10-Q 1 c78696e10vq.txt FORM 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 June 30, 2003 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 1-8864 USG CORPORATION ------------------------------------------------------------------------------ (Exact name of registrant as specified in its charter) Delaware 36-3329400 -------------------------------------------------------------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 125 South Franklin Street, Chicago, Illinois 60606-4678 ------------------------------------------------------------------------------ (Address of principal executive offices) (Zip code) Registrant's telephone number, including area code (312) 606-4000 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 Exchange Act Rule 12b-2). Yes (X) No ( ) Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13, or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes (X) No ( ) As of June 30, 2003, 43,050,592 shares of USG common stock were outstanding. TABLE OF CONTENTS
Page ---- PART I FINANCIAL INFORMATION Item 1. Financial Statements: Consolidated Statements of Earnings: Three Months and Six Months Ended June 30, 2003 and 2002 3 Consolidated Balance Sheets: As of June 30, 2003 and December 31, 2002 4 Consolidated Statements of Cash Flows: Six Months Ended June 30, 2003 and 2002 5 Notes to Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Results of Operations and Financial Condition 42 Item 4. Controls and Procedures 57 Report of Independent Public Accountants 58 PART II OTHER INFORMATION Item 1. Legal Proceedings 60 Item 4. Submission of Matters to a Vote of Security Holders 60 Item 6. Exhibits and Reports on Form 8-K 61 SIGNATURES 62
-2- PART I FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS USG CORPORATION CONSOLIDATED STATEMENTS OF EARNINGS (DOLLARS IN MILLIONS EXCEPT PER SHARE DATA) (UNAUDITED)
THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, ---------------------------- ---------------------------- 2003 2002 2003 2002 ------------ ------------ ------------ ------------ Net sales $ 914 $ 885 $ 1,776 $ 1,714 Cost of products sold 780 718 1,525 1,415 Selling and administrative expenses 81 80 161 162 Chapter 11 reorganization expenses 3 7 5 9 ------------ ------------ ------------ ------------ Operating profit 50 80 85 128 Interest expense 2 2 3 3 Interest income (1) (1) (2) (2) Other income, net (5) (2) (5) (1) ------------ ------------ ------------ ------------ Earnings before income taxes and cumulative effect of accounting change 54 81 89 128 Income taxes 23 33 36 54 ------------ ------------ ------------ ------------ Earnings before cumulative effect of accounting change 31 48 53 74 ------------ ------------ ------------ ------------ Cumulative effect of accounting change, net of tax - - (16) (96) ------------ ------------ ------------ ------------ Net earnings (loss) 31 48 37 (22) ============ ============ ============ ============ EARNINGS (LOSS) PER COMMON SHARE: Basic and diluted before cumulative effect of accounting change 0.73 1.11 1.24 1.71 Cumulative effect of accounting change - - (0.37) (2.22) ------------ ------------ ------------ ------------ Basic and diluted 0.73 1.11 0.86 (0.52) ============ ============ ============ ============ Dividends paid per common share - - - - Average common shares 43,045,854 43,250,655 43,097,190 43,309,735 Average diluted common shares 43,045,854 43,250,655 43,097,190 43,309,735
See accompanying Notes to Consolidated Financial Statements. -3- USG CORPORATION CONSOLIDATED BALANCE SHEETS (DOLLARS IN MILLIONS) (UNAUDITED)
AS OF AS OF JUNE 30, DECEMBER 31, 2003 2002 ------------ ------------ ASSETS Current Assets: Cash and cash equivalents $ 529 $ 649 Short-term marketable securities 66 50 Restricted cash 21 - Receivables (net of reserves - $17 and $17) 369 284 Inventories 287 270 Income taxes receivable 11 14 Deferred income taxes 51 49 Other current assets 76 77 ------------ ------------ Total current assets 1,410 1,393 Long-term marketable securities 172 131 Property, plant and equipment (net of accumulated depreciation and depletion - $761 and $701) 1,794 1,788 Deferred income taxes 190 199 Other assets 109 106 ------------ ------------ Total Assets 3,675 3,617 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts payable 200 170 Accrued expenses 189 243 Income taxes payable 27 25 ------------ ------------ Total current liabilities 416 438 Long-term debt 2 2 Other liabilities 406 370 Liabilities subject to compromise 2,255 2,272 Stockholders' Equity: Preferred stock - - Common stock 5 5 Treasury stock (258) (257) Capital received in excess of par value 414 412 Accumulated other comprehensive loss (9) (32) Retained earnings 444 407 ------------ ------------ Total stockholders' equity 596 535 ------------ ------------ Total Liabilities and Stockholders' Equity 3,675 3,617 ============ ============
See accompanying Notes to Consolidated Financial Statements. -4- USG CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN MILLIONS) (UNAUDITED)
SIX MONTHS ENDED JUNE 30, -------------------- 2003 2002 -------- -------- OPERATING ACTIVITIES: Net earnings (loss) $ 37 $ (22) Adjustments to reconcile net earnings (loss) to net cash: Cumulative effect of accounting change 16 96 Depreciation, depletion and amortization 52 51 Deferred income taxes 18 33 (Increase) decrease in working capital: Receivables (85) (56) Income taxes receivable 3 15 Inventories (17) (27) Payables 32 43 Accrued expenses (55) 37 Increase in other assets (12) (8) Increase in other liabilities 5 9 Decrease in asbestos receivables 19 11 Decrease in liabilities subject to compromise (17) (24) Other, net - 1 -------- -------- Net cash (used for) provided by operating activities (4) 159 -------- -------- INVESTING ACTIVITIES: Capital expenditures (36) (38) Purchases of marketable securities (148) - Sales or maturities of marketable securities 91 - Net proceeds from asset dispositions - 1 Acquisition of business (2) - -------- -------- Net cash used for investing activities (95) (37) -------- -------- FINANCING ACTIVITIES: Deposit of restricted cash (21) - -------- -------- Net cash used for financing activities (21) - -------- -------- Net (decrease) increase in cash and cash equivalents (120) 122 Cash and cash equivalents at beginning of period 649 493 -------- -------- Cash and cash equivalents at end of period 529 615 ======== ======== SUPPLEMENTAL CASH FLOW DISCLOSURES: Interest paid 1 1 Income taxes paid, net 9 6
See accompanying Notes to Consolidated Financial Statements. -5- USG CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (1) PREPARATION OF FINANCIAL STATEMENTS The accompanying unaudited consolidated financial statements of USG Corporation and its subsidiaries ("the Corporation") have been prepared in accordance with applicable United States Securities and Exchange Commission guidelines pertaining to interim financial information. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Actual results could differ from those estimates. In the opinion of management, the financial statements reflect all adjustments, which are of a normal recurring nature, necessary for a fair presentation of the Corporation's financial results for the interim periods. These financial statements and notes are to be read in conjunction with the financial statements and notes included in the Corporation's 2002 Annual Report on Form 10-K which was filed on February 27, 2003. (2) VOLUNTARY REORGANIZATION UNDER CHAPTER 11 On June 25, 2001 (the "Petition Date"), the parent company (the "Parent Company") of the Corporation and the 10 United States subsidiaries listed below (collectively, the "Debtors") filed voluntary petitions for reorganization (the "Filing") under chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the District of Delaware (the "Bankruptcy Court"). The chapter 11 cases of the Debtors (collectively, the "Chapter 11 Cases") are being jointly administered as In re: USG Corporation et al. (Case No. 01-2094). The Chapter 11 Cases do not include any of the Corporation's non-U.S. subsidiaries. The following subsidiaries filed chapter 11 petitions: United States Gypsum Company; USG Interiors, Inc.; USG Interiors International, Inc.; L&W Supply Corporation; Beadex Manufacturing, LLC; B-R Pipeline Company; La Mirada Products Co., Inc.; Stocking Specialists, Inc.; USG Industries, Inc.; and USG Pipeline Company. This action was taken to resolve asbestos claims in a fair and equitable manner, to protect the long-term value of the Debtors' businesses, and to maintain the Debtors' leadership positions in their markets. CONSEQUENCES OF THE FILING The Debtors are operating their businesses without interruption as debtors-in-possession subject to the provisions of the Bankruptcy Code. All vendors are being paid for all goods furnished and services provided after the Filing. However, as a consequence of the Filing, pending litigation against the Debtors as of the Petition Date is stayed, and no -6- party may take any action to pursue or collect pre-petition claims except pursuant to an order of the Bankruptcy Court. Three creditors' committees, one representing asbestos personal injury claimants, another representing asbestos property damage claimants, and a third representing general unsecured creditors, were appointed as official committees in the Chapter 11 Cases and, in accordance with the provisions of the Bankruptcy Code, will have the right to be heard on all matters that come before the Bankruptcy Court. The Bankruptcy Court also appointed the Honorable Dean M. Trafelet as the legal representative for future asbestos claimants in the Debtors' bankruptcy proceeding. Mr. Trafelet was formerly a judge of the Circuit Court of Cook County, Illinois. The Debtors expect that the appointed committees, together with Mr. Trafelet, will play important roles in the Chapter 11 Cases and the negotiation of the terms of any plan of reorganization. Debtors intend to address all pending and future asbestos personal injury claims as well as all other pre-petition claims in a plan or plans of reorganization confirmed by the Bankruptcy Court. Debtors expect that the plan will include the creation of one or more independently administered trusts under Section 524(g) of the Bankruptcy Code, which will be funded by Debtors to allow payment of present and future asbestos personal injury claims and demands. Debtors also expect that the plan of reorganization will address Debtors' liability for asbestos property damage claims, whether by including those liabilities in a Section 524(g) trust or by other means. It is anticipated that, as a result of creation and funding of the Section 524(g) trust(s), the Bankruptcy Court will issue a permanent injunction barring the assertion of present and future asbestos claims against Debtors, their successors, and their affiliates, and channeling those claims to the trust(s) for payment in whole or in part. Section 524(g) contains specific requirements for issuance of such a permanent injunction, including the requirement that the trust must own, or have the right to own upon the occurrence of contingencies specified in the plan of reorganization, a majority of the voting shares of the debtor or its parent. Section 524(g) also requires that the plan be approved by 75% of the voting asbestos claimants whose claims are addressed by the trust. Similar plans of reorganization containing Section 524(g) trusts have been confirmed in the chapter 11 cases of other companies with asbestos liabilities, but there is no guarantee that the Bankruptcy Court in Debtors' Chapter 11 Cases will approve creation of a Section 524(g) trust or issue a permanent injunction channeling to the trust all asbestos claims against Debtors, and/or their successors and affiliates. In addition, if federal legislation addressing asbestos personal injury claims is passed, which is extremely speculative at this time, such legislation may affect the manner in which asbestos personal injury claims are to be addressed in Debtors' Chapter 11 Cases and may affect whether the Debtors establish a trust under Section 524(g). (see Potential Federal Legislation Regarding Asbestos Personal Injury Claims, below) -7- Pursuant to the Bankruptcy Code, the Debtors had the exclusive right to propose a plan of reorganization for 120 days following the Petition Date, unless extended. The Bankruptcy Court has granted requests by the Debtors to extend the period of exclusivity, which currently runs through September 1, 2003. The Debtors intend to seek one or more additional extensions depending upon developments in the Chapter 11 Cases. If the Debtors fail to file a plan of reorganization during such extension period, or if such plan is not accepted by