term liabilities 61 131 ----- ----- Total Liabilities 2,542 2,670 Shareholders' Equity 2,104 1,968 ----- ----- TOTAL LIABILITIES AND SHAREHOLDERS' $ 4,646 $ 4,638 EQUITY ===== =====
See the notes to consolidated financial statements. 5 SUMMARIZED STATEMENTS OF CASH FLOW PARENT COMPANY (TEMPLE-INLAND INC.) Unaudited
First Nine Months ---------- 2004 2003 ---- ---- (In millions) CASH PROVIDED BY (USED FOR) OPERATIONS Net income $ 110 $ 135 Adjustments: Depreciation and amortization 166 176 Non-cash stock based compensation 26 22 Non-cash pension and postretirement 45 41 expense Cash contribution to pension and (13) (11) postretirement plans Other non-cash charges (credits) 14 (133) Deferred income taxes 53 10 Net earnings of financial services (79) (83) Dividends from financial services 70 120 Joint venture earnings (19) (2) Dividends from joint ventures 10 4 Net assets of discontinued operations (9) (1) Cumulative effect of accounting change - 1 Other 16 12 ----- ----- 390 291 Changes in: Receivables (86) (48) Inventories (44) 18 Prepaid expenses and other 3 (9) Accounts payable and accrued expenses 8 12 ----- ----- 271 264 ----- ----- CASH PROVIDED BY (USED FOR) INVESTING Capital expenditures (117) (96) Sales of non-strategic assets 63 36 Other acquisitions and joint ventures (3) (7) ----- ----- (57) (67) ----- ----- CASH PROVIDED BY (USED FOR) FINANCING Payments of debt (155) (169) Payments of other long-term liabilities (64) - Cash dividends paid to shareholders (60) (55) Proceeds from exercise of stock options 60 - Additions to debt - 24 ----- ----- (219) (200) ----- ----- (5) (3) Effect of exchange rate changes on cash - - ----- ----- Net increase (decrease) in cash and cash (5) (3) equivalents Cash and cash equivalents at beginning of period 20 17 ----- ----- Cash and cash equivalents at end of period $ 15 $ 14 ===== =====
See the notes to consolidated financial statements. 6 SUMMARIZED STATEMENTS OF INCOME FINANCIAL SERVICES Unaudited
Third Quarter First Nine Months ------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- (In millions) INTEREST INCOME Loans and loans held for sale $ 122 $ 129 $ 354 $ 393 Securities available-for-sale 13 16 42 54 Securities held-to-maturity 40 33 129 109 Other earning assets 1 1 2 3 ---- ---- ---- ---- Total interest income 176 179 527 559 INTEREST EXPENSE Deposits 37 43 104 145 Borrowed funds 43 41 128 130 ---- ---- ---- ---- Total interest expense 80 84 232 275 ---- ---- ---- ---- NET INTEREST INCOME 96 95 295 284 (Provision) credit for loan losses 5 (13) 9 (44) ---- ---- ---- ---- NET INTEREST INCOME AFTER (PROVISION) 101 82 304 240 ---- ---- ---- ---- NON-INTEREST INCOME Loan servicing fees 8 8 24 24 Amortization and impairment of (21) (12) (34) (53) Loan origination and sale of loans 34 71 117 225 Real estate operations 8 14 43 34 Insurance commissions and fees 12 12 36 33 Service charges on deposits 11 9 31 26 Operating lease income 2 3 8 8 Other 9 8 26 29 ---- ---- ---- ---- Total non-interest income 63 113 251 326 ---- ---- ---- ---- NON-INTEREST EXPENSE Compensation and benefits 65 84 209 256 Loan servicing and origination 3 5 9 12 Real estate operations, other than 4 9 24 24 Insurance operations, other than 1 1 4 4 Occupancy 9 9 24 25 Data processing 5 7 14 20 Other 40 31 122 93 Charges related to asset impairments and severance 21 1 21 3 ---- ---- ---- ---- Total non-interest expense 148 147 427 437 ---- ---- ---- ---- INCOME BEFORE TAXES 16 48 128 129 Income tax (expense) (7) (17) (49) (46) ---- ---- ---- ---- NET INCOME $ 9 $ 31 $ 79 $ 83 ==== ==== ==== ====
See the notes to consolidated financial statements. 7 SUMMARIZED BALANCE SHEETS FINANCIAL SERVICES Unaudited
Third Quarter Year-End 2004 2003 --------- -------- (In millions) ASSETS Cash and cash equivalents $ 421 $ 379 Loans held for sale 535 551 Loans, net of allowance for losses of $96 in 2004 and $111 in 2003 9,690 9,026 Securities available-for-sale 1,170 1,374 Securities held-to-maturity 4,232 5,267 Real estate 241 295 Premises and equipment, net 174 164 Accounts, notes and accrued interest receivable 133 138 Goodwill 152 147 Mortgage servicing rights - 89 Assets held for sale 67 - Other assets 222 231 ------ ------ TOTAL ASSETS $ 17,037 $ 17,661 ====== ====== LIABILITIES AND SHAREHOLDER'S EQUITY Deposits $ 8,991 $ 8,698 Federal Home Loan Bank advances 4,834 4,992 Securities sold under repurchase agreements 1,162 1,327 Obligations to settle trade date securities - 567 Other liabilities 418 410 Other borrowings 198 239 Preferred stock issued by subsidiaries 305 305 ------ ------ TOTAL LIABILITIES 15,908 16,538 ------ ------ SHAREHOLDER'S EQUITY 1,129 1,123 ------ ------ TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY $ 17,037 $ 17,661 ====== ======
See the notes to consolidated financial statements. 8 SUMMARIZED STATEMENTS OF CASH FLOWS FINANCIAL SERVICES Unaudited
First Nine Months ----------------- 2004 2003 ---- ---- (In millions) CASH PROVIDED BY (USED FOR) OPERATIONS Net income $ 79 $ 83 Adjustments: Depreciation of premises and equipment 18 18 Depreciation of leased assets 7 6 Amortization and impairment of servicing rights 34 53 Non-cash charges related to mortgage banking repositioning 17 - Provision (credit) for loan losses (9) 44 Amortization and accretion of financial instruments 14 17 Deferred income taxes (9) (12) ----- ----- 151 209 Changes in: Loans held for sale, originations of loans (5,464) (11,144) Loans held for sale, sales of loans 5,479 11,611 Collections on loans services for others, net (5) (24) Other (1) (41) ----- ----- 160 611 ----- ----- CASH PROVIDED BY (USED FOR) INVESTING Securities available-for-sale: Purchases (28) (17) Principal payments and maturities 229 452 Securities held-to-maturity: Purchases (896) (2,008) Principal payments and maturities 1,349 1,706 Loans originated or acquired, net of (725) 198 collections Sale of loans 36 41 Acquisitions, net of cash acquired (20) (1) Capital expenditures (30) (25) Sale of assets and other 56 10 ----- ----- (29) 356 ----- ----- CASH PROVIDED BY (USED FOR) FINANCING Net increase (decrease) in deposits 293 (234) Repurchase agreements and short-term borrowings, net (85) (241) Additions to long-term FHLB advances and other borrowings 321 282 Payments of long-term FHLB advances and other borrowings (562) (647) Dividends paid to parent company (70) (120) Other 14 11 ----- ----- (89) (949) ----- ----- Net increase (decrease) in cash and cash equivalents 42 18 Cash and cash equivalents at beginning of period 379 438 ----- ----- Cash and cash equivalents at end of period $ 421 $ 456 ===== =====
See the notes to consolidated financial statements. 9 CONSOLIDATED STATEMENTS OF INCOME TEMPLE-INLAND INC. AND SUBSIDIARIES Unaudited
Third Quarter First Nine Months ------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- (In millions, except per share amounts) REVENUES Manufacturing $ 955 $ 878 $ 2,788 $ 2,602 Financial services 239 292 778 885 ------ ------ ------ ------ 1,194 1,170 3,566 3,487 ------ ------ ------ ------ COSTS AND EXPENSES Manufacturing 874 882 2,640 2,658 Financial services 223 244 650 756 ------ ------ ------ ------ 1,097 1,126 3,290 3,414 ------ ------ ------ ------ OPERATING INCOME 97 44 276 73 Parent company interest (31) (33) (97) (103) Other non-operating expense - (8) (2) (8) ------ ------ ------ ------ INCOME (LOSS) BEFORE TAXES 66 3 177 (38) Income tax (expense) benefit (26) (6) (69) 173 ------ ------ ------ ------ INCOME (LOSS) FROM CONTINUING OPERATIONS 40 (3) 108 135 Discontinued operations 1 - 2 1 ------ ------ ------ ------ INCOME (LOSS) BEFORE ACCOUNTING CHANGE 41 (3) 110 136 Effect of accounting change - - - (1) ------ ------ ------ ------ NET INCOME (LOSS) $ 41 $ (3) $ 110 $ 135 ====== ====== ====== ====== EARNINGS (LOSS) PER SHARE Basic: Income (loss) from continuing operations $ 0.71 $(0.06) $ 1.95 $ 2.49 Discontinued operations 0.02 - 0.03 0.01 Effect of accounting change - - - (0.01) ------ ------ ------ ------ Net income (loss) $ 0.73 $(0.06) $ 1.98 $ 2.49 ====== ====== ====== ====== Diluted: Income (loss) from continuing operations $ 0.71 $(0.06) $ 1.93 $ 2.49 Discontinued operations 0.02 - 0.03 0.01 Effect of accounting change - - - (0.01) ------ ------ ------ ------ Net income (loss) $ 0.73 $(0.06) $ 1.96 $ 2.49 ====== ====== ====== ====== DIVIDENDS PAID PER SHARE OF COMMON STOCK $ 0.36 $ 0.34 $ 1.08 $ 1.02 ====== ====== ====== ======
See the notes to consolidated financial statements. 10 CONSOLIDATING BALANCE SHEETS TEMPLE-INLAND INC. AND SUBSIDIARIES Third Quarter 2004 Unaudited
Parent Financial Company Services Consolidated ------- -------- ------------ (In millions) ASSETS Cash and cash equivalents $ 15 $ 421 $ 436 Loans held for sale - 535 535 Loans receivable - 9,690 9,690 Securities available-for-sale - 1,170 1,170 Securities held-to-maturity - 4,232 4,232 Trade receivables 445 - 445 Inventories 372 - 372 Timber and timberlands 497 - 497 Property and equipment 1,747 174 1,921 Goodwill 235 152 387 Other assets 206 663 821 Investment in financial services 1,129 - - ------ ------- ------- TOTAL ASSETS $ 4,646 $ 17,037 $ 20,506 ====== ======= ======= LIABILITIES AND SHAREHOLDERS' EQUITY Deposits $ - $ 8,991 $ 8,991 Federal Home Loan Bank advances - 4,834 4,834 Securities sold under repurchase agreements - 1,162 1,162 Other liabilities 576 418 975 Long-term debt 1,457 198 1,655 Deferred income taxes 80 - 51 Postretirement benefits 144 - 144 Pension liability 285 - 285 Preferred stock issued by subsidiaries - 305 305 ------ ------- ------- TOTAL LIABILITIES $ 2,542 $ 15,908 $ 18,402 ------ ------- ------- SHAREHOLDERS' EQUITY Preferred stock - par value $1 per - share: authorized 25,000,000 shares; none issued Common stock - par value $1 per 61 share: authorized 200,000,000 shares; issued 61,389,552 shares including shares held in the treasury Additional paid-in capital 402 Accumulated other comprehensive loss (186) Retained earnings 2,073 ------- 2,350 Cost of shares held in the treasury: 5,397,908 shares (246) ------- TOTAL SHAREHOLDERS' EQUITY 2,104 ------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 20,506 =======
See the notes to consolidated financial statements. 11 CONSOLIDATING BALANCE SHEETS TEMPLE-INLAND INC. AND SUBSIDIARIES Year-End 2003 Unaudited