the requisite numbers of creditors and equity holders entitled to vote on the plan, other parties in interest in the Chapter 11 Cases may be permitted to propose their own plan(s) of reorganization for the Debtors. While it is the Debtors' intention to seek a full recovery for their creditors, it is not possible to predict how the plan of reorganization will treat asbestos and other pre-petition claims and what impact any plan may have on the value of the shares of the Corporation's common stock and other outstanding securities. Under the Bankruptcy Code, a plan of reorganization, including a plan creating a Section 524(g) trust, may be confirmed without the consent of non-asbestos creditors and equity security holders if certain requirements of the Code are met. There is no assurance that there will be sufficient assets to satisfy the Debtors' pre-petition liabilities in whole or in part, and the pre-petition creditors of some Debtors may be treated differently from the pre-petition creditors of other Debtors. The payment rights and other entitlements of pre-petition creditors and USG shareholders may be substantially altered by any plan or plans of reorganization confirmed in the Chapter 11 Cases. Pre-petition creditors may receive under the plan of reorganization less than 100% of the face value of their claims, and the interests of the Corporation's equity security holders are likely to be substantially diluted or cancelled in whole or in part. It is also not possible to predict at this time how the plan of reorganization will treat intercompany indebtedness, licenses, transfers of goods and services and other intercompany arrangements, transactions, and relationships that were entered into before the Petition Date. These arrangements, transactions, and relationships may be challenged by various parties in the Chapter 11 Cases, and the outcome of those challenges, if any, may have an impact on the treatment of various claims under any plan of reorganization. Whether the Corporation's equity has significant value and Debtors' non-asbestos creditors recover the full value of their claims depend upon the outcome of the analysis of the amount of Debtors' assets and liabilities, especially asbestos liabilities, that must be funded under the plan. Counsel for the Official Committee of Asbestos Personal Injury Claimants and counsel for the legal representative for future asbestos personal injury claimants have advised the court that is presiding over the Chapter 11 Cases that they believe Debtors' asbestos liabilities exceed the value of Debtors' assets and that Debtors are insolvent. The Debtors have advised the court that they believe they are solvent if their asbestos -8- liabilities are fairly and appropriately valued. Toward that end, the Debtors filed a motion with the court requesting the court to begin proceedings to estimate the value of Debtors' asbestos personal injury liabilities. In response to the Debtors' motion requesting an estimation of asbestos personal injury liabilities, the court issued an order and memorandum opinion on February 19, 2003, setting forth a procedure for estimating Debtors' liability for asbestos personal injury claims alleging cancer. (See Note 12. Litigation, for additional information on this procedure.) The court has not set a timetable for this process. Thus, Debtors do not know when estimation of Debtors' liability for these cancer claims will occur, what the outcome of that proceeding will be, what impact that proceeding will have on estimating Debtors' liability for asbestos personal injury claims alleging other diseases, and whether the estimation proceeding will lead to a negotiated resolution of Debtors' asbestos personal injury liabilities. Debtors also cannot predict at this time the estimated cost of resolving asbestos property damage claims (see Note 12, Litigation, for additional information.) If the amount of the Debtors' asbestos liabilities cannot be resolved through negotiation or is not addressed by legislation (see Potential Federal Legislation Regarding Asbestos Personal Injury Claims, below), the outcome of the estimation proceedings regarding Debtors' liability for cancer claims, as provided in the Court's order, likely will be a significant component of determining Debtors' asbestos personal injury liability, Debtors' solvency, and the recovery of Debtors' pre-petition creditors and equity security holders under any plan or plans of reorganization. As a result of this uncertainty, it is not possible at this time to predict the timing or outcome of the Chapter 11 Cases, the terms and provisions of any plan or plans of reorganization, or the effect of the chapter 11 reorganization process on the claims of pre-petition creditors of the Debtors or the interests of the Corporation's equity security holders. There can be no assurance as to the value of any distributions that might be made under any plan or plans of reorganization with respect to such pre-petition claims, equity interests, or other outstanding securities. Recent developments in the Corporation's bankruptcy proceeding are discussed in Note 12. Litigation. In connection with the Filing, the Corporation implemented a Bankruptcy Court approved key employee retention plan that commenced on July 1, 2001, and continues until the date the Corporation emerges from bankruptcy, or June 30, 2004, whichever occurs first. Under the plan, participants receive semiannual payments that began in January 2002. Expenses associated with this plan amounted to $5.5 million in the second quarter of 2003 and 2002 and $11.1 million in the first six months of each year. POTENTIAL FEDERAL LEGISLATION REGARDING ASBESTOS PERSONAL INJURY CLAIMS The Corporation has for many years actively supported proposals for federal legislation addressing asbestos personal injury claims. On July -9- 10, 2003, the Judiciary Committee of the United States Senate narrowly approved the Fairness in Asbestos Injury Resolution Act of 2003 (Senate Bill 1125, the "FAIR Bill"), which is intended to establish a nationally administered trust to compensate asbestos personal injury claimants. This bill has not been approved by the Senate, has not been introduced in the House of Representatives, and is not law. Under the terms of the FAIR Bill as approved by the Judiciary Committee, companies that have been defendants in asbestos personal injury litigation, as well as insurance companies, are to contribute amounts to a national trust on a periodic basis to fund payment of claims filed by asbestos personal injury claimants who qualify for payment under the FAIR Bill based on an allocation methodology specified in the FAIR Bill. The FAIR Bill also provides, among other things, that the national fund would terminate if the administrator could not certify that 95% of the previous year's eligible claimants had been paid, in which case the claimants and defendants would return to the tort system on a retroactive basis. There are many other provisions in the FAIR Bill that would affect its impact on the Corporation and its Chapter 11 Cases. It is not possible to determine whether the FAIR Bill will ever be presented for a vote or passed by the full Senate or the House of Representatives, or whether the FAIR Bill will be signed into law. Nor is it possible at this time to predict the final terms or cost of any bill that might become law or its impact on the Corporation or the Chapter 11 Cases. The Corporation anticipates that, during the legislative process, the terms of the FAIR Bill as approved by the Judiciary Committee will change and that any such changes may be material to the FAIR Bill's impact on the Corporation. It is possible that the level of funding required from insurers and defendants, including the Corporation, would increase. Many organized labor organizations, including the AFL-CIO, have indicated their opposition to the FAIR Bill, and the American Insurance Association, a national organization of insurance companies, has also expressed opposition to the FAIR Bill in the form passed by the Judiciary Committee. In light of such opposition, as well as other factors, there is no assurance that any legislation will be enacted. Enactment of the FAIR Bill or other legislation addressing the financial contributions of USG Corporation for asbestos personal injury claims would have a material impact on the Corporation's Chapter 11 Cases. Legislation such as the FAIR Bill would have a material impact on the amount of the Corporation's asbestos personal injury liability that must be addressed in Debtors' Chapter 11 Cases. Such legislation may also affect the manner in which such liability may be addressed in Debtors' Chapter 11 Cases. As noted above (See Consequences of the Filing, above), the amount of Debtors' asbestos personal injury liability is a principal factor in determining the payment rights and other entitlements of the Corporation's pre-petition creditors and its shareholders. At this time, however, the outcome of the legislative process is extremely speculative, and there can be no assurance that national legislation will be enacted or what the -10- terms of any such legislation might be. During this process, the Corporation anticipates that the Chapter 11 Cases, including the proceedings regarding estimation of the Corporation's asbestos personal injury liabilities, will continue. (see Consequences of the Filing, above, and Note 12. Litigation) CHAPTER 11 FINANCING On July 31, 2001, a $350 million debtor-in-possession financing facility (the "DIP Facility") was approved by the Bankruptcy Court to supplement liquidity and fund operations during the reorganization process. The DIP Facility was provided by a syndicate of lenders led by JPMorgan Chase Bank (formerly The Chase Manhattan Bank) as agent. In January 2003, the Corporation reduced the size of the DIP Facility to $100 million and subsequently terminated the DIP Facility in June 2003. These actions were taken at the election of the Corporation due to the levels of cash and marketable securities on hand and to eliminate costs associated with the DIP Facility. The DIP Facility was used largely for the issuance of standby letters of credit needed to support business operations. As of June 30, 2003, $15.2 million of standby letters of credit remained outstanding under the DIP Facility. Following the termination of the DIP Facility, the Corporation has been required to cash collateralize 105% of these outstanding letters of credit until the letters of credit either expire or are returned by the beneficiary. The Corporation expects the collateral related to the DIP Facility to be released during the third quarter of 2003. In June 2003, the Corporation entered a three-year, $100 million credit agreement with LaSalle Bank to be used exclusively to support the issuance of standby letters of credit. As of June 30, 2003, $4.5 million of standby letters of credit, which are cash collateralized at 103%, had been issued under this facility to replace those to be surrendered by the beneficiaries in connection with the termination of the DIP Facility. As of June 30, 2003, a total of $21 million in cash collateral was posted to back up letters of credit as indicated above and was reported as restricted cash on the consolidated balance sheet. PRE-PETITION LIABILITIES OTHER THAN ASBESTOS PERSONAL INJURY Subsequent to the Filing, the Debtors received approval from the Bankruptcy Court to pay or otherwise honor certain of their pre-petition obligations, including employee wages, salaries, benefits and other employee obligations, and from limited available funds, pre-petition claims of certain critical vendors, real estate taxes, environmental obligations, certain customer programs and warranty claims, and certain other pre-petition claims. Pursuant to the Bankruptcy Code, schedules were filed by the Debtors with the Bankruptcy Court on October 23, 2001, and certain of the schedules were amended on May 31, 2002 and December 13, 2002, setting forth the -11- assets and liabilities of the Debtors as of the date of the Filing. The Bankruptcy Court established a bar date of January 15, 2003, by which proofs of claim were required to be filed against the Debtors for all claims other than asbestos-related personal injury claims as defined in the Court's order. Approximately 5,000 proofs of claim for general unsecured creditors (including pre-petition debtholders), totaling approximately $8.7 billion were filed by the bar date. There was an additional approximately $500 million of contingent claims. The Debtors are analyzing the proofs of claim filed by the bar date. Many of them are duplicates of other proofs of claim or of liabilities previously scheduled by the Debtors. In addition, many claims were filed against multiple Debtors or against an incorrect Debtor. Of these to date, the court has expunged 233 claims totaling $24 million as duplicates, 115 claims totaling $15 million as amended or superceded and allowed a correction of the Debtors on another 446 claims. Of the duplicate claims, approximately $5.7 billion have been withdrawn to date. The Debtors continue to analyze and reconcile filed claims on an on-going basis. On June 25, 2003, the second anniversary of the filing of the Chapter 11 Cases, the period during which the Debtors could bring avoidance actions in the Chapter 11 Cases expired. Such avoidance actions could include claims to avoid alleged preferences made during the 90-day period prior to the filing (or one-year period for insiders) and other transfers made or obligations incurred which could be alleged to be constructive or actual fraudulent conveyances under bankruptcy and state law. In advance of such expiration date, the Debtors had provided to the several Creditor Committees information regarding payments or other relevant transactions that had occurred between the Debtors and third persons, together with the Debtors' recommendation that no avoidance actions be filed against any third persons. On June 24, 2003, the Committee representing the unsecured creditors filed a motion with the Bankruptcy Court requesting authorization to file a complaint seeking to avoid and recover as preferences certain pre-petition payments made by Debtors to 206 creditors in amounts greater than $500,000. The Committee also requested the Court to extend the time by which the summons and complaint are served upon each named defendant until 90 days after confirmation of a plan of reorganization filed in connection with the Chapter 11 Cases. Recently, the Bankruptcy Court granted the Committee's motion. In addition, prior to the June 24, 2003 deadline for filing avoidance actions, certain of the Debtors entered into a Tolling Agreement pursuant to which the Debtors voluntarily agreed to extend the time during which actions could be brought to avoid certain intercompany transactions that occurred during the one-year period prior to the filing of the Chapter 11 Cases. The transactions as to which the Tolling Agreement applies are the creation of liens on certain assets of the Debtor subsidiaries in favor of the Parent Company in connection with intercompany loan agreements, a transfer by U.S. Gypsum Company to the Parent Company of a 9% interest in -12- the equity of CGC Inc., the principal Canadian subsidiary of the Parent Company, and transfers made by the Parent Company to USG Foreign Investments, Ltd., a non-Debtor subsidiary. The Bankruptcy Court approved the Tolling Agreement in June 2003. The Debtors expect to address claims for general unsecured creditors through liquidation, estimation or disallowance of the claims. In connection with this process, Debtors will make adjustments to their schedules and financials statements as appropriate. Any such adjustments could be material to the Company's consolidated financial position and results of operations in any given period. At this time, it is not possible to estimate the Debtors' liability for these claims. However, it is likely that the Debtors' liability for these claims will be different from the amounts presently recorded by the Debtors. Proofs of claim alleging asbestos property damage claims are discussed in Note 12. Litigation, under Developments in the Reorganization Process. FINANCIAL STATEMENT PRESENTATION The accompanying consolidated financial statements have been prepared in accordance with AICPA Statement of Position 90-7 ("SOP 90-7"), "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code," and on a going-concern basis, which contemplates continuity of operations, realization of assets and liquidation of liabilities in the ordinary course of business. However, as a result of the Filing, such realization of assets and liquidation of liabilities, without substantial adjustments and/or changes of ownership, are subject to uncertainty. Given this uncertainty, there is substantial doubt about the Corporation's ability to continue as a going concern. Such doubt includes, but is not limited to, a possible change in control of the Corporation, as well as a potential change in the composition of the Corporation's business portfolio. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. While operating as debtors-in-possession under the protection of chapter 11 of the Bankruptcy Code and subject to Bankruptcy Court approval or otherwise as permitted in the ordinary course of business, the Debtors, or any of them, may sell or otherwise dispose of assets and liquidate or settle liabilities for amounts other than those reflected in the consolidated financial statements. Further, a plan of reorganization could materially change the amounts and classifications in the historical consolidated financial statements. The appropriateness of using the going-concern basis for the Corporation's financial statements is dependent upon, among other things, (i) the ability of the Corporation to maintain adequate cash on hand (ii) the ability of the Corporation to generate cash from operations (iii) confirmation of a plan or plans of reorganization under the Bankruptcy Code and (iv) the Corporation's ability to achieve profitability following such confirmation. The Corporation believes that cash and marketable securities on hand and future cash available from operations will provide sufficient liquidity to allow its businesses to operate in the normal course without interruption for the duration of the chapter 11 -13- proceedings. This includes its ability to meet post-petition obligations of the Debtors and to meet obligations of the non-Debtor subsidiaries. LIABILITIES SUBJECT TO COMPROMISE: As reflected in the consolidated financial statements, liabilities subject to compromise refers to Debtors' liabilities incurred prior to the commencement of the Chapter 11 Cases. The amounts of the various liabilities that are subject to compromise are set forth in the table below. These amounts represent the Debtors' estimate of known or potential pre-petition claims to be resolved in connection with the Chapter 11 Cases. Such claims remain subject to future adjustments. Adjustments may result from (i) negotiations, (ii) actions of the Bankruptcy Court, (iii) further developments with respect to disputed claims, (iv) rejection of executory contracts and unexpired leases, (v) the determination as to the value of any collateral securing claims, (vi) proofs of claim, (vii) effect of any legislation which may be enacted or (viii) other events. The amount shown below for the asbestos reserve reflects the Corporation's pre-petition estimate of liability associated with asbestos claims to be filed in the tort system through 2003, and this liability, including liability for post-2003 claims, is the subject of significant legal proceedings and negotiation in the Chapter 11 Cases. See Note 12. Litigation for additional information on asbestos and related bankruptcy litigation. As of the date of this report, virtually all of the Corporation's pre-petition debt is in default due to the Filing and included in liabilities subject to compromise. This includes debt outstanding of $469 million under the pre-petition bank credit facilities and $536 million of other outstanding debt. Payment terms for liabilities subject to compromise will be established as part of a plan of reorganization under the Chapter 11 Cases. Liabilities subject to compromise in the consolidated and DIP balance sheets consist of the following items (dollars in millions):
As of As of June 30, December 31, 2003 2002 --------------------------- Accounts payable $ 160 $ 157 Accrued expenses 52 56 Debt 1,005 1,005 Asbestos reserve 1,061 1,061 Other long-term liabilities 20 36 ------------------------------------------------------------------------- Subtotal 2,298 2,315 Elimination of intercompany accounts payable (43) (43) ------------------------------------------------------------------------- Total liabilities subject to compromise 2,255 2,272 =========================================================================
-14- INTERCOMPANY TRANSACTIONS: In the normal course of business, the operating subsidiaries and the Parent Company engage in intercompany transactions. To document the relations created by these transactions, the Parent Company and the operating subsidiaries, from the formation of USG Corporation in 1985, have been parties to intercompany loan agreements that evidence their obligations as borrowers or rights as lenders arising out of intercompany cash transfers and various allocated intercompany charges (the "Intercompany Corporate Transactions"). The Corporation operates a consolidated cash management system under which the cash receipts of the domestic operating subsidiaries are ultimately concentrated in Parent Company accounts. Cash disbursements for those operating subsidiaries originate from those Parent Company concentration accounts. Allocated intercompany charges from the Parent Company to the operating subsidiaries primarily include expenses related to rent, property taxes, information technology, and research and development, while allocated intercompany charges between certain operating subsidiaries primarily include expenses for shared marketing, sales, customer service, engineering and accounting services. Detailed accounting records are maintained of all cash flows and intercompany charges through the system in either direction. Net balances, receivables or payables of such cash transactions, are reviewed on a regular basis with interest earned or accrued on the balances. During the first six months of 2001, the Corporation took steps to secure the obligations from each of the principal domestic operating subsidiaries under the intercompany loan agreements when it became clear that the asbestos liability claims of U.S. Gypsum were becoming an increasingly greater burden on the Corporation's cash resources. As of June 30, 2003, U.S. Gypsum and USG Interiors had net pre-petition payable balances to the Parent Company for Intercompany Corporate Transactions of $297 million and $109 million, respectively. L&W Supply had a net pre-petition receivable balance from the Parent Company of $32 million. These pre-petition balances are subject to the provisions of the Tolling Agreement discussed above. (see Pre-Petition Liabilities Other Than Asbestos Personal Injury, above) As of June 30, 2003, U.S. Gypsum, USG Interiors and L&W Supply had net post-petition receivable balances from the Parent Company for Intercompany Corporate Transactions of $166 million, $1 million and $160 million, respectively. In addition to the above transactions, the operating subsidiaries engage in ordinary course purchase and sale of products with other operating subsidiaries (the "Intercompany Trade Transactions"). Detailed accounting records also are maintained of all such transactions, and settlements are made on a monthly basis. Certain Intercompany Trade Transactions between U.S. and non-U.S. operating subsidiaries are settled via wire transfer payments utilizing several payment systems. -15- CHAPTER 11 REORGANIZATION EXPENSES: Chapter 11 reorganization expenses in the consolidated and DIP statements of earnings consist of the following (dollars in millions):
THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, ---------------------------------- 2003 2002 2003 2002 ---------------------------------- Legal and financial advisory fees $ 5 $ 9 $ 9 $ 13 Bankruptcy-related interest income (2) (2) (4) (4) ----------------------------------------------------------------------------- Total chapter 11 reorganization expenses 3 7 5 9 =============================================================================