Parent Financial Company Services Consolidated ------- -------- ------------ (In millions) ASSETS Cash and cash equivalents $ 20 $ 379 $ 399 Loans held for sale - 551 551 Loans receivable - 9,026 9,026 Securities available-for-sale - 1,374 1,374 Securities held-to-maturity - 5,267 5,267 Trade receivables 359 - 359 Inventories 330 - 330 Timber and timberlands 497 - 497 Property and equipment 1,854 164 2,018 Goodwill 237 147 384 Other assets 218 753 938 Investment in financial services 1,123 - - ------ ------- ------- TOTAL ASSETS $ 4,638 $ 17,661 $ 21,143 ------ ------- ------- LIABILITIES AND SHAREHOLDERS' EQUITY Deposits $ - $ 8,698 $ 8,698 Federal Home Loan Bank advances - 4,992 4,992 Securities sold under repurchase agreements - 1,327 1,327 Obligations to settle trade date securities - 567 567 Other liabilities 638 410 1,033 Long-term debt 1,611 239 1,850 Deferred income taxes 25 - 7 Postretirement benefits 146 - 146 Pension liability 250 - 250 Preferred stock issued by subsidiaries - 305 305 ------ ------- ------- TOTAL LIABILITIES $ 2,670 $ 16,538 $ 19,175 ====== ======= ======= SHAREHOLDERS' EQUITY Preferred stock - par value $1 per - share: authorized 25,000,000 shares; none issued Common stock - par value $1 per 61 share: authorized 200,000,000 shares; issued 61,389,552 shares including shares held in the treasury Additional paid-in capital 377 Accumulated other comprehensive loss (185) Retained earnings 2,023 ------- 2,276 Cost of shares held in the treasury: 6,792,410 shares (308) ------- TOTAL SHAREHOLDERS' EQUITY 1,968 ------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 21,143 =======
See the notes to consolidated financial statements. 12 CONSOLIDATED STATEMENT OF CASH FLOWS TEMPLE-INLAND INC. AND SUBSIDIARIES Unaudited
First Nine Months ----------------- 2004 2003 ---- ---- (In millions) CASH PROVIDED (USED FOR) OPERATIONS Net income $ 110 $ 135 Adjustments: Depreciation and amortization 191 200 Amortization and accretion of financial instruments 48 70 Provision for loan losses (9) 44 Deferred income taxes 44 (2) Other non-cash charges (credits) 31 (133) Net assets of discontinued operations (9) (1) Joint venture earnings (19) (2) Dividends from joint ventures 10 4 Cumulative effect of accounting change - 1 Other 73 23 ----- ----- 470 339 Changes in: Receivables (86) (48) Inventories (44) 18 Prepaid expenses and other 3 (9) Accounts payable and accrued expenses 8 12 Loans held for sale, originations of loans (5,464) (11,144) Loans held for sale, sales of loans 5,479 11,611 Collections on loans services for others, net (5) (24) ----- ----- 361 755 ----- ----- CASH PROVIDED BY (USED FOR) INVESTING Capital expenditures (147) (121) Sale of non-strategic assets 63 36 Securities available-for-sale, net 201 435 Securities held-to-maturity, net 453 (302) Loans originated or acquired, net of principal collected (725) 198 Proceeds from sale of loans 36 41 Acquisitions, net of cash acquired (20) (1) Other 53 3 ----- ----- (86) 289 ----- ----- CASH PROVIDED BY (USED FOR) FINANCING Deposits, net 293 (234) Additions to long-term debt 321 306 Payments of long-term debt (717) (816) Payments of other long-term liabilities (64) - Repurchase agreements and short-term borrowings, net (85) (241) Cash dividends paid to shareholders (60) (55) Proceeds from exercise of stock options 60 - Other 14 11 ----- ----- (238) (1,029) ----- ----- 37 15 Effect of exchange rate changes on cash - - ----- ----- Net increase (decrease) in cash and cash equivalents 37 15 Cash and cash equivalents at beginning of period 399 455 ----- ----- Cash and cash equivalents at end of period $ 436 $ 470 ===== =====
See the notes to consolidated financial statements. 13 TEMPLE-INLAND INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Note A - Basis Of Presentation We prepared these unaudited interim financial statements in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. As a result, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. However, in our opinion, all adjustments (consisting only of normal accruals) considered necessary for a fair presentation have been included. These interim operating results are not necessarily indicative of the results that may be expected for the entire year. For further information, refer to the financial statements and footnotes included in our Annual Report on Form 10-K for the fiscal year ended January 3, 2004. The consolidated financial statements include the accounts of Temple-Inland Inc. and its manufacturing and financial services subsidiaries. Substantially all of our consolidated net assets invested in financial services are subject to regulatory rules and restrictions including restrictions on the ability of our financial services subsidiaries to pay dividends to us. Accordingly, included as an integral part of the consolidated financial statements are separate summarized financial statements for our parent company and for our financial services subsidiaries. The parent company summarized financial statements include the accounts of Temple-Inland and its manufacturing segments. The net assets invested in financial services are reflected using the equity method. Related earnings, however, are presented before tax to be consistent with the consolidated financial statements. We have eliminated all material intercompany amounts and transactions. We have reclassified certain prior period amounts to conform to current year's classifications. Note B - Earnings Per Share Denominators used in computing per share amounts were:
Third Quarter First Nine Months ------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- (In millions) Denominator for basic earnings per share: Weighted average common 55.9 54.2 55.5 54.1 shares outstanding Dilutive effect of: Equity purchase contracts 0.2 - 0.1 - Stock options 0.6 0.1 0.5 - ----- ----- ----- ----- Denominator for diluted earnings per share 56.7 54.3 56.1 54.1 ===== ===== ===== =====
We will settle the equity purchase contracts in May 2005. At that time, we will issue common stock in exchange for $345 million cash. The actual number of shares we will issue will be based on the average market price of our stock with a floor of $52, in which case we would issue 6.6 million shares, and a ceiling of $63, in which case we would issue 5.5 million shares. 14 TEMPLE-INLAND INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Note C - Comprehensive Income (Loss) Comprehensive income (loss) consists of:
Third Quarter First Nine Months -------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- (In millions) Net income (loss) $ 41 $ (3) $ 110 $ 135 Other comprehensive income (loss), net of taxes: Unrealized gains (losses) on: Available-for-sale securities - (2) (3) (1) Derivative instruments (1) - 3 (1) Foreign currency translation adjustments - (3) (1) (5) ----- ----- ----- ----- Other comprehensive income (loss) (1) (5) (1) (7) ----- ----- ----- ----- Comprehensive income (loss) $ 40 $ (8) $ 109 $ 128 ===== ===== ===== =====
At third quarter-end 2004, the aggregate fair value of all of our derivative instruments was a $4 million liability consisting of $6 million of liabilities for our interest rate swap derivatives and a $2 million asset for our linerboard and OCC derivatives. Of the interest rate swap derivative liabilities, $3 million is related to a hedged transaction and $3 million is related to a non-hedged transaction. The ineffective portion of the interest rate swap derivative designated as a hedged transaction resulted in a $1 million reduction in interest expense in first nine months 2004. During second quarter 2004, a portion of the interest rate swap derivative was reclassified as a non-hedged transaction, which resulted in the reclassification of $4 million from other comprehensive income to interest expense. During third quarter 2004, the loss charged to other non-operating expense for the non-hedged transaction was less than $1 million. Note D - Segment Information We have three reportable segments: corrugated packaging, forest products, and financial services. We evaluate performance based on operating income before other operating (income) expense and unallocated expenses, principally general and administrative expenses. We do not allocate parent company interest to the business segments. Other operating (income) expense includes gain or loss on sale of assets, asset impairments and expenses associated with consolidation initiatives and facility closures. 15 TEMPLE-INLAND INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
Corrugated Forest Financial For Third Quarter 2004 Packaging Products Services Unallocated Total ---------------------- ---------- -------- --------- ----------- ----- (In millions) Revenues from external customers $ 689 $ 266 $ 239 $ - $ 1,194 Depreciation and amortization 40 13 9 2 64 Operating income (loss) 42 68 37 (50) 97 Financial services, net interest income - - 96 - 96 Capital expenditures 36 15 12 2 65 --------------------------------------------------------------------------------------- For First Nine Months 2004 or at Third Quarter-End 2004 -------------------------------- (In millions) Revenues from external customers $ 2,049 $ 739 $ 778 $ - $ 3,566 Depreciation and amortization 119 41 25 6 191 Operating income (loss) 78 165 149 (116) 276 Financial services, net interest income - - 295 - 295 Total assets 2,370 1,010 17,037 89 20,506 Capital expenditures 77 34 30 6 147 Goodwill 235 - 152 - 387 --------------------------------------------------------------------------------------- For Third Quarter 2003 ---------------------- (In millions) Revenues from external customers $ 667 $ 211 $ 292 $ - $ 1,170 Depreciation and amortization 40 16 8 2 66 Operating income (loss) 7 24 49 (36) 44 Financial services, net interest income - - 95 - 95 Capital expenditures 27 8 14 3 52 --------------------------------------------------------------------------------------- For First Nine Months 2003 or at Third Quarter-End 2003 -------------------------------- (In millions) Revenues from external customers $ 2,019 $ 583 $ 885 $ - $ 3,487 Depreciation and amortization 123 48 24 5 200 Operating income (loss) 16 32 132 (107) 73 Financial services, net interest income - - 284 - 284 Total assets 2,427 1,104 17,752 71 21,354 Capital expenditures 68 23 25 5 121 Goodwill 239 - 148 - 387 --------------------------------------------------------------------------------------- Includes other expenses for third quarter 2004 of $25 million, which consists of a $4 million charge associated with converting and production facility closures, a $1 million charge related to consolidation and supply chain initiatives, a $21 million charge associated with the repositioning of mortgage origination and servicing activities and $1 million of income related to the collection of notes previously written-off. Of these amounts, $3 million applies to corrugated packaging, $ 21 million applies to financial services, and $1 million is unallocated. Includes other expenses for first nine months 2004 of $49 million, which consists of a $21 million charge associated with converting and production facility closures, a $7 million charge related to consolidation and supply chain initiatives, a $21 million charge associated with the repositioning of mortgage origination and servicing activities, $1 million of income related to the collection of notes previously written-off, and $1 million of other. Of these amounts, $9 million applies to corrugated packaging, $12 million applies to forest products, $21 applies to financial services and $7 million is unallocated. 