INTEREST EXPENSE: For the second quarter and first six months of 2003, contractual interest expense not accrued or recorded on pre-petition debt totaled $18 and $36 million, respectively. From the Petition Date through June 30, 2003, contractual interest expense not accrued or recorded on pre-petition debt totaled $151 million. Although no post-petition accruals are required to be made for such contractual interest expense, debtholders may seek to recover such amounts in the Chapter 11 Cases. DIP FINANCIAL STATEMENTS: Under the Bankruptcy Code, the Corporation is required to file periodically with the Bankruptcy Court various documents including financial statements of the Debtors (the "Debtor-In-Possession" or "DIP" financial statements). The Corporation cautions that these financial statements are prepared according to requirements under the Bankruptcy Code. While these financial statements accurately provide information required under the Bankruptcy Code, they are nonetheless unconsolidated, unaudited and prepared in a format different from that used in the Corporation's consolidated financial statements filed under the securities laws. Accordingly, the Corporation believes the substance and format do not allow meaningful comparison with the Corporation's regular publicly disclosed consolidated financial statements. The Debtors consist of the Parent Company and the following wholly owned subsidiaries: United States Gypsum Company; USG Interiors, Inc.; USG Interiors International, Inc.; L&W Supply Corporation; Beadex Manufacturing, LLC; B-R Pipeline Company; La Mirada Products Co., Inc.; Stocking Specialists, Inc.; USG Industries, Inc.; and USG Pipeline Company. On March 1, 2002, USG Funding, a non-Debtor subsidiary of USG Corporation, declared a dividend in the amount of $50 million (subsequently reduced to $30 million in the second quarter) payable to the Parent Company, which was paid in effect by eliminating the intercompany payable from USG Corporation. This payment is included in other (income) expense, net in the DIP statement of earnings for the six months ended June 30, 2002. The condensed financial statements of the Debtors are presented as follows: -16- USG CORPORATION DEBTOR-IN-POSSESSION STATEMENT OF EARNINGS (DOLLARS IN MILLIONS) (UNAUDITED)
THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, -------------------- -------------------- 2003 2002 2003 2002 ------- ------- ------- ------- Net sales $ 827 $ 798 $ 1,608 $ 1,548 Cost of products sold 719 658 1,403 1,298 Selling and administrative expenses 70 69 139 140 Chapter 11 reorganization expenses 3 7 5 9 Interest expense 2 1 3 3 Interest income (1) - (1) - Other (income) expense, net (2) 19 (4) (31) ------- ------- ------- ------- Earnings before income taxes and cumulative effect of accounting change 36 44 63 129 Income taxes 17 29 29 47 ------- ------- ------- ------- Earnings before cumulative effect of accounting change 19 15 34 82 Cumulative effect of accounting change - - (13) (41) ------- ------- ------- ------- Net earnings 19 15 21 41 ======= ======= ======= =======
-17- USG CORPORATION DEBTOR-IN-POSSESSION BALANCE SHEETS (DOLLARS IN MILLIONS) (UNAUDITED)
AS OF AS OF JUNE 30, DECEMBER 31, 2003 2002 ----------- ------------ ASSETS Current Assets: Cash and cash equivalents $ 364 $ 478 Short-term marketable securities 66 50 Restricted cash 21 - Receivables (net of reserves - $13 and $13) 305 235 Inventories 237 227 Income taxes receivable 11 14 Deferred income taxes 51 49 Other current assets 58 67 ----------- ------------ Total current assets 1,113 1,120 Long-term marketable securities 172 131 Property, plant and equipment (net of accumulated depreciation and depletion - $601 and $557) 1,556 1,572 Deferred income taxes 209 218 Other assets 390 378 ----------- ------------ Total Assets 3,440 3,419 =========== ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts payable 167 142 Accrued expenses 165 207 Income taxes payable 27 20 ----------- ------------ Total current liabilities 359 369 Other liabilities 389 362 Liabilities subject to compromise 2,255 2,272 Stockholders' Equity: Preferred stock - - Common stock 5 5 Treasury stock (258) (257) Capital received in excess of par value 101 99 Accumulated other comprehensive income 3 4 Retained earnings 586 565 ----------- ------------ Total stockholders' equity 439 416 ----------- ------------ Total Liabilities and Stockholders' Equity 3,440 3,419 =========== ============
-18- USG CORPORATION DEBTOR-IN-POSSESSION STATEMENTS OF CASH FLOWS (DOLLARS IN MILLIONS) (UNAUDITED)
SIX MONTHS ENDED JUNE 30, ---------------------- 2003 2002 -------- -------- OPERATING ACTIVITIES: Net earnings $ 21 $ 41 Adjustments to reconcile net earnings to net cash: Cumulative effect of accounting change 13 41 Depreciation, depletion and amortization 44 42 Deferred income taxes 16 34 (Increase) decrease in working capital: Receivables (70) (42) Income taxes receivable 3 15 Inventories (10) (25) Payables 31 44 Accrued expenses (43) 34 Decrease in pre-petition intercompany receivable - - Increase in post-petition intercompany receivable (10) (52) (Increase) decrease in other assets (3) 23 Increase in other liabilities 2 8 Decrease in asbestos receivables 19 11 Decrease in liabilities subject to compromise (17) (24) Other, net (6) (7) -------- -------- Net cash (used for) provided by operating activities (10) 143 -------- -------- INVESTING ACTIVITIES: Capital expenditures (24) (31) Purchases of marketable securities (148) - Sale or maturities of marketable securities 91 - Net proceeds from asset dispositions - 1 Acquisition of business (2) - -------- -------- Net cash used for investing activities (83) (30) -------- -------- FINANCING ACTIVITIES: Deposit of restricted cash (21) - -------- -------- Net cash used for financing activities (21) - -------- -------- Net (decrease) increase in cash and cash equivalents (114) 113 Cash and cash equivalents at beginning of period 478 346 -------- -------- Cash and cash equivalents at end of period 364 459 ======== ======== SUPPLEMENTAL CASH FLOW DISCLOSURES: Interest paid 1 1 Income taxes paid (refunded), net 1 (1)
-19- (3) EXIT ACTIVITIES 2002 DOWNSIZING PLAN: In the fourth quarter of 2002, the Corporation recorded a nontaxable charge of $11 million related to the shutdown of the Aubange, Belgium, ceiling tile plant and other downsizing activities in Europe to address the continuing weakness of the commercial ceilings market in Europe. The charge was included in cost of products sold for USG International and reflected severance of $6 million related to a workforce reduction of over 50 positions (salaried and hourly), equipment writedowns of $3 million and other reserves of $2 million. The other reserves primarily related to lease cancellations, inventories and receivables. As of June 30, 2003, 53 employees were terminated. The Aubange, Belgium, plant ceased operations in December 2002. The reserve for the 2002 downsizing plan was included in accrued expenses on the consolidated balance sheets. Charges against the reserve included the $3 million write-off of equipment in 2002 and payments totaling $6 million in the first six months of 2003. All payments associated with the 2002 downsizing plan are being funded with cash from operations. 2001 RESTRUCTURING PLAN: In the fourth quarter of 2001, the Corporation recorded a charge of $12 million pretax ($10 million after-tax) related to a restructuring plan that included the shutdown of a gypsum wallboard plant in Fremont, Calif., a drywall steel plant in Prestice, Czech Republic, a ceiling tile plant in San Juan Ixhuatepec, Mexico, a ceiling tile manufacturing line in Greenville, Miss., and other restructuring activities. Included in the $12 million pretax charge was $8 million for severance related to a workforce reduction of more than 350 positions (primarily hourly positions), $2 million for the write-off of property, plant and equipment, and $2 million for line shutdown and removal and contract cancellations. The 2001 restructuring was intended to allow the Corporation to optimize its manufacturing operations. A total of 348 employees were terminated, and 26 open positions were eliminated, and a ceiling tile manufacturing line at Greenville, Miss., and the plants in San Juan Ixhuatepec, Mexico, and Prestice, Czech Republic, were shut down. The Fremont, Calif., plant ceased production in the second quarter of 2002. The reserve for the 2001 restructuring plan was included in accrued expenses on the consolidated balance sheets. Charges against the reserve in 2001 included the $2 million write-off of property, plant and equipment and payments totaling $2 million. An additional $3 million of payments were made and charged against the reserve in 2002. The remaining $5 million of payments were made and charged against the reserve in the first quarter of 2003. All payments associated with the 2001 restructuring plan were funded with cash from operations. The following table details the reserves and activity for the 2002 downsizing and 2001 restructuring plan (dollars in millions): -20-
Provisions for Writedown of Reserve Downsizing/ Assets to Net Cash Balance Restructuring Realizable Value Payments 6/30/03 ----------------------------------------------------------------------------------------------------------- 2002 Downsizing: Severance (salaried and hourly) $ 6 $ - $ (6) $ - Equipment write-off 3 (3) - - Other reserves 2 - - 2 ----------------------------------------------------------------------------------------------------------- Subtotal 11 (3) (6) 2 ----------------------------------------------------------------------------------------------------------- 2001 Restructuring: Severance (primarily hourly) 8 - (8) - Property, plant and equipment write-off 2 (2) - - Line shutdown/removal and contract cancellations 2 - (2) - ----------------------------------------------------------------------------------------------------------- Subtotal 12 (2) (10) - ----------------------------------------------------------------------------------------------------------- Total 23 (5) (16) 2 ===========================================================================================================
(4) EARNINGS PER SHARE Basic earnings per share are based on the weighted average number of common shares outstanding. Diluted earnings per share are based on the weighted average number of common shares outstanding and the dilutive effect of the potential exercise of outstanding stock options. Diluted earnings per share exclude the potential exercise of outstanding stock options for any period in which such exercise would have an anti-dilutive effect. The reconciliation of basic earnings per share to diluted earnings per share is shown in the following table (dollars in millions except share data):
NET SHARES PER SHARE THREE MONTHS ENDED JUNE 30, EARNINGS (000) AMOUNT ----------------------------------------------------------------------------------------------------------- 2003: Basic earnings $ 31 43,046 $ 0.73 Dilutive effect of stock options - ----------------------------------------------------------------------------------------------------------- Diluted earnings 31 43,046 0.73 =========================================================================================================== 2002: Basic earnings 48 43,251 1.11 Dilutive effect of stock options - ----------------------------------------------------------------------------------------------------------- Diluted earnings 48 43,251 1.11 ===========================================================================================================
-21-
NET SHARES PER SHARE SIX MONTHS ENDED JUNE 30, EARNINGS (000) AMOUNT ------------------------------------------------------------------- 2003: Basic earnings $ 37 43,097 $ 0.86 Dilutive effect of stock options - ------------------------------------------------------------------- Diluted earnings 37 43,097 0.86 =================================================================== 2002: Basic loss (22) 43,310 (0.52) Dilutive effect of stock options - ------------------------------------------------------------------- Diluted loss (22) 43,310 (0.52) ===================================================================
(5) MARKETABLE SECURITIES As of June 30, 2003, the Corporation's investments in marketable securities consisted of the following:
Fair Amortized Market Cost Value -------------------- Asset-backed securities $ 108 $ 108 U.S. government and agency securities 64 65 Municipal securities 28 28 Time deposits 10 10 Corporate securities 27 27 ---------------------------------------------------------------- Total marketable securities 237 238 ================================================================
Contractual maturities of marketable securities as of June 30, 2003, were as follows (dollars in millions):
Fair Amortized Market Cost Value -------------------- Due in 1 year or less $ 59 $ 60 Due in 1-5 years 44 44 Due in 5-10 years 3 3 Due after 10 years 23 23 ---------------------------------------------------------------- 129 130 ---------------------------------------------------------------- Asset-backed securities 108 108 ---------------------------------------------------------------- Total marketable securities 237 238 ================================================================