16 TEMPLE-INLAND INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Includes other expenses for third quarter 2003 of $16 million, which consists of a $3 million charge associated with converting and production facility closures and a $13 million charge related to consolidation and supply chain initiatives. Of these amounts, $4 million applies to corrugated packaging, $1 million applies to forest products, $1 million applies to financial services, and $10 million is unallocated. Includes other expenses for first nine months 2003 of $48 million, which consists of a $10 million charge associated with converting and production facility closures, a $39 million charge related to consolidation and supply chain initiatives, and other income of $1 million related to the collection of notes previously written-off. Of these amounts, $9 million applies to corrugated packaging, $2 million applies to forest products, $3 million applies to financial services, and $34 million is unallocated. As a result of the consolidation of our administrative functions and adoption of a shared services concept, beginning first quarter 2004, we changed the way we allocate cost to the business segments. The effect of this change was to increase segment operating income and to increase unallocated expenses by a like amount. Third quarter and first nine months 2003 amounts have been reclassified to reflect this change as follows: Originally As Reported Reclassifications Reclassified ---------- ----------------- ------------ (In millions) Third Quarter 2003 Corrugated packaging $ - $ 7 $ 7 Forest products 22 2 24 Financial services 49 - 49 ----- ----- ----- Segment operating income 71 9 80 Unallocated expenses (27) (9) (36) ----- ----- ----- Operating income $ 44 $ - $ 44 ===== ===== ===== First Nine Months 2003 Corrugated packaging $ (3) $ 19 $ 16 Forest products 25 7 32 Financial services 132 - 132 ----- ----- ----- Segment operating income 154 26 180 Unallocated expenses (81) (26) (107) ----- ----- ----- Operating income $ 73 $ - $ 73 ===== ===== =====
Note E - Employee Benefit Plans The components of net periodic benefit cost of our defined benefit pension plans are:
Third Quarter First Nine Months ------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- (In millions) Service costs $ 6 $ 6 $ 18 $ 17 Interest cost on projected benefit obligation 18 17 54 49 Expected return on plan assets (17) (16) (51) (47) Amortization of prior - - - 2 service costs Amortization of net loss 6 5 18 10 ---- ---- ---- ---- Net periodic benefit cost $ 13 $ 12 $ 39 $ 31 ==== ==== ==== ====
17 TEMPLE-INLAND INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The components of net periodic benefit cost of our postretirement benefit plans are:
Third Quarter First Nine Months ------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- (In millions) Service costs $ 1 $ 1 $ 3 $ 3 Interest cost on projected benefit obligation 2 3 6 8 Expected return on plan assets - - - - Amortization of prior service costs (1) (1) (3) (3) Amortization of net loss - 1 - 2 ---- ---- ---- ---- Net periodic benefit cost $ 2 $ 4 $ 6 $ 10 ==== ==== ==== ====
Note F - Stock-Based Compensation Prior to 2003, we used the intrinsic value method in accounting for stock-based compensation. As a result, no stock- based compensation expense related to stock options granted prior to 2003 is reflected in net income, as all stock options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. Therefore, the cost related to stock-based compensation recognized in net income for third quarter and first nine months 2004 and 2003 is less than would have been recognized if the fair value method had been applied to all stock options granted since 1995. The following table illustrates the effect on net income and earnings per share as if the fair value method had been applied to all stock options granted since 1995.
Third Quarter First Nine Months ------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- (In millions) Net income (loss), as reported $ 41 $ (3) $ 110 $ 135 Add: Stock-based compensation expense, net of related tax effects,included in the determination of reported net income 6 8 16 18 Deduct: Total stock-based compensation expense, net of related tax effects, determined under the fair value based method for all awards (8) (11) (23) (26) ----- ----- ----- ----- Pro forma net income (loss) $ 39 $ (6) $ 103 $ 127 ===== ===== ===== ===== Earnings (loss) per share: Basic, as reported $ 0.73 $ (0.06) $ 1.96 $ 2.49 Basic, pro forma $ 0.70 $ (0.11) $ 1.86 $ 2.35 Diluted, as reported $ 0.73 $ (0.06) $ 1.96 $ 2.49 Diluted, pro forma $ 0.69 $ (0.11) $ 1.84 $ 2.35
Note G - Contingencies We are involved in various legal proceedings that arise from time to time in the ordinary course of doing business. We believe that the possibility of a material liability from any of these proceedings is remote and we do not believe that the outcome of any of these proceedings should have a material adverse effect on our financial position, results of operations, or cash flow. Note H - Assets Held For Sale Assets held for sale include assets of discontinued operations and other assets held for sale. At third quarter-end 2004, discontinued operations consist of the chemical business obtained in the 2002 acquisition of Gaylord Container Corporation and accruals related to the 1999 sale of our bleached paperboard operations. At third quarter-end 18 TEMPLE-INLAND INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED 2004, the assets and liabilities of the discontinued operations include $5 million of working capital, $18 million of property and equipment, and $18 million of environmental and other long- term accruals. Revenues from discontinued operations for third quarter 2004 were $4 million and for first nine months 2004 were $12 million. Net income from discontinued operations includes a $2 million gain from the early settlement of a note received in connection with the 2003 sale of the retail bag business obtained in the acquisition of Gaylord and a $1 million charge related to the settlement of certain liabilities related to the retail bag business. During first nine months 2004 we sold certain assets used in our specialty packaging operations, our Clarion MDF facility, and other non-strategic assets for $72 million of which $61 million was cash and $11 million was a note due in 2009. At third quarter-end 2004, the carrying value of other assets held for sale was $1 million compared with $23 million at year-end 2003. Impairment charges related to and gains or losses recognized upon sale of these assets are included in other operating (income) expense. During third quarter 2004, we announced our intentions to reposition our financial services mortgage origination activities and sell our third-party mortgage servicing portfolio. At third quarter-end 2004, the carrying value of those assets held for sale was $67 million, including $64 million of third-party mortgage servicing rights. Note I - Other Operating (Income) Expense
Third Quarter First Nine Months ------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- (In millions) Expenses associated with consolidation of administrative functions $ 1 $ 12 $ 7 $ 36 Loss on closure of production and converting facilities 4 3 21 10 Collection of notes that were previously written-off (1) - (1) (1) Other - - 1 - ---- ---- ---- ---- Total $ 4 $ 15 $ 28 $ 45 ==== ==== ==== ====
Expenses associated with the consolidation of administrative functions consist principally of severance, most of which was paid during 2003. During third quarter 2004, we revised our estimates of contractual relocation expense and reduced our accrual for these expenses by $2 million. In conjunction with our previously announced plans, we closed one converting facility in first quarter 2004, one converting facility in second quarter 2004, and three converting facilities in third quarter 2004. With respect to the loss on closure of production and converting facilities, we recognized asset impairments and gains (losses) upon disposition of assets of $14 million during first nine months 2004, of which $12 million related to the closure of our Clarion MDF facility, and $7 million in severance and other costs. We expect to incur additional severance and exit costs in fourth quarter 2004. A summary of the activity within our accruals for exit costs during third quarter 2004 follows:
Beginning of Cash End of Period Additions Payments Period ------ --------- -------- ------ (In millions) Involuntary employee termination and severance $ 3 $ 2 $ (3) $ 2 Contract termination penalties 6 - - 6 Environmental compliance 11 - (1) 10 Demolition 10 - (1) 9 ---- ---- ---- ---- Total $ 30 $ 2 $ (5) $ 27 ==== ==== ==== ====