The average duration of the portfolio is less than one year because a majority of the longer-term securities have paydown or put features. -22- (6) ADOPTION OF SFAS NO. 143 On January 1, 2003, the Corporation adopted Statement of Financial Accounting Standards ("SFAS") No. 143, "Accounting for Asset Retirement Obligations." This standard requires the recording of the fair value of a liability for an asset retirement obligation in the period in which it is incurred. The Corporation's asset retirement obligations include reclamation requirements as regulated by government authorities related principally to assets such as the Corporation's mines, quarries, landfills, ponds and wells. The impact of adopting SFAS No. 143 was an increase in the Corporation's assets and liabilities of $14 million and $30 million, respectively. A noncash, after-tax charge of $16 million ($27 million pretax) was reflected on the consolidated statement of earnings as a cumulative effect of a change in accounting principle as of January 1, 2003. (7) ADOPTION OF SFAS NO. 142 On January 1, 2002, the Corporation adopted SFAS No. 142, "Goodwill and Other Intangible Assets." Although SFAS No. 142 eliminated the amortization of goodwill and certain other intangible assets, it initiated an annual assessment of goodwill for impairment. The initial assessment was completed as of the adoption date. The assessment was performed for each reporting unit (as defined by SFAS No. 142) that had goodwill. For the Corporation, the reporting units with goodwill were the North American Gypsum and the Building Products Distribution operating segments. The Corporation determined that goodwill for its Building Products Distribution segment was not impaired, but will be reviewed at least annually for impairment. However, goodwill for its North American Gypsum segment was impaired. This impairment was attributable to U.S. Gypsum's asbestos liability and related filing for bankruptcy protection on June 25, 2001. As a result, the Corporation recorded a noncash, nontaxable impairment charge of $96 million. This charge included a $90 million write-off of goodwill (net of accumulated amortization of $8 million) and a $6 million write-off of deferred currency translation. In accordance with SFAS No. 142, the Corporation reflected this charge in its financial statements as a cumulative effect of a change in accounting principle as of January 1, 2002. -23- (8) DERIVATIVE INSTRUMENTS The Corporation uses derivative instruments to manage selected commodity price and foreign currency exposures. The Corporation does not use derivative instruments for trading purposes. Under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended, all derivative instruments must be recorded on the balance sheet at fair value. For derivatives designated as fair value hedges, the changes in the fair values of both the derivative instrument and the hedged item are recognized in earnings in the current period. For derivatives designated as cash flow hedges, the effective portion of changes in the fair value of the derivative is recorded to accumulated other comprehensive income (loss) and is reclassified to earnings when the underlying transaction has an impact on earnings. COMMODITY DERIVATIVE INSTRUMENTS: The Corporation uses swap contracts from time to time to hedge anticipated purchases of natural gas, wastepaper and fuel to be used in its manufacturing and shipping operations. The current contracts, all of which mature by December 31, 2004, are generally designated as cash flow hedges, with changes in fair value recorded to accumulated other comprehensive income (loss) until the hedged transaction occurs, at which time it is reclassified to earnings. As of June 30, 2003, the fair value of these swap contracts, which remained in accumulated other comprehensive income (loss), was $16 million ($10 million after-tax). FOREIGN EXCHANGE DERIVATIVE INSTRUMENTS: The Corporation has operations in a number of countries and uses forward contracts from time to time to hedge selected risk of changes in cash flows resulting from forecasted intercompany and third-party sales or purchases in foreign currencies. These contracts are generally designated as cash flow hedges, for which changes in fair value are recorded to accumulated other comprehensive income (loss) until the underlying transaction has an impact on earnings. As of June 30, 2003, the Corporation had foreign currency contracts in place which mature on the anticipated date of the underlying transaction, and all contracts mature by December 31, 2003. The notional amounts of foreign currency contracts as of June 30, 2003, was $1 million. The fair value of these contracts as of June 30, 2003, was zero. COUNTERPARTY RISK: The Corporation is exposed to credit losses in the event of nonperformance by the counterparties on its financial instruments. All counterparties have investment grade credit standing; accordingly, the Corporation anticipates that these counterparties will be able to satisfy fully their obligations under the contracts. The Corporation does not generally obtain collateral or other security to support financial instruments subject to credit risk but regularly monitors the credit standing of all counterparties. -24- (9) COMPREHENSIVE INCOME (LOSS) The components of comprehensive income (loss) are summarized in the following table (dollars in millions):
THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, ------------------------------------ 2003 2002 2003 2002 ------------------------------------ Net earnings (loss) $ 31 $ 48 $ 37 $ (22) ------------------------------------------------------------------------------------- Pretax gain (loss) on derivatives (2) (8) (2) 5 Income tax benefit (expense) 1 3 1 (2) ------------------------------------------------------------------------------------- Gain (loss) on derivatives, net of tax (1) (5) (1) 3 ------------------------------------------------------------------------------------- Deferred currency translation 13 7 24 12 ------------------------------------------------------------------------------------- Unrealized gain (loss) on marketable securities, net of tax - - - - ------------------------------------------------------------------------------------- Total comprehensive income (loss) 43 50 60 (7) =====================================================================================
There was no tax impact on the foreign currency translation adjustments. The components of accumulated other comprehensive income (loss) included on the consolidated balance sheet are summarized in the following table (dollars in millions):
As of As of June 30, December 31, 2003 2002 ------------------------ Gain on derivatives, net of tax $ 17 $ 18 Deferred currency translation (15) (39) Minimum pension liability, net of tax (11) (11) Unrealized gain (loss) on marketable securities, net of tax - - ----------------------------------------------------------------------------------------- Total accumulated other comprehensive income (loss) (9) (32) =========================================================================================
During the second quarter of 2003, $6 million of accumulated net after-tax gains ($10 million pretax) on derivatives were reclassified from accumulated other comprehensive income (loss) to earnings. As of June 30, 2003, the estimated net after-tax gain expected to be reclassified within the next 12 months from accumulated other comprehensive income (loss) into earnings is $15 million. -25- (10) STOCK-BASED COMPENSATION The Corporation accounts for stock-based compensation under the provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." APB No. 25 prescribes the use of the intrinsic value method, which measures compensation cost as the quoted market price of the stock at the date of grant less the amount, if any, that the employee is required to pay. If the Corporation had elected to recognize compensation cost for stock-based compensation grants consistent with the fair value method prescribed by SFAS No. 123, "Accounting for Stock-Based Compensation," as amended by SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure," net earnings (loss) and net earnings (loss) per common share would have changed to the following pro forma amounts:
THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, ------------------------------------ 2003 2002 2003 2002 ------------------------------------ NET EARNINGS (LOSS): Net Earnings(Loss): As reported $ 31 $ 48 $ 37 $ (22) Deduct: Fair value method of stock -based employee compensation expense, net of tax - - - (1) ------------------------------------------------------------------------------------ Pro forma net earnings(loss) 31 48 37 (23) ==================================================================================== BASIC AND DILUTED EARNINGS (LOSS) PER SHARE: As reported 0.73 1.11 0.86 (0.52) Pro forma 0.73 1.11 0.86 (0.54) ====================================================================================
Subsequent to the Filing, no stock option grants have been issued. The deduction of $1 million shown above to the first six months of 2002 net earnings reflects the vesting of options granted prior to the Filing. As of June 30, 2003, common shares totaling 2,600,375 were reserved for future issuance in conjunction with existing stock option grants. In addition, 2,263,620 common shares were reserved for future grants. Shares issued in option exercises may be from original issue or available treasury shares. -26- (11) OPERATING SEGMENTS The Corporation's operations are organized into three operating segments: North American Gypsum, which manufactures SHEETROCK brand gypsum wallboard and joint compounds, DUROCK brand cement board and other related building products in the United States, Canada and Mexico; Worldwide Ceilings, which manufactures ceiling tile in the United States and ceiling grid in the United States, Canada, Europe and the Asia-Pacific region; and Building Products Distribution, which distributes gypsum wallboard, drywall metal, ceiling products, joint compound and other building products throughout the United States. Operating segment results were as follows (dollars in millions):
THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, ------------------------------------ 2003 2002 2003 2002 ------------------------------------ NET SALES: North American Gypsum $ 566 $ 551 $1,108 $1,076 Worldwide Ceilings 154 158 301 306 Building Products Distribution 325 306 620 581 Eliminations (131) (130) (253) (249) ------------------------------------------------------------------------------------ Total USG Corporation 914 885 1,776 1,714 ==================================================================================== OPERATING PROFIT (LOSS): North American Gypsum 47 81 85 139 Worldwide Ceilings 9 11 17 16 Building Products Distribution 16 13 24 20 Corporate (18) (17) (36) (37) Chapter 11 reorganization expenses (3) (7) (5) (9) Eliminations (1) (1) - (1) ------------------------------------------------------------------------------------ Total USG Corporation 50 80 85 128 ====================================================================================