19 TEMPLE-INLAND INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED During third quarter 2004, we announced our intentions to reposition our financial services mortgage origination activities and sell our third-party mortgage servicing portfolio. These actions will affect approximately 1,500 employees and will reduce our costs and our exposure to changing market conditions. At third quarter-end 2004, the carrying value of these assets held for sale was $67 million, including $64 million of mortgage servicing rights. In connection with these actions, we recognized $17 million in asset and goodwill impairments and incurred $4 million in retention, severance and other exit costs, most of which will be paid in fourth quarter 2004. These impairment charges and exit costs are included in financial services non-interest expense. During fourth quarter 2004, we entered into a letter of intent to sell our servicing rights. We anticipate closing this sale by year-end 2004. As these actions are finalized it is likely that additional impairments, severance and other exit costs will be incurred, and such amounts could be significant. Note J - Acquisitions And Other Items During first quarter 2004, financial services acquired an insurance agency for $15 million cash. The purchase price was allocated to acquired assets and liabilities based upon their fair values with $10 million allocated to goodwill. During third quarter 2004, financial services acquired two branches and $150 million in deposits for a $5 million premium of which $3 million was allocated to goodwill and the remainder was allocated to other intangible assets. The unaudited pro forma results of operations, assuming the acquisition had been effected at the beginning of the year, would not have been materially different from those reported. During second quarter 2004, we recognized a $2 million charge, which is included in other non-operating expense, related to our early retirement of $44 million of debt. Note K - Accounting Pronouncements During first quarter 2004, we were required to adopt the following accounting pronouncements: FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities an Interpretation of ARB No. 51. This interpretation provides guidance for determining whether an entity is a variable interest entity and which beneficiary of the variable interest entity, if any, should consolidate the variable interest entity. There was no effect on earnings or financial position of adopting this interpretation. Disclosures required by this interpretation follow: * In 1999 we entered into an agreement to lease particleboard and medium density fiberboard facilities in Mt. Jewett, PA. The lease is for 20 years and includes fixed price purchase options in 2014 and at the end of the lease. The option prices were intended to approximate the estimated fair values of the facilities at those dates and do not represent a guarantee of the facilities' residual values. After exhaustive efforts, we were unable to determine whether the lease is with a variable interest entity or if there is a primary beneficiary because the unrelated third-party lessors will not provide the necessary financial information. The lease is accounted for as an operating lease and at year-end 2003 our financial interest was limited to our obligation to make the remaining $191 million of contractual lease payments, $10 million per year. * In 1999 we invested $2 million in the form of equity and subordinated debt in a residential land development partnership that meets the definition of a variable interest entity. However, we have determined that we are not the primary beneficiary of the entity and, therefore, are not required to consolidate this entity. At year-end 2003, this partnership had total assets of $88 million and total liabilities of $89 million. 20 TEMPLE-INLAND INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Our maximum exposure to loss is the carrying amount of our subordinated debt and equity investments in this partnership, currently $2 million. * At third quarter-end 2004, $192 million of financial services' real estate construction loans (and $121 million of unfunded commitments to lend) are to single-asset entities that meet the definition of a variable interest entity. All of these loans are secured by financial guarantees or tri-party takeout commitment from substantive third parties. We have determined that we are not the primary beneficiary of any of these entities. Our maximum exposure to loss is the committed loan amount. Securities and Exchange Commission Staff Accounting Bulletin No.105, Application of Accounting Principles to Loan Commitments. This bulletin applies to loan commitments issued after March 2004 and accounted for as derivative instruments, and it precludes the recognition of an asset at the inception of the loan commitment. The effect of adopting this bulletin was not significant. FASB Staff Position, No. FAS 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003. The effect of adopting this staff position was not significant. 21 ITEM 2.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. Our actual results may differ significantly from the results discussed in the forward- looking statements. Factors that might cause such differences include general economic, market, or business conditions; the opportunities or lack thereof that may or may not be presented to and pursued by us; availability and price of raw materials we use; competitive actions by others; changes in laws or regulations; the accuracy of our judgments and estimates concerning the integration of acquired operations and the consolidation and supply chain initiatives; and other factors, many of which are beyond our control. Results of Operations for Third Quarter and First Nine Months 2004 and 2003 Summary A summary of our consolidated results for third quarter and first nine months follows:
Third Quarter First Nine Months ------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- (In millions, except per share) Consolidated revenues $ 1,194 $ 1,170 $ 3,566 $ 3,487 Income (loss) from continuing operations 40 (3) 108 135 Income (loss) from continuing operations, per diluted share 0.71 (0.06) 1.93 2.49 Average diluted shares outstanding 56.7 54.3 56.1 54.1
Significant items affecting third quarter 2004 compared with third quarter 2003 income from continuing operations included: * charges and expenses of $25 million, principally related to the repositioning of the mortgage origination and servicing activities, and the closure of three converting facilities; * higher corrugated packaging shipments and prices and lower converting costs, partially offset by higher energy and recycled fiber costs; * higher pricing and shipments for lumber, gypsum, and medium density fiberboard; and * lower financial services operating income, principally due to a $15 million increase in the mortgage servicing valuation allowance, partially offset by lower loan loss provisions. Business Segments We manage our operations through three business segments: * Corrugated packaging, * Forest products, and * Financial services. Our operations are affected to varying degrees by supply and demand factors and economic conditions including changes in interest rates, new housing starts, home repair and remodeling activities, and the strength of the U.S. dollar. Given the commodity nature of our manufactured products, we have little control over market pricing or market demand. 22 A summary of the results of operations by business segment follows:
Third Quarter First Nine Months ------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- (In millions) Revenues Corrugated packaging $ 689 $ 667 $ 2,049 $ 2,019 Forest products 266 211 739 583 Financial services 239 292 778 885 ----- ----- ------ ------ Total revenues $1,194 $1,170 $ 3,566 $ 3,487 ===== ===== ====== ====== Segment Operating Income Corrugated packaging $ 42 $ 7 $ 78 $ 16 Forest products 68 24 165 32 Financial services 37 49 149 132 ----- ----- ------ ------ Total segment operating income 147 80 392 180 Unallocated expenses (25) (20) (67) (59) Other income (expense) (25) (24) (51) (56) Parent company interest (31) (33) (97) (103) ----- ----- ------ ------ Income (loss) before taxes 66 3 177 (38) Income tax (expense) benefit (26) (6) (69) 173 ----- ----- ------ ------ Income (loss) from continuing operations 40 (3) 108 135 Discontinued operations 1 - 2 1 Effect of accounting change - - - (1) ----- ----- ------ ------ Net income (loss) $ 41 $ (3) $ 110 $ 135 ===== ===== ====== ====== Includes the effect of a reclassification of $6 million related to first quarter 2004. The reclassification had no effect on operating income. As a result of the consolidation of our administrative functions and adoption of a shared services concept, beginning first quarter 2004, we changed the way we allocate cost to the business segments. The effect of this change was to increase segment operating income and to increase unallocated expenses by a like amount. Third quarter and first nine months 2003 amounts have been reclassified to reflect this change as follows: Originally As Reported Reclassifications Reclassified ---------- ----------------- ------------ (In millions) Third Quarter 2003 Corrugated packaging $ - $ 7 $ 7 Forest products 22 2 24 Financial services 49 - 49 ----- ----- ----- Segment operating income 71 9 80 Unallocated expenses (27) (9) (36) ----- ----- ----- Operating income $ 44 $ - $ 44 ===== ===== ===== First Nine Months 2003 Corrugated packaging $ (3) $ 19 $ 16 Forest products 25 7 32 Financial services 132 - 132 ----- ----- ----- Segment operating income 154 26 180 Unallocated expenses (81) (26) (107) ----- ----- ----- Operating income $ 73 $ - $ 73 ===== ===== ===== Other income (expense) for third quarter 2004 consists of a $4 million charge associated with converting and production facility closures, a $1 million charge related to consolidation and supply chain initiatives, a $21 million charge associated with the repositioning of the mortgage origination and servicing activities, and income of $1 million related to the collection of notes previously written-off. Of these amounts, $3 million applies to corrugated packaging, $21 million applies to financial services, and $1 million is unallocated. Other income (expense) for third quarter 2003 consists of a $3 million charge related to a production facility closure, a $13 million charge related to consolidation and supply chain initiatives, and $8 million related to the early redemption of debentures. Of these 23 amounts $4 million applies to corrugated packaging, $1 million applies to forest products, $1 million applies to financial services, and $18 million is unallocated. Other income (expense) for first nine months 2004 consists of a $21 million charge associated with converting and production facility closures, a $7 million charge related to consolidation and supply chain initiatives, a $21 million charge associated with the repositioning of the mortgage origination and servicing activities, $1 million of income related to collection of notes previously written-off, $1 million of other, and a $2 million premium related to the early redemption of debt. Of these amounts, $9 million applies to corrugated packaging, $12 million to forest products, $21 million to financial services, and $9 is unallocated. Other income (expense) for first nine months 2003 consists of a $10 million charge associated with converting and production facility closures, a $39 million charge related to consolidation and supply chain initiatives, an $8 million premium related to the early redemption of debt, and income of $1 million related to the collection of notes previously written-off. Of these amounts, $9 million applies to corrugated packaging, $2 million to forest products, $3 million to financial services, and $42 million is unallocated. Includes a one-time tax benefit of $165 million in first nine months 2003.