(12) LITIGATION ASBESTOS AND RELATED BANKRUPTCY LITIGATION One of the Corporation's subsidiaries, U.S. Gypsum, is among many defendants in lawsuits arising out of the manufacture and sale of asbestos-containing materials. On June 25, 2001 (the "Petition Date"), U.S. Gypsum, the Parent Company, and other domestic subsidiaries (the "Debtors") filed voluntary petitions for reorganization ("Filing") under chapter 11 of the U.S. Bankruptcy Code to manage the growing costs of resolving asbestos claims and to achieve a fair and final resolution of liability for both pending and future asbestos claims. The Debtors' chapter 11 cases ("Chapter 11 Cases") are being jointly administered as In re: USG Corporation et al. (Case No. 01-2094) in the United States Bankruptcy Court for the District of Delaware (the "Bankruptcy Court"). -27- U.S. Gypsum's asbestos liability derives from its sale of certain asbestos-containing products beginning in the late 1920s; in most cases, the products were discontinued or asbestos was removed from the formula by 1972, and no asbestos-containing products were produced after 1978. Certain of the asbestos lawsuits against U.S. Gypsum seek to recover compensatory and, in many cases, punitive damages for costs associated with the maintenance or removal and replacement of asbestos-containing products in buildings (the "Property Damage Cases"). Other asbestos lawsuits seek compensatory and, in many cases, punitive damages for personal injury allegedly resulting from exposure to asbestos-containing products (the "Personal Injury Cases"). A more detailed description of the Property Damage and Personal Injury Cases against U.S. Gypsum and certain other Debtors is set forth below. As a result of the Filing, all pending Personal Injury and Property Damage Cases against U.S. Gypsum are stayed, and no party may take any action to pursue or collect on these claims absent specific authorization of the Bankruptcy Court. Since the Filing, U.S. Gypsum has ceased making both cash payments and accruals with respect to asbestos lawsuits, including cash payments and accruals pursuant to settlements of asbestos lawsuits. The Bankruptcy Court has approved creditors' committees that represent claimants in Personal Injury and Property Damage Cases and, as noted below, a legal representative for future asbestos claimants. Debtors anticipate that U.S. Gypsum's liability for asbestos personal injury and property damage claims will be addressed in a plan of reorganization developed and approved in the bankruptcy proceeding. The Debtors' exclusive right to propose such a plan of reorganization has been extended by the Bankruptcy Court to September 1, 2003. The Debtors intend to seek one or more additional extensions depending upon developments in the Chapter 11 Cases. Debtors expect that the plan of reorganization will include creation of one or more independently administered trusts under Section 524(g) of the Bankruptcy Code, which will be funded by Debtors to allow payment of present and future asbestos personal injury claims and demands. Debtors also expect that the plan of reorganization will address Debtors' liability for asbestos property damage claims, whether by including those liabilities in a Section 524(g) trust or by other means. It is anticipated that, as a result of creation and funding of the Section 524(g) trust(s), the Bankruptcy Court will issue a permanent injunction barring the assertion of present and future asbestos claims against Debtors, their successors, and their affiliates, and channeling those claims to the trust(s) for payment in whole or in part. Similar plans of reorganization containing Section 524(g) trusts have been confirmed in the chapter 11 cases of other companies with asbestos liabilities, but there is no guarantee that the Bankruptcy Court in Debtors' Chapter 11 Cases will approve creation of a Section 524(g) trust or issue a permanent injunction channeling to the -28- trust all asbestos claims against Debtors and/or their successors and affiliates. In addition, if federal legislation addressing asbestos personal injury claims is passed, which is extremely speculative at this time, such legislation may affect the manner in which asbestos personal injury claims are to be addressed in Debtors' Chapter 11 Cases and may affect whether the Debtors establish a trust under Section 524(g). (see Note 2. Voluntary Reorganization Under Chapter 11 - Potential Federal Legislation Regarding Asbestos Personal Injury Claims) While it is the Debtors' intention to seek a full recovery for their creditors, it is not possible to predict how the plan of reorganization will treat asbestos and other pre-petition claims and what impact any plan may have on the value of the shares of the Corporation's common stock and other outstanding securities. Under the Bankruptcy Code, a plan of reorganization, including a plan creating a Section 524(g) trust, may be confirmed without the consent of non-asbestos creditors and equity security holders if certain requirements of the Code are met. There is no assurance that there will be sufficient assets to satisfy the Debtors' pre-petition liabilities in whole or in part, and the pre-petition creditors of some Debtors may be treated differently from the pre-petition creditors of other Debtors. The payment rights and other entitlements of pre-petition creditors and USG shareholders may be substantially altered by any plan or plans of reorganization confirmed in the Chapter 11 Cases. Pre-petition creditors may receive under the plan of reorganization less than 100% of the face value of their claims, and the interests of the Corporation's equity security holders are likely to be substantially diluted or cancelled in whole or in part. Whether the Corporation's equity has significant value and Debtors' non-asbestos creditors recover the full value of their claims depend upon the outcome of the analysis of the amount of Debtors' assets and liabilities, especially asbestos liabilities, that must be funded under the plan. Counsel for the Official Committee of Asbestos Personal Injury Claimants and counsel for the legal representative for future asbestos personal injury claimants have advised the court that is presiding over the Chapter 11 Cases that they believe Debtors' asbestos liabilities exceed the value of Debtors' assets and that Debtors are insolvent. The Debtors have advised the court that they believe they are solvent if their asbestos liabilities are fairly and appropriately valued. Toward that end, the Debtors filed a motion with the court requesting the court to begin proceedings to estimate the value of Debtors' asbestos personal injury liabilities. In response to the Debtors' motion requesting an estimation of asbestos personal injury liabilities, the court issued an order and memorandum opinion on February 19, 2003, setting forth a procedure for estimating Debtors' liability for asbestos personal injury claims alleging cancer. (See Developments in the Reorganization Proceeding, below.) The court has not set a timetable for this process. Thus, Debtors do not know when -29- estimation of Debtors' liability for these cancer claims will occur, what the outcome of that proceeding will be, what impact that proceeding will have on estimating Debtors' liability for asbestos personal injury claims alleging other diseases, and whether the estimation proceeding will lead to a negotiated resolution of Debtors' asbestos personal injury liabilities. Debtors also cannot predict at this time the estimated cost of resolving asbestos property damage claims. If the amount of the Debtors' asbestos liabilities cannot be resolved through negotiation or is not addressed by legislation (see Note 2. Voluntary Reorganization Under Chapter 11 - Potential Federal Legislation Regarding Asbestos Personal Injury Claims), the outcome of the estimation proceeding regarding Debtors' liability for cancer claims likely will be a significant component of determining Debtors' asbestos personal injury liability, Debtors' solvency, and the recovery of Debtors' pre-petition creditors and equity security holders under any plan or plans of reorganization. As a result of this uncertainty, it is not possible at this time to predict the timing or outcome of the Chapter 11 Cases, the terms and provisions of any plan or plans of reorganization, or the effect of the chapter 11 reorganization process on the claims of pre-petition creditors of the Debtors or the interests of the Corporation's equity security holders. There can be no assurance as to the value of any distributions that might be made under any plan or plans of reorganization with respect to such pre-petition claims, equity interests, or other outstanding securities. Recent developments in the Corporation's bankruptcy proceeding and a more detailed discussion of the Debtors' asbestos liabilities are addressed below. DEVELOPMENTS IN THE REORGANIZATION PROCEEDING: During the fourth quarter of 2001, the Corporation's bankruptcy proceeding, along with four other asbestos-related bankruptcy proceedings pending in the federal courts in the District of Delaware, were assigned to the Honorable Alfred M. Wolin of the United States District Court for the District of New Jersey. Judge Wolin has indicated that he will handle all issues relating to asbestos personal injury claims and that other bankruptcy claims and issues in the Chapter 11 Cases, including issues relating to asbestos property damage claims, will remain assigned to Bankruptcy Judge Randall J. Newsome in the United States Bankruptcy Court for the District of Delaware. In July 2002, the Bankruptcy Court appointed the Honorable Dean M. Trafelet as the legal representative for future asbestos claimants in the Debtors' bankruptcy proceeding. Mr. Trafelet was formerly a judge of the Circuit Court of Cook County, Illinois. The Debtors filed a motion requesting Judge Wolin to conduct hearings to substantively estimate the Debtors' liability for asbestos personal injury claims. The Debtors requested that the court hear evidence and make rulings -30- regarding the characteristics of valid asbestos personal injury claims against the Debtors, and then estimate the Debtors' liability for present and future asbestos personal injury claims based upon these rulings. One of the key liability issues is whether claimants who do not have objective evidence of asbestos-related disease have valid claims and are entitled to be compensated by Debtors, or whether such claimants are entitled to compensation only if and when they develop asbestos-related disease. The Official Committee of Asbestos Personal Injury Claimants opposed the substantive estimation hearings proposed by Debtors. The committee contends that U.S. Gypsum's liability for present and future asbestos personal injury claims should be based on extrapolation from U.S. Gypsum's settlement history of such claims and not on litigating liability issues in the bankruptcy proceeding. The committee contends that the Court does not have the power to exclude claimants who do not meet objective evidence of asbestos-related disease if such claimants are compensated in the tort system outside of bankruptcy. In August 2002, Debtors also filed a motion with Judge Wolin requesting a ruling that putative claimants who cannot satisfy objective standards of asbestos-related disease are not entitled to vote on a Section 524(g) plan. The Debtors' motion on this voting issue has been stayed by order of Judge Wolin. It is expected that the Official Committee of Asbestos Personal Injury Claimants will oppose the Debtors' motion. In response to the Debtors' motion seeking substantive estimation of Debtors' asbestos personal injury liability, Judge Wolin issued a Memorandum Opinion and Order ("Order") on February 19, 2003, setting forth a procedure for estimating Debtors' liability for asbestos personal injury claims alleging cancer. The Order states that a bar date will be established for filing claims by all persons who wish to assert an asbestos personal injury claim alleging cancer against Debtors. The bar date will not apply to non-malignant claims, which the Order states will not be addressed at this time. The Order provides that after the claims bar date for these cancer claims has passed, the Court will hold an estimation hearing under 11 U.S.C. Section 502(c) at which the "debtors will be permitted to present their defenses." Although the Order explicitly contemplates a bar date for filing these cancer claims, the Order does not establish a bar date or a date for the subsequent estimation hearing. The Order contemplates that after the estimation of Debtors' liability for present and future cancer claims, the Court will determine whether Debtors' liability for these claims exceeds Debtors' assets. The Court notes that the Official Committee of Asbestos Personal Injury Claimants has asserted that the Debtors are insolvent and do not have sufficient assets to pay cancer claimants, without regard to Debtors' liability for non-malignant asbestos personal injury claims. The Court further notes that Debtors dispute this contention. According to the -31- Order, the determination of whether the Debtors have sufficient assets to pay legitimate cancer claimants will guide the Court in determining whether the Debtors' resources should be spent resolving the issue of the validity of non-malignant claims where there is no objective evidence of asbestos-related disease. Pursuant to the Order, on March 21, 2003, the Debtors submitted to the court a proposed timetable for the bar date for cancer claims, a proposed proof of claim form, and a plan for providing notice of the bar date. The Committee for Asbestos Personal Injury Claimants has requested the Court to limit the bar date and estimation proceeding to asbestos personal injury cancer claimants who filed a lawsuit against Debtors before the Petition Date. The court has indicated that it likely will limit the bar date to cancer claimants who filed a lawsuit against Debtors before the Petition Date, but the Court has not yet issued any order to that effect and has not yet set a bar date for cancer claims or a date for any hearing on estimation of Debtors' liability for these claims. At this stage in the proceedings, Debtors do not know when estimation of Debtors' liability for these cancer claims will occur, what the outcome of the estimation proceeding will be, what impact that proceeding will