Corrugated Packaging A summary of our corrugated packaging results follows:
Third Quarter First Nine Months ------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- (In millions) Revenues $ 689 $ 667 $ 2,049 $ 2,019 Segment operating income 42 7 78 16
Corrugated packaging shipments and pricing continued to improve. We announced a $50 per ton increase in the price of linerboard effective March 2004 and a similar increase in corrugated packaging prices effective April 2004. We announced another $50 per ton increase in the price of linerboard effective June 2004 and a similar increase in corrugated packaging prices effective July 2004.
Third Quarter First Nine Months 2004 versus Third 2004 versus First Quarter 2003 Nine Months 2003 ----------------- ----------------- Increase (Decrease) Corrugated packaging Average prices 3 % (2)% Shipments per workday, tons 6 % 7 % Industry shipments, average week (msf) 3 % 4 % Linerboard Average prices 22 % 5 % Shipments to third parties, tons (62)% (43)% Source: Fibre Box Association
The increase in corrugated packaging shipments was generated with seven fewer converting facilities at third quarter-end 2004 compared with third quarter-end 2003. Compared with second quarter 2004, average corrugated packaging prices were up four percent and shipments per workday were down three percent. Linerboard sales and shipments to third parties were down because more of our production was used in our converting facilities. Compared with second quarter 2004, average linerboard prices were up 12 percent while shipments were down 19 percent. 24 In addition to reductions in converting costs due to the closure of converting facilities, other factors affecting operating income include fluctuations in the following costs and expenses:
Third Quarter First Nine Months 2004 versus Third 2004 versus First Quarter 2003 Nine Months 2003 ----------------- ----------------- Increase (Decrease) (In millions) Recycled fiber $ 6 $ 22 Energy, principally natural gas 3 - Depreciation - (4) Pension and postretirement 2 5
Our recycled fiber costs averaged $115 per ton during third quarter 2004 compared with $90 per ton during third quarter 2003. Our recycled fiber costs averaged $112 per ton during first nine months 2004 compared with $89 per ton during first nine months 2003. Our recycled fiber and energy costs fluctuate based on the market prices we pay for these commodities. Information about our mills and converting facilities follows:
Third Quarter First Nine Months ------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- (In millions) Number of converting facilities (at quarter-end) 72 79 72 79 Mill capacity, in thousand tons 826 824 2,467 2,455 Mill production, in thousand tons 853 808 2,533 2,390 Percent mill production used internally 93 % 81 % 91 % 82 % Corrugating medium purchases from our Premier Boxboard Limited LLC joint venture, in thousand tons 23 45 78 118
We continue our efforts to improve return on investment. These include reviewing operations that are unable to meet return objectives and determining appropriate courses of action. In conjunction with our previously announced plans, we closed our Dallas, Texas converting facility in March 2004 and our Raleigh, North Carolina converting facility in April 2004. We closed a converting facility in Rock Hill, Tennessee, in July 2004 and converting facilities in Louisville, Kentucky, and Mishawaka, Indiana, in September 2004. As a result, we paid $2 million in severance cost during third quarter 2004, and we expect to incur additional severance and other exit costs during fourth quarter 2004. We also recognized asset impairments, net of adjustments of less than $1 million during third quarter 2004 and $1 million during first nine months 2004 related to these closures. We sold certain assets used in our specialty packaging operations and other non-strategic assets for $27 million cash during second quarter 2004 and recognized a gain of $1 million. As a result of the sale of the specialty packaging assets, during second quarter 2004, we incurred $1 million in severance and other exit costs, most of which was paid during second quarter 2004. The accounting effects of these items are included in other operating expense and are excluded from segment operating income. Forest Products A summary of our forest products results follows:
Third Quarter First Nine Months ------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- (In millions) Revenues $ 266 $ 211 $ 739 $ 583 Segment operating income 68 24 165 32
25 Product prices and shipments continued to improve due in part to the strong housing and remodeling markets.
Third Quarter First Nine Months 2004 versus Third 2004 versus First Quarter 2003 Nine Months 2003 ----------------- ----------------- Increase (Decrease) Average Average Prices Shipments Prices Shipments ------- --------- ------- --------- Lumber 18 % 4 % 21 % 10 % Particleboard 41 % (5)% 27 % 4 % Gypsum 30 % 23 % 28 % 21 % MDF 24 % 12 % 13 % 6 %
Comparisons of shipments for MDF and particleboard are affected by the indefinite closures of our Clarion MDF facility in third quarter 2003 and sale of this facility in second quarter 2004 and by the indefinite closure of our Mt. Jewett particleboard facility in second quarter 2003. Compared with second quarter 2004, average prices were up 10 percent for particleboard, eight percent for MDF, and five percent for gypsum, while average prices were down one percent for lumber. Shipments were up one percent for lumber and three percent for gypsum, while shipments were down 13 percent for particleboard and 16 percent for MDF. Information about our converting and manufacturing facilities follows:
Third Quarter First Nine Months ------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- Number of converting and manufacturing facilities (at quarter-end) 17 18 17 18 Average operating rates for all product lines: High 106 % 93 % 95 % 95 % Low 60 % 52 % 60 % 45 %
Average operating rates include the effects of the indefinite closure of our Clarion MDF facility in third quarter 2003 and sale of this facility in second quarter 2004 and by the indefinite closure of our Mt. Jewett particleboard facility in second quarter 2003. Excluding these effects, the average operating rates for all product lines during third quarter 2004 would range from a high of 106 percent to a low of 88 percent and during first nine months 2004 would range from a high of 95 percent to a low of 84 percent. Other factors affecting operating income include fluctuations in the following costs and expenses:
Third Quarter First Nine Months 2004 versus Third 2004 versus First Quarter2003 Nine Months 2003 ----------------- ----------------- Increase (Decrease) (In millions) Energy, principally natural gas $ 3 $ 3 Depreciation (3) (7)
Information regarding sales of our high value land follows:
Third Quarter First Nine Months ------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- Acres sold 469 347 1,811 1,650 Profit included in segment operating income (in millions) $ 3 $ 2 $ 12 $ 8
We continue our efforts to enhance return on investment. These include reviewing operations, including our MDF facilities, that are unable to meet return objectives and determining appropriate courses of action. During second quarter 2004, we 26 sold our Clarion MDF facility and recognized a gain on disposition of less than $1 million and incurred an insignificant amount of severance and related exit costs most of which was paid during second quarter 2004. During first quarter 2004, we recognized an asset impairment of $12 million related to this facility. The accounting effect of this item is included in other operating expense and is excluded from segment operating income. Financial Services A summary of our financial services results follows:
Third Quarter First Nine Months ------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- (In millions) Net interest income $ 96 $ 95 $ 295 $ 284 Segment operating income 37 49 149 132
Improvements in our net interest income and lower loan loss provisions were more than offset by an increase in the mortgage servicing valuation allowance due to the recent reduction in long- term interest rates and the decision to sell the third-party servicing portfolio. Compared with third quarter 2003, our interest rate spread improved, partially due to a repricing of maturing certificates of deposit at lower market rates. In addition, we have changed the composition of our asset and deposit base primarily by increasing our residential housing loans, which have fixed interest rates for the first three to five years and adjustable rates thereafter, and by increasing demand deposits and money market accounts and decreasing certificates of deposit. Given this current position, if interest rates remain relatively stable, it is likely that our net interest income will remain near its current level. However, if interest rates change significantly, it is likely that our net interest income will decline. Although our interest rate spread was higher in third quarter 2004 than in third quarter 2003, our net interest income was approximately the same because we have lower earning assets in 2004 than in 2003, primarily because our single-family mortgage-backed security portfolio has declined in size as a result of prepayments of the underlying mortgage loans in these securities. Information concerning our interest rate spread follows:
Third Quarter First Nine Months --------------------------------- ----------------------------------- 2004 2003 2004 2003 --------------- ---------------- ---------------- ----------------- Average Yield/ Average Yield/ Average Yield/ Average Yield/ Balance Rate Balance Rate Balance Rate Balance Rate ------- ----- ------- ----- ------- ----- ------- ----- (Dollars in millions) Earning assets $ 15,799 4.46% $ 17,075 4.19% $ 16,073 4.37% $ 16,973 4.39% Interest-bearing liabilities 14,956 2.14% 15,430 2.16% 15,180 2.04% 15,559 2.35% ---- ---- ---- ---- Interest rate spread spread 2.32% 2.03% 2.33% 2.04%
The following tables summarize the composition of earning assets and deposits:
Third Quarter End ----------------- 2004 2003 ---- ---- (Dollars in millions) Residential housing assets (loans and securities) $ 13,079 $ 13,279 Other earning assets 2,899 3,286 ------ ------ Total earning assets $ 15,978 $ 16,565 ====== ====== Residential housing assets as a percentage of total earning assets 82 % 80 % Demand deposit and savings accounts $ 5,165 $ 4,962 Certificates of deposit 3,826 3,965 ------ ------ Total deposits $ 8,991 $ 8,927 ====== ======
27 The decrease in earning assets was primarily due to a decrease in single-family mortgage-backed securities resulting from reduced purchases coupled with prepayments related to refinancing activity and a decrease in commercial real estate loans resulting from repayment. We expect the trend of repayments of commercial real estate loans to continue for several months. As a result of the repositioning of our mortgage activities discussed below, we anticipate a substantial decrease during fourth quarter 2004 in our mortgage loans held for sale and in deposits related to third-party servicing escrow accounts. During third quarter 2004, we acquired two branches and $150 million in deposits for a $5 million premium, of which $3 million was allocated to goodwill and the remainder was allocated to other intangible assets. During third quarter 2004, we announced our intentions to reposition our mortgage origination activities and sell our third- party mortgage servicing portfolio in order to reduce our costs and our exposure to changing market conditions, including a slow down in refinancing activity. While we will still originate mortgage loans for our own portfolio and, to a lesser extent, for sale to others, we intend to limit our product offerings and reposition our retail origination activities. We will continue to originate loans through brokers and correspondent networks and in certain other retail channels, including the retail branches of our bank. These actions will affect over 1,500 employees and approximately 110 of our mortgage origination outlets. We expect the repositioning and sales to be substantially completed by year- end 2004. These actions will substantially reduce our future non- interest income derived from loan originations and sale of loans and loan servicing fees and the related servicing rights amortization and impairment. In addition, these actions will substantially reduce future non-interest expenses, principally compensation and benefits and occupancy costs. As a result of these actions, during third quarter 2004, we recognized $17 million in asset and goodwill impairments and incurred $4 million in retention, severance and other exit costs. As these actions are finalized it is likely that additional impairments, severance and other exit costs will be incurred, and such amounts could be significant. The accounting effects of these actions are included in non-interest expense and are excluded from segment operating income. Other factors affecting operating income include fluctuations in the following non-interest income and expenses:
Third Quarter First Nine Months 2004 versus Third 2004 versus First Quarter2003 Nine Months 2003 ----------------- ----------------- Increase (Decrease) (In millions) Non-interest income: Loan origination and sale of loans $ (37) $ (108) Servicing rights amortization and impairment 9 (19)
The decrease in loan origination and sale of loans was due to the decline in mortgage loan origination activity as refinancing activity slowed considerably. The increase in servicing rights amortization and impairment in the third quarter was due to the recent decline in long-term interest rates and the decision to sell the third-party mortgage servicing portfolio. The mortgage servicing impairment valuation allowance was increased by $15 million in third quarter 2004 and by $12 million in first nine months 2004 compared with a decrease of $7 million in third quarter 2003 and an increase of less than $1 million in first nine months 2003. As mortgage interest rates rise, mortgage loan origination activity and servicing rights amortization and impairment generally decline and as mortgage interest rates decline, mortgage loan origination activity and servicing rights amortization and impairment generally increase. Information regarding mortgage loan origination activity follows:
Third Quarter First Nine Months ------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- (In millions) Loans originated for sale to third parties $ 1,162 $ 3,516 $ 4,115 $ 9,988 Value of mortgage servicing rights retained $ 3 $ 19 $ 18 $ 38
28 Factors affecting non-interest expense follow:
Third Quarter First Nine Months 2004 versus Third 2004 versus First Quarter2003 Nine Months 2003 ----------------- ----------------- Increase (Decrease) (In millions) Non-interest expense: Compensation and benefits $ (19) $ (47) Real estate operations (5) -
A significant portion of our compensation cost is directly related to our mortgage loan origination volume. In third quarter and first nine months 2004, compensation costs declined in conjunction with the decline in mortgage loan origination volume. A portion of our mortgage loan origination-related costs is directly variable with origination volume. However, other mortgage loan origination-related operating costs are fixed or only partially variable. In connection with the repositioning of our mortgage origination activities, we are carrying the assets related to these activities at fair value less cost to sell. At third quarter-end 2004, the carrying value of these assets was $3 million. We anticipate selling or closing these retail origination outlets by year end. Information regarding the mortgage loans we service for others and our mortgage servicing rights follows:
Third Quarter First Nine Months ---------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- (Dollars in millions) Outstanding balance of loans serviced for third parties (at quarter-end) $ 7,827 $ 8,149 $ 7,827 $ 8,149 Annualized prepayment rate 26 % 55 % 31 % 50 % Carrying amount of mortgage servicing rights as a percent of balance serviced (at quarter-end) 0.82 % 1.08 % 0.82 % 1.08 %
As previously announced, we have decided to sell our third- party mortgage servicing rights. As a result, our mortgage servicing rights are carried at fair value less estimated cost to sell. At third quarter-end 2004, the carrying value of our mortgage servicing rights was $64 million, net of a $31 million valuation allowance, which includes $8 million for estimated costs to sell. During fourth quarter 2004, we entered into a letter of intent to sell our servicing rights. We anticipate closing this sale by year-end 2004. Asset Quality and Allowance for Loan Losses The following table summarizes various asset quality measures:
Third Quarter-End Year-End ----------------- -------- 2004 2003 2003 ---- ---- ---- (Dollars in millions) Non-performing loans $ 56 $ 86 $ 65 Restructured operating lease assets 37 41 40 Foreclosed real estate 17 12 26 ---- ---- ---- Non-performing assets $ 110 $ 139 $ 131 ==== ==== ==== Non-performing loans as a percentage of total loans 0.58 % 0.91 % 0.71 % Non-performing assets ratio 1.12 % 1.46 % 1.42 % Allowance for loan losses as a percent of: Non-performing loans 170 % 152 % 172 % Total loans 0.98 % 1.38 % 1.22 %
We have contracts to sell one of our foreclosed real estate assets for an amount approximating its $10 million carrying value. 29 The following table summarizes changes in the allowance for loan losses:
Third Quarter First Nine Months ------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- (Dollars in millions) Balance at beginning of period $ 100 $ 117 $ 111 $ 132 Net charge-offs 1 - (6) (46) Provision (credit) for loan losses (5) 13 (9) 44 ----- ---- ---- ----- Balance at end of period $ 96 $ 130 $ 96 $ 130 ===== ==== ==== ===== Net charge-offs as a percentage of average loans outstanding (0.01%) - % 0.09 % 0.62 %
Third quarter 2004 and first nine months 2004 provision for loan loss was a credit to earnings due to repayments on loans for which we had previously provided loan loss reserves, recoveries of previously charged-off loans and general improvement in overall loan quality. While several loans required additional loan loss reserves and we charged off a portion of several loans that were foreclosed upon, our loan losses in 2004 have been substantially less than in 2003. Third quarter and first nine months 2003 charge-offs and loan loss provisions were principally related to asset-based loans. Unallocated Expenses, Other (Income) Expense and Interest The change in unallocated expenses in first nine months 2004 was principally due to an increase in stock-based compensation and expenses related to our assessment of internal controls over financial reporting mandated by the Sarbanes-Oxley Act. Other operating (income) expense items are not allocated to business segments. In addition to the items previously discussed within the segments, the remainder of unallocated other operating (income) expense includes expenses related to initiatives to consolidate administrative functions and effect improvements in supply chain management of $1 million in third quarter 2004 and $12 million in third quarter 2003 and $7 million in first nine months 2004 and $36 million in first nine months 2003. During third quarter 2004, we revised our estimates of contractual relocation expense and reduced our accrual for these expenses by $2 million. The change in parent company interest expense in third quarter and first nine months 2004 was due to a reduction in long- term debt and lower interest rates. Other non-operating expense consists of a charge related to our early retirement of debt. Income Taxes Our effective tax rate was 39 percent in third quarter 2004 and first nine months 2004, the likely effective tax rate for the year 2004. Our effective tax rate was 200 percent in third quarter 2003 and, excluding the one-time tax benefit discussed below, was 21 percent in first nine months 2003. Differences between the effective tax rate and the statutory rate are due to state income taxes, nondeductible items, foreign operating losses, and other items for which no financial benefit is recognized until realized. During second quarter 2003, the Internal Revenue Service concluded its examination of our tax returns through 1996, including matters related to net operating losses and minimum tax credit carryforwards, which resulted from certain deductions following our 1988 acquisition of Guaranty Bank and for which no financial accounting benefit had been recognized. Also, we resolved certain state tax refund claims for the years 1991 through 1994. As a result, valuation allowances and tax accruals previously provided for these matters were no longer required. Accordingly, during second quarter 2003, we recorded a one-time benefit of $165 million, or $3.05 per diluted share. Of this one- time benefit, approximately $26 million represents cash refunds of previously paid taxes plus related interest. The remainder was a non-cash benefit. Average Shares Outstanding The change in average shares outstanding in third quarter 2004 and first nine months 2004 was principally due to employee exercises of stock options. 30 Capital Resources and Liquidity for First Nine Months 2004 Substantially all of our consolidated net assets invested in financial services are subject to regulatory rules and regulations including restrictions on the ability of financial services to pay dividends to the parent company. Accordingly, the parent company and the financial services capital resources and liquidity are discussed separately. Parent Company Operating Activities Cash provided by operations was $271 million in first nine months 2004 and $264 million in first nine months 2003. Depreciation and other non-cash charges and credits were $251 million in first nine months 2004 and $106 million in first nine months 2003. Dividends received from financial services were $70 million in first nine months 2004 and $120 million in first nine months 2003. No dividends were received during third quarter 2004. Our working capital needs increased $119 million in first nine months 2004 and $27 million in first nine months 2003. The change was principally due to an increase in receivables and inventories. Working capital is always subject to the timing of collections on receivables and payments on payables and to a lesser extent to seasonal fluctuations in our operations. Investing Activities Our investing activities used $57 million in first nine months 2004 and $67 million in first nine months 2003. Capital expenditures were $117 million in first nine months 2004, 70 percent of depreciation, and $96 million in first nine months 2003, 55 percent of depreciation. Cash proceeds from sales of non-strategic assets were $63 million in first nine months 2004 and $36 million in first nine months 2003. We made no capital contributions to financial services in first nine months 2004 or first nine months 2003. Financing Activities Our financing activities used $219 million in first nine months 2004 and $200 million in first nine months 2003. Debt was reduced by $155 million in first nine months 2004. In June 2004, we redeemed all of the outstanding 9.38% to 9.88% senior subordinated and senior notes issued by Gaylord Container Corporation. The principal amount held by third parties was $44 million and the redemption premium was $2 million. During third quarter 2004, we repaid $100 million in 7.25% notes that became due. Also during second quarter 2004, we paid $64 million of other long-term liabilities, principally timber rights purchase obligations. We issued 1,143,579 shares of our common stock to employees exercising options having an aggregate exercise price of $60 million during first nine months 2004. We paid cash dividends to our shareholders of $60 million, or $1.08 per share, in first nine months 2004 and $55 million, or $1.02 per share, in first nine months 2003. Liquidity Our sources of short-term funding are our operating cash flows, which include dividends received from financial services, and borrowings under our existing credit arrangements and accounts receivable securitization program. We operate in cyclical industries, and our operating cash flows vary accordingly. The dividends we receive from financial services are dependent on its level of earnings and capital needs and are subject to regulatory approval and restrictions. At third quarter-end 2004, we had cash and short-term investments of $15 million. Also, we had $562 million in unused borrowing capacity under our credit agreements and $249 million under our accounts receivable securitization program, which matures in May 2007. At third quarter-end 2004, we complied with all the terms and conditions of our credit agreements and of our accounts receivable securitization program. As we did earlier in 2004, from time to time we may refinance existing debt obligations or use available cash flow to retire existing debt obligations before they come due. 31 Financial Services Operating Activities Cash provided by operations was $160 million in first nine months 2004 and $611 million in first nine months 2003. The change was principally because in 2004 we have sold approximately the same amount of mortgage loans as we originated, whereas in 2003 we sold substantially more than we originated, reducing our available loans held for sale. Changes in loans held for sale are always subject to the timing of loan originations and loan sales, however, we anticipate our loans held for sale and related cash flows will decrease substantially as a result of our announced intentions to reposition our mortgage origination activities. Investing Activities Our investing activities used $29 million in first nine months 2004 and provided $356 million in first nine months 2003. The change was principally because we received less principal payments on mortgage-backed securities as mortgage prepayments decreased in 2004. Assets held for sale approximate $67 million at third quarter-end 2004. It is likely these assets will be sold during fourth quarter 2004. Financing Activities Our financing activities used $89 million in first nine months 2004 and $949 million in first nine months 2003. The change was principally because we repaid fewer borrowings and because we accepted more deposits. Financial services paid dividends to the parent company of $70 million in first nine months 2004 and $120 million in first nine months 2003. No dividends were paid during third quarter 2004. Liquidity Our sources of short-term funding are our operating cash flows, new deposits, borrowings under our existing agreements and, if necessary, sales of assets. Assets that can be readily converted to cash or against which we can readily borrow include short-term investments, loans, mortgage loans held for sale, and securities. At third quarter-end 2004, we had available liquidity of $2.9 billion, an increase over second quarter 2004 as a result of obtaining improved collateral credit for some of our assets. As a result of our planned sale of mortgage servicing rights, we anticipate transferring deposits we hold for mortgage borrowers and third-party mortgage investors to the purchaser of our mortgage servicing rights. These deposits totaled $184 million at third quarter end 2004. Off-Balance Sheet Arrangements We enter into commitments to extend credit for loans, leases, and letters of credit in the normal course of our business. We generally require collateral upon funding of these commitments and they carry substantially the same risk as loans. These commitments normally include provisions allowing us to exit the commitment under certain circumstances. Our unfunded commitments consist of:
Third Quarter-End Year-End 2004 2003 ---- ---- (In millions) Single-family mortgage loans $ 725 $ 509 Unused lines of credit 1,790 1,696 Other loans 3,447 3,141 Letters of credit 381 290 ----- ----- Total $ 6,343 $ 5,636 ===== =====
As a result of our decision to reposition our mortgage origination activities and sell our third-party mortgage servicing portfolio, it is likely that our unfunded single-family mortgage loans commitments will decrease significantly. 32 Regulatory Matters At third quarter-end 2004, Guaranty met or exceeded all applicable regulatory capital requirements. We expect to maintain Guaranty's capital at a level that exceeds the minimum required for designation as "well capitalized" under the capital adequacy regulations of the Office of Thrift Supervision (OTS). From time to time, we may make capital contributions to or receive dividends from Guaranty. Selected financial and regulatory capital data for Guaranty and its consolidated mortgage banking and insurance subsidiaries follow:
Third Quarter-End Year-End 2004 2003 ---- ---- (In millions) Balance sheet data: Total assets $ 16,669 $ 17,247 Total deposits 8,991 8,698 Shareholder's equity 1,007 999
Regulatory For Categorization as Actual Minimum "Well Capitalized" ------ ------- ------------------ Regulatory capital ratios: Tangible capital 6.63 % 2.00 % N/A Leverage capital 6.63 % 4.00 % 5.00 % Risk-based capital 10.93 % 8.00 % 10.00 %
An internal investigation, which is still ongoing, has revealed that our mortgage origination operation failed to file certain regulatory reports on a timely basis and may have violated applicable laws or regulations. We have taken a number of actions as a result of this investigation, including improving compliance controls in the mortgage origination process. We reported these events to the OTS, including the results of our internal investigation and our remediation activities to date. The OTS is authorized to pursue supervisory actions, including the assessment of monetary penalties, to correct violations of certain regulations. We do not expect that monetary penalties or corrective actions, if any, imposed as a result of these circumstances will have a material impact on our financial position or results of operations. To date we have incurred $5 million of expenses, principally third-party consultants, to assist in the investigation and remedial actions. These expenses are included in non-operating expenses and are included in segment operating income. We have not incurred any material financial loss as a result of this matter and have no reason to believe that our investigation, when completed, will result in any material loss. Pension and Postretirement Matters Based on preliminary estimates, we expect to incur in the range of $50 million in non-cash pension expense for the year 2005; about the same as expected for the year 2004, and that our minimum pension liability will increase by $8 million to about $258 million. Also based on these preliminary estimates, we do not expect our cash funding requirements to be significantly different from this year, in the range of $2 million or less. The Medicare Prescription Drug, Improvement and Modernization Act of 2003 was enacted in December 2003. This act expands Medicare to include, for the first time, coverage for prescription drugs. Our postretirement benefit plans provide for medical coverage, including a prescription drug subsidy, for certain participants. Due to the absence of detailed guidance necessary to implement the act, we are unable to precisely determine its effects on our postretirement benefit plans. However, based on our current understanding and analysis, it is likely that the effects will not significantly reduce our cost for these plans. In second quarter 2004, we adopted FASB Staff Position, No. 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003. This staff position permits us to defer recognizing the effects of the act when we conclude they are not significant until our next annual plan measurement date. Based on preliminary estimates, we expect the effect of the act will be to reduce our 2005 postretirement expense by approximately $1 million and reduce our year-end 2004 postretirement liability by approximately $8 million. 33 Energy and the Effects of Inflation Energy costs were $211 million in first nine months 2004 compared with $208 million in first nine months 2003. Our energy costs fluctuate based on the market prices we pay for these commodities and on the amount and mix of the types of fuel we may use. We hedge very little of our energy needs. It is likely that these costs will continue to fluctuate during 2004. Accounting Policies Critical Accounting Estimates In third quarter 2004, there were no significant changes in our critical accounting estimates from those we identified in our Form 10-K for the year 2003. New Accounting Pronouncements Adopted In second quarter 2004, we adopted FASB Staff Position, No. 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003. This staff position provides guidance on accounting for the effects of this act on post retirement benefit plans that provide prescription drug benefits. In first quarter 2004, we were required to adopt the following accounting pronouncements: * FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities an interpretation of ARB No. 51. This interpretation provides guidance for determining whether an entity is a variable interest entity and which beneficiary of the variable interest entity, if any, should consolidate the variable interest entity (the primary beneficiary). * Securities and Exchange Commission Staff Accounting Bulletin No.105, Application of Accounting Principles to Loan Commitments. This bulletin applies to loan commitments issued after March 2004 and accounted for as derivative instruments and it precludes the recognition of an asset at the inception of the loan commitment. The effect of adopting these pronouncements was not significant. Litigation and Related Matters We are involved in various legal proceedings that arise from time to time in the ordinary course of business. We believe that the possibility of a material liability from any of these proceedings is remote, and we do not believe that the outcome of any of these proceedings should have a material adverse effect on our financial position, results of operations, or cash flow. Since we filed our Quarterly Report on Form 10-Q for the period ended July 3, 2004, there have been no material developments in pending legal proceedings, except as follows: On October 15, 2003, a release of what is suspected to have been nitrogen dioxide and nitrogen oxide took place at Gaylord's linerboard mill lift station and sewer system in Bogalusa, Louisiana. Based upon our investigation, the total amount of released nitrogen oxide and nitrogen dioxide is believed to be no more than twenty pounds. The gaseous release dispersed in the atmosphere and was not observed beyond the fence-line. The mill followed appropriate protocols for handling this type event, notifying the Louisiana Department of Environmental Quality, the U.S. Environmental Protection Agency, and local law enforcement officials. We assisted the environmental agencies in investigating the incident and no citations or penalties were issued. In October 2004, a class action lawsuit was filed against Gaylord by local residents seeking damages related to this incident. We believe the likelihood of a material loss from this litigation is remote and do not believe that the outcome should have a material adverse effect on our financial position, results of operations, or cash flow. On July 22, 2002, a delivery driver for a chemical supply company overfilled a storage tank for caustic soda at a Gaylord converting facility in Tipton, Indiana. The excess caustic soda drained through an overflow pipe into the city sewer system, 34 resulting in a temporary shutdown of the city wastewater treatment plant and killing approximately 2,000 fish in a local creek. Gaylord removed the fish, assisted in restoring operations at the wastewater treatment plant, and took other corrective actions to assure no ongoing effect to human health or the environment. We continue to assist the environmental agencies in investigating the incident. At this time, we are not able to predict whether Gaylord will be subject to any monetary sanctions arising out of this incident or the amount of any such monetary sanctions. 35 STATISTICAL AND OTHER DATA Parent Company The following table presents revenues and unit sales for our manufacturing segments:
Third Quarter First Nine Months ---------------- ----------------- 2004 2003 2004 2003 ---- ---- ---- ---- (Dollars in millions) Revenues Corrugated Packaging Corrugated packaging $ 667 $ 617 $1,965 $1,877 Linerboard 22 50 84 142 ---- ---- ----- ----- Total $ 689 $ 667 $2,049 $2,019 ==== ==== ===== ===== Forest Products Pine lumber $ 90 $ 73 $ 258 $ 193 Particleboard 48 38 143 113 Medium density fiberboard 28 21 84 70 Gypsum wallboard 30 19 81 53 Fiberboard 23 20 62 51 Other 47 40 111 103 ---- ---- ---- ----- Total $ 266 $ 211 $ 739 $ 583 ==== ==== ==== ===== Unit sales Corrugated Packaging Corrugated packaging, thousands of tons 842 793 2,556 2,382 Linerboard, thousands of tons 57 150 240 421 ---- ---- ---- ----- Total, thousands of tons 899 943 2,796 2,803 ==== ==== ==== ===== Forest Products Pine lumber, mbf 237 227 707 641 Particleboard, msf 141 149 463 444 Medium density fiberboard, msf 57 51 182 172 Gypsum wallboard, msf 203 165 571 472 Fiberboard, msf 121 123 331 312 Revenues and unit sales do not include joint venture operations.