have on estimating Debtors' liability for asbestos personal injury claims alleging other diseases, and whether the estimation proceeding will lead to a negotiated resolution of Debtors' asbestos liabilities. Debtors also do not know whether the Court will ultimately address the validity and voting rights of non-malignant claims. If the amount of the Debtors' asbestos liabilities cannot be resolved through negotiation or is not addressed by legislation (see Note 2. Voluntary Reorganization Under Chapter 11 - Potential Federal Legislation Regarding Asbestos Personal Injury Claims), as has been the case to date, the outcome of the estimation proceeding regarding Debtors' liability for cancer claims likely will be a significant component of determining Debtors' asbestos personal injury liability, Debtors' solvency, and the recovery of Debtors' pre-petition creditors and equity security holders under any plan or plans of reorganization. There have also been developments in the reorganization proceedings regarding asbestos property damage claims. The Bankruptcy Court established a bar date of January 15, 2003, by which all entities with asbestos-related property damage claims or any other types of claims (except asbestos personal injury claims or claims derivative thereof) must file their claims against the Debtors in the bankruptcy proceeding. The Debtors mailed and published notice of the claims bar date to potential asbestos property damage claimants as well as other claimants affected by the bar date. The Debtors have made a preliminary analysis of the asbestos-related property damage claims received as of the claims bar date. Approximately 1,400 asbestos property damage claims were filed, representing more than -32- 2,000 buildings. In contrast, as of the Petition Date, 11 Property Damage Cases were pending against U.S. Gypsum. Approximately 500 of the asbestos property damage claims filed by the bar date assert a specific dollar amount of damages, and the total damages alleged in those claims is approximately $1.6 billion. However, this amount reflects numerous duplicate claims filed against multiple Debtors, and therefore, likely overstates the claimed damages. Approximately 900 claims do not specify a damage amount. Many of the filed claims do not provide any evidence that Debtors' products were ever installed in any of the buildings at issue, and some of the claims are duplicates of other claims. Debtors believe that they have substantial defenses to many of these property damage claims, including the lack of evidence that Debtors' products were ever installed in the buildings at issue, the claims are barred by the applicable statutes of limitation, and the claims lack evidence that the claimants have any damages. Debtors intend to address many of these claims through an objection and disallowance process in the bankruptcy court. Because of the preliminary nature of this process, Debtors' cannot predict the outcome of these proceedings or the impact the proceedings may have on the estimated cost of resolving asbestos property damage claims. (see Estimated Cost, below) The following is a summary of the Property Damage and Personal Injury Cases pending against U.S. Gypsum and certain other Debtors as of the Petition Date. PROPERTY DAMAGE CASES: As of the Petition Date, U.S. Gypsum was a defendant in 11 Property Damage Cases, most of which involved multiple buildings. One of the cases is a conditionally certified class action comprising all colleges and universities in the United States, which certification is presently limited to the resolution of certain allegedly "common" liability issues. (Central Wesleyan College v. W.R. Grace & Co., et al., U.S.D.C. S.C.). On June 15, 2001, a Property Damage Case was filed by The County of Orange, Texas, in the district court of Orange County, Texas, naming as defendants U.S. Gypsum and other manufacturers of asbestos-containing materials. This was the first Property Damage case filed against U.S. Gypsum since June 1998. The Orange County case is a putative class action brought by The County of Orange on behalf of an alleged class comprising the State of Texas, its public colleges and universities, and all political subdivisions of the State of Texas. As to U.S. Gypsum, the putative class also includes all private and/or non-public colleges, universities, junior colleges, community colleges, and elementary and secondary schools in the State of Texas. The Orange County action seeks recovery of the costs of removing and replacing asbestos-containing materials in buildings at issue as well as punitive damages. The complaint does not specify how many buildings are at issue. As a result of the Filing, all Property Damage Cases, including the Central Wesleyan and Orange County cases, are stayed against U.S. Gypsum. U.S. Gypsum's estimated cost of resolving the Property Damage Cases is discussed below. (see Estimated Cost, below) -33- PERSONAL INJURY CASES: As reported by the Center for Claims Resolution (the "Center"), U.S. Gypsum was a defendant in approximately 106,000 pending Personal Injury Cases as of the Petition Date, as well as an additional approximately 52,000 Personal Injury Cases that are the subject of settlement agreements. In the first half of 2001, up to the Petition Date, approximately 26,200 new Personal Injury Cases were filed against U.S. Gypsum, as reported by the Center, as compared to 27,800 new filings in the first half of 2000. Filings of new Personal Injury Cases totaled approximately 53,000 claims in 2000, 48,000 claims in 1999, and 80,000 claims in 1998. Prior to the Filing, U.S. Gypsum managed the handling and settlement of Personal Injury Cases through its membership in the Center. From 1988 up to February 1, 2001, the Center administered and arranged for the defense and settlement of Personal Injury Cases against U.S. Gypsum and other Center members. During that period, costs of defense and settlement of Personal Injury Cases were shared among the members of the Center pursuant to predetermined sharing formulae. Effective February 1, 2001, the Center members, including U.S. Gypsum, ended their prior settlement-sharing arrangement. The Center continued to administer and arrange for the defense and settlement of the Personal Injury Cases, but liability payments were not shared among the Center members. As of the Petition Date and as a result of the stay of asbestos lawsuits against U.S. Gypsum, U.S. Gypsum no longer requires the services of the Center in negotiating or defending Personal Injury Cases. In 2000 and years prior, U.S. Gypsum and other Center members negotiated a number of settlements with plaintiffs' law firms that included agreements to resolve over time the firms' pending Personal Injury Cases as well as certain future claims (the "Long-Term Settlements"). With regard to future claims, these Long-Term Settlements typically provide that the plaintiffs' firms will recommend to their future clients that they defer filing, or accept nominal payments on, personal injury claims that do not meet established disease criteria, and, with regard to those claims meeting established disease criteria, that the future clients accept specified amounts to settle those claims. These Long-Term Settlements typically resolve claims for amounts consistent with historical per-claim settlement costs paid to the plaintiffs' firms involved. As a result of the Filing, cash payments by U.S. Gypsum under these Long-Term Settlements have ceased, and U.S. Gypsum expects that its obligations under these settlements will be determined in the bankruptcy proceeding and plan of reorganization. In 2000, U.S. Gypsum closed approximately 57,000 Personal Injury Cases. U.S. Gypsum's cash payments in 2000 to defend and resolve Personal Injury Cases totaled $162 million, of which $90 million was paid or reimbursed by insurance. In 2000, the average settlement per case was approximately $2,600, exclusive of defense costs. U.S. Gypsum made cash payments of $100 million in 1999 and $61 million in 1998 to resolve Personal Injury Cases, -34- of which $85 million and $45.5 million, respectively, were paid or reimbursed by insurance. In the first and second quarters of 2001, prior to the Filing, payments to resolve Personal Injury Cases increased dramatically, primarily as a result of the bankruptcy filings of other defendants in asbestos personal injury lawsuits. Following these bankruptcy filings, plaintiffs substantially increased their settlement demands to the remaining defendants, including U.S. Gypsum. In response to these increased settlement demands, U.S. Gypsum attempted to manage its asbestos liability by contesting, rather than settling, a greater number of cases that it believed to be non-meritorious. As a result, in the first and second quarters of 2001, U.S. Gypsum agreed to settle fewer Personal Injury Cases, but at a significantly higher cost per case. In the first half of 2001 (up to the Petition Date), U.S. Gypsum closed approximately 18,900 Personal Injury Cases. In the first half of 2001 (up to the Petition Date), U.S. Gypsum's total asbestos-related cash payments, including defense costs, were approximately $124 million, of which approximately $10 million was paid or reimbursed by insurance. A portion of these payments were for settlements agreed to in prior periods. As of March 31, 2001, U.S. Gypsum had estimated that cash expenditures for Personal Injury Cases in 2001 would total approximately $275 million before insurance recoveries of approximately $37 million. In addition to the Personal Injury Cases pending against U.S. Gypsum, one of the Corporation's subsidiaries and a Debtor in the bankruptcy proceeding, L&W Supply, was named as a defendant in approximately 21 pending Personal Injury Cases as of the Petition Date. L&W Supply, a distributor of building products manufactured by U.S. Gypsum and other building products manufacturers, has not made any payments in the past to resolve Personal Injury Cases. Because of the small number of Personal Injury Cases against L&W Supply to date and the lack of development of the cases against L&W Supply, the Corporation does not have sufficient information at this time to predict as to how any plan or plans of reorganization will address any asbestos-related liability of L&W Supply and whether any such liability will be limited to L&W Supply's role as a distributor of U.S. Gypsum products. One of U.S. Gypsum's subsidiaries and a Debtor in the bankruptcy proceeding, Beadex Manufacturing, LLC ("Beadex"), manufactured and sold joint compound containing asbestos from 1963 through 1978 in the northwest United States. As of the Petition Date, Beadex was a named defendant in approximately 40 Personal Injury Cases pending primarily in the states of Washington and Oregon. Beadex has approximately $11 million in primary or umbrella insurance coverage available to pay asbestos-related costs, as well as $15 million in available excess coverage. The Corporation expects that any asbestos-related liability of Beadex will be addressed in the plan -35- of reorganization. However, because of the small number of Personal Injury Cases pending against Beadex to date, the Corporation does not have sufficient information at this time to predict as to how any plan or plans of reorganization will address any asbestos-related liability of Beadex. INSURANCE COVERAGE: During the second quarter of 2003, U.S. Gypsum received $7 million of insurance payments of which $3 million was applied to the insurance receivable, while unanticipated payments of $4 million were recorded to earnings. As of June 30, 2003, U.S. Gypsum has recorded a $12 million insurance receivable relating to insurance remaining to cover asbestos-related costs. The insurance receivable is scheduled to be collected at various times through the next 12 months and is included in other current assets on the consolidated balance sheet. ESTIMATED COST: In evaluating U.S. Gypsum's estimated asbestos liability prior to the Filing, the Corporation considered numerous uncertainties that made it difficult to estimate reliably U.S. Gypsum's asbestos liability in the tort system for both pending and future asbestos claims. In the Property Damage Cases, such uncertainties included, but were not limited to, the identification and volume of asbestos-containing products in the buildings at issue in each case, which is often disputed; the claimed damages associated therewith; the viability of statute of limitations, product identification and other defenses, which varies depending upon the facts and jurisdiction of each case; the amount for which such cases can be resolved, which normally (but not uniformly) has been substantially lower than the