36 Financial Services The following table summarizes the composition of our loan portfolio:
Third Quarter-End Year-End ----------------- -------- 2004 2003 2003 ---- ---- ---- (In millions) Single-family mortgage $ 3,627 $ 3,082 $ 3,255 Single-family mortgage warehouse 544 395 387 Single-family construction 1,280 1,054 889 Multifamily and senior housing 1,691 1,831 1,769 ----- ----- ----- Total residential housing 7,142 6,362 6,300 Commercial real estate 623 1,175 1,015 Commercial and business 694 622 585 Energy lending 690 520 562 Asset-based lending and leasing 441 595 499 Consumer and other 196 177 176 ----- ----- ----- Total loans 9,786 9,451 9,137 Less allowance for loan losses (96) (130) (111) ----- ----- ----- Loans receivable, net $ 9,690 $ 9,321 $ 9,026 ===== ===== =====
37 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Interest Rate Risk Our current level of interest rate risk is primarily due to the lending and funding activities of our financial services segment. The following table illustrates the estimated effect on our pre-tax income of immediate, parallel and sustained shifts in interest rates for the next 12-months at third quarter-end 2004, with comparative year-end 2003 information. This estimate considers the effect of changing prepayment speeds, repricing characteristics and average balances over the next 12 months.
Increase (Decrease) in Income Before Taxes -------------------------------------------- Third Quarter-End 2004 Year-End 2003 ---------------------- ----------------- Parent Financial Parent Financial Company Services Company Services ------- -------- ------- -------- (In millions) Change in Interest Rates -------------- +2% $ 1 $ (5) $ (2) $ 8 +1% - 17 (1) 28 -1% - (27) 1 (20)
We did not present a two percent interest rate decrease because of the current low interest rate environment. The analysis assumes that debt reductions from contractual payments will be replaced with short-term variable rate debt; however, that may not be the financing alternative we choose to follow. Our parent company's interest rate risk is related to our long-term debt and our interest rate swap. Since our parent company debt is primarily fixed rate, interest rate changes are not expected to affect earnings significantly. However, interest rate changes will affect the value of the interest rate swap derivative transaction but we would not expect that would be significant. Our financial services segment is subject to interest rate risk to the extent interest-earning assets and interest-bearing liabilities repay or reprice at different times or in differing amounts or both. Our financial services segment's interest rate sensitivity has changed from year-end 2003, due principally to increases in market interest rates that have occurred since then. The rise in interest rates has resulted in an improved spread relationship between the yields on our earning assets and costs of funding sources, principally because our projected mortgage yields are benefiting from slower prepayments and our deposit rates have lagged the increase in market rates. We believe a further modest increase in interest rates would result in improved income, but to a lesser extent than in the past. However, we expect that would not be the case if interest rates increase significantly because we believe our deposit rates would become more responsive to changes in rates. The table above does not reflect the effect of changes in interest rates on the fair value of our mortgage servicing rights (estimated at $72 million, exclusive of selling costs at third quarter-end 2004). We estimate a one percent decline in long- term fixed mortgage rates from current levels would decrease the fair value of the mortgage servicing rights by $18 million. However, during fourth quarter 2004, we entered into a letter of intent to sell our servicing rights. We anticipate closing this sale by year-end 2004. Foreign Currency Risk In third quarter 2004, there were no significant changes in foreign currency risk from that disclosed in our Annual Report on Form 10-K for the year 2003. Commodity Price Risk In third quarter 2004, there were no significant changes in commodity price risk from that disclosed in our Annual Report on Form 10-K for the year 2003. 38 ITEM 4. CONTROLS AND PROCEDURES (a) Evaluation of disclosure controls and procedures The Company's chief executive officer and its chief financial officer, based on their evaluation of the Company's disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) as of the end of the period covered by this Quarterly Report on Form 10-Q, have concluded that the Company's disclosure controls and procedures are adequate and effective to ensure that the information required to be disclosed by us in the reports we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. (b) Changes in internal control over financial reporting. There were no changes in the Company's internal control over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. PART II. OTHER INFORMATION Item 1. Legal Proceedings. The information set forth in Note G of the Notes to Consolidated Financial Statements in Part I of this report is incorporated by reference thereto. Since we filed our Quarterly Report on Form 10-Q for the period ended July 3, 2004, there have been no material developments in pending legal proceedings, except as set forth below: On October 15, 2003, a release of what is suspected to have been nitrogen dioxide and nitrogen oxide took place at Gaylord's linerboard mill lift station and sewer system in Bogalusa, Louisiana. Based upon our investigation, the total amount of released nitrogen oxide and nitrogen dioxide is believed to be no more than twenty pounds. The gaseous release dispersed in the atmosphere and was not observed beyond the fence-line. The mill followed appropriate protocols for handling this type event, notifying the Louisiana Department of Environmental Quality, the U.S. Environmental Protection Agency, and local law enforcement officials. We assisted the environmental agencies in investigating the incident and no citations or penalties were issued. In October 2004, a class action lawsuit was filed against Gaylord by local residents seeking damages related to this incident. We believe the likelihood of a material loss from this litigation is remote and do not believe that the outcome should have a material adverse effect on our financial position, results of operations, or cash flow. On July 22, 2002, a delivery driver for a chemical supply company overfilled a storage tank for caustic soda at a Gaylord converting facility in Tipton, Indiana. The excess caustic soda drained through an overflow pipe into the city sewer system, resulting in a temporary shutdown of the city wastewater treatment plant and killing approximately 2,000 fish in a local creek. Gaylord removed the fish, assisted in restoring operations at the wastewater treatment plant, and took other corrective actions to assure no ongoing effect to human health or the environment. We continue to assist the environmental agencies in investigating the incident. At this time, we are not able to predict whether Gaylord will be subject to any monetary sanctions arising out of this incident or the amount of any such monetary sanctions. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. None. Item 3. Defaults Upon Senior Securities. None. Item 4. Submission of Matters to a Vote of Security Holders. None. 39 Item 5. Other Information. None. Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits. 31.1 - Certification of Chief Executive Officer pursuant to Exchange Act Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 - Certification of Chief Financial Officer pursuant to Exchange Act Rule 13a-14(a), as adopted pursuant to Section302 of the Sarbanes-Oxley Act of 2002. 32.1 - Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32.2 - Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (b) Reports on Form 8-K During the quarter ended October 2, 2004, the Company filed the following Current Reports on Form 8-K: 1. Current Report on Form 8-K dated July 27, 2004, reporting under Items 9 and 12 a press release issued by the Company announcing earnings for the period ended July 3, 2004. 2. Current Report on Form 8-K dated July 27, 2004, reporting under Item 9 presentation materials of Kenneth M. Jastrow, II, Chief Executive Officer of Temple-Inland Inc., used in Mr. Jastrow's conference call on July 27, 2004, discussing the Company's earnings for the quarter ended July 3, 2004. 3. Current Report on Form 8-K dated August 4, 2004, reporting under Item 5 a press release issued by the Company announcing plans to reposition mortgage activities within its wholly-owned subsidiary, Guaranty Residential Lending, Inc. 4. Current Report on Form 8-K dated September 20, 2004, reporting under Item 8.01 a press release issued by the Company announcing that its wholly-owned subsidiary, Guaranty Residential Lending, Inc., plans to sell its third party mortgage servicing portfolio. 5. Current Report on Form 8-K dated September 23, 2004, furnishing under Item 7.01 the presentation materials of Kenneth M. Jastrow, II, Chief Executive Officer of the Company, used in Mr. Jastrow's address on September 23, 2004, to the Global Paper and Forest Products Conference sponsored by UBS Warburg. 40 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. TEMPLE-INLAND INC. (Registrant) Dated: November 10, 2004 By /s/ Louis R. Brill --------------------------- Louis R. Brill Chief Accounting Officer 41 INDEX TO EXHIBITS Exhibit No. Description Page No. ----------- -------------------------------- -------- 31.1 Certification of Chief Executive 42 Officer pursuant to Exchange Act Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification of Chief Financial 44 Officer pursuant to Exchange Act Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 Certification of Chief Executive 46 Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes- Oxley Act of 2002 32.2 Certification of Chief Financial 47 Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes- Oxley Act of 2002