claimed damages; and the viability of claims for punitive and other forms of multiple damages. Uncertainties in the Personal Injury Cases included, but were not limited to, the number, disease and occupational characteristics, and venue of Personal Injury Cases that are filed against U.S. Gypsum; the age and level of asbestos-related disease of claimants; the viability of claims for conspiracy or punitive damages; the elimination of indemnity sharing among Center members for future settlements and its negative impact on U.S. Gypsum's ability to continue to resolve claims at historical or acceptable levels; the adverse impact on U.S. Gypsum's settlement costs of recent bankruptcies of co-defendants; the continued solvency of other defendants and the possibility of additional bankruptcies; the possibility of significant adverse verdicts due to recent changes in settlement strategies and related effects on liquidity; the inability or refusal of former Center members to fund their share of existing settlements and its effect on such settlement agreements; the continued ability to negotiate settlements or develop other mechanisms that defer or reduce claims from unimpaired claimants; and the possibility that federal legislation addressing asbestos litigation would be enacted. The Corporation reported that adverse developments with respect to any of these uncertainties could have a material impact on U.S. Gypsum's settlement costs and could materially -36- increase the cost above the estimated range discussed below. Prior to the fourth quarter of 2000, the Corporation, in the opinion of management, was unable to reasonably estimate the probable cost of resolving future asbestos claims in the tort system, although the Corporation had estimated and reserved for costs associated with then-pending claims. However, in 1999 and increasingly in 2000, as U.S. Gypsum entered into Long-Term Settlements of Personal Injury Cases, the Corporation undertook a detailed, independent study of U.S. Gypsum's current and potential future asbestos liability. This analysis was based on the assumption that U.S. Gypsum's asbestos liability would continue to be resolved in the tort system. The analysis was completed in the fourth quarter of 2000. As part of this analysis, the Corporation reviewed, among other things, historical case filings and increasing settlement costs; the type of products U.S. Gypsum sold and the occupations of claimants expected to bring future asbestos-related claims; epidemiological data concerning the incidence of past and projected future asbestos-related diseases; trends in the propensity of persons alleging asbestos-related disease to sue U.S. Gypsum; the adverse effect on settlement costs of historical reductions in the number of solvent defendants available to pay claims, including reductions in membership of the Center; the pre-agreed settlement recommendations in, and the continued viability of, the Long-Term Settlements described above; and anticipated trends in recruitment by plaintiffs' law firms of non-malignant or unimpaired claimants. The study attempted to weigh relevant variables and assess the impact of likely outcomes on future case filings and settlement costs. In addition, the Corporation considered future defense costs, as well as allegations that U.S. Gypsum and the other Center members bear joint liability for the share of certain settlement agreements that was to be paid by former members that now have refused or are unable to pay. In the fourth quarter of 2000, the Corporation concluded that it was possible to provide a reasonable estimate of U.S. Gypsum's liability in the tort system for asbestos cases to be filed through 2003 as well as those currently pending. Based on an independent study, the Corporation determined that, although substantial uncertainty remained, it was probable that asbestos claims currently pending against U.S. Gypsum and future asbestos claims to be filed against it through 2003 (both property damage and personal injury) could be resolved in the tort system for an amount between $889 million and $1,281 million, including defense costs, and that within this range the most likely estimate was $1,185 million. Consistent with this analysis, in the fourth quarter of 2000, the Corporation recorded a pretax noncash charge of $850 million to results of operations, which, combined with the previously existing reserve, increased U.S. Gypsum's reserve for asbestos claims to $1,185 million. Substantially all of this reserve relates to the estimated costs of resolving then-pending asbestos -37- personal injury claims and those expected to be filed through 2003, and the reserve reflected management's expectation that U.S. Gypsum's average payment per asbestos personal injury claim would increase at least in the short term due to distortions caused by the bankruptcy filings of other asbestos personal injury defendants discussed above. Less than 10 percent of the reserve is attributable to defense and administrative costs. At the time of recording this reserve, it was expected that the reserve amounts would be expended over a period extending several years beyond 2003, because asbestos cases have historically been resolved an average of three years after filing. The Corporation concluded that it did not have adequate information to allow it to reasonably estimate the number of claims to be filed after 2003, or the liability associated with such claims. During 2001 up to the Filing, U.S. Gypsum's cash payments for asbestos claims and related legal fees totaled approximately $124 million, reducing its reserve for asbestos claims to $1,061 million as of June 30, 2001. The reserve remained at $1,061 million as of June 30, 2003. The above amounts are stated before tax benefit and are not discounted to present value. It is the Corporation's view that, as a result of the Filing, there is even greater uncertainty in estimating the reasonably possible range of asbestos liability for pending and future claims as well as the most likely estimate of liability within this range. There are significant differences in the treatment of asbestos claims in a bankruptcy proceeding as compared to the tort litigation system. Among other things, these uncertainties include how the Long-Term Settlements will be treated in the bankruptcy proceeding and plan of reorganization and whether those settlements will be set aside; the number of asbestos-related claims that will be filed in the proceeding; the number of future claims that will be estimated in connection with preparing a plan of reorganization; how claims for punitive damages and claims by persons with no asbestos-related disease will be treated and whether such claims will be allowed; the impact historical settlement values for asbestos claims may have on the estimation of asbestos liability in the bankruptcy proceeding; the results of the estimation proceeding regarding asbestos personal injury claims alleging cancer; the treatment of asbestos property damage claims in the bankruptcy proceeding; and the impact any relevant potential federal legislation may have on the proceeding (see Note 2. Voluntary Reorganization Under Chapter 11 - Potential Federal Legislation Regarding Asbestos Personal Injury Claims). These factors, as well as the uncertainties discussed above in connection with the resolution of asbestos cases in the tort system, increase the uncertainty of any estimate of asbestos liability. As a result, it is the Corporation's view that no change should be made at this time to the previously recorded reserve for asbestos claims, except to reflect certain minor asbestos-related costs incurred since the Filing. -38- However, it is possible that the cost of resolving asbestos claims in the Chapter 11 Cases will be greater than that set forth in the high end of the range estimated in 2000. Counsel for the Official Committee of Asbestos Personal Injury Claimants and counsel for the legal representative for future asbestos personal injury claimants, appointed in the Chapter 11 Cases, have indicated that they believe that the liabilities for pending and future asbestos claims exceed the value of Debtors' assets, and, therefore, are significantly greater than both the reserved amount and the high end of the range estimated in 2000. As the Chapter 11 Cases proceed, and the court addresses the issues relating to estimation of Debtors' asbestos liabilities, the Debtors likely will gain more information from which a reasonable estimate of the Debtors' probable asbestos liability may be determined. If such estimate differs from the existing reserve, the reserve will be adjusted to reflect the estimate, and it is possible that a charge to results of operations will be necessary at that time. It is also possible that, in such a case, the Debtors' asbestos liability may vary significantly from the recorded estimate of liability and that this difference could be material to the Corporation's financial position, results of operations and cash flows in the period recorded. BOND TO SECURE CERTAIN CCR OBLIGATIONS: In January 2001, U.S. Gypsum obtained a performance bond from Safeco Insurance Company of America ("Safeco") in the amount of $60.3 million to secure certain obligations of U.S. Gypsum for extended payout settlements of Personal Injury Cases and other obligations owed by U.S. Gypsum to the Center. The bond is secured by an irrevocable letter of credit obtained by the Corporation in the amount of $60.3 million and issued by Chase Manhattan Bank to Safeco. After the Filing, by letter dated July 6, 2001, the Center stated that certain amounts allegedly covered by the bond, totaling approximately $15.7 million, were overdue from U.S. Gypsum to the Center. In subsequent letters dated November 19, 2001, and December 11, 2001, the Center stated that additional amounts allegedly covered by the bond totaling approximately $14 million and $113 million, respectively, were also overdue from U.S. Gypsum. The amounts for which the Center made demand were for the payment of, among other things, settlements of Personal Injury Cases that were entered into pre-petition. By letter dated November 16, 2001, the Center made a demand to Safeco for payment of $15.7 million under the bond, and by letter dated December 28, 2001, the Center made a demand to Safeco for payment of approximately $127 million under the bond. The total amount demanded by the Center under the bond, approximately $143 million, exceeds the original penal sum of the bond, which is $60.3 million. Safeco has not made any payment under the bond. On November 30, 2001, the Corporation and U.S. Gypsum filed an Adversary Complaint in the Chapter 11 Cases to, among other things, enjoin the Center from drawing on the bond and enjoin Safeco from paying on the bond during the pendency of these bankruptcy proceedings. This Adversary Proceeding is pending in the United States Bankruptcy Court for the District of Delaware -39- and is captioned USG Corporation and United States Gypsum Company v. Center for Claims Resolution, Inc. and Safeco Insurance Company of America, No. 01-08932. Judge Wolin has consolidated the Adversary Proceeding with similar adversary proceedings brought by Federal-Mogul Corp., et al., and Armstrong World Industries, Inc., et al., in their bankruptcy proceedings. The parties filed cross-motions for summary judgment in the consolidated proceedings. On March 28, 2003, in response to the cross-motions for summary judgment, Judge Wolin issued an order and memorandum opinion which granted in part and denied in part the CCR's motion for summary judgment. Although the court ruled that Safeco is not required to remit any surety bond proceeds to the CCR at this time, the court stated that certain settlements that were completed before U.S. Gypsum's Petition Date likely are covered by the surety bond but that the bond does not cover settlement payments that were not yet due as of the Petition Date. The court did not rule on whether the bond covers other disputed obligations and reserved these issues to a subsequent phase of the litigation. As a result of the court's decision, it is likely that, absent a settlement of this matter, some portion of the bond may be drawn but that the amount drawn will be substantially less than the full amount of the bond. To the extent that Safeco were to pay any portion of the bond, it is likely that Safeco would draw down the Chase letter of credit to cover the bond payment and Chase would assert a pre-petition claim in a corresponding amount against the Corporation in the bankruptcy proceeding. CONCLUSION: There are many uncertainties associated with the resolution of asbestos liability in the bankruptcy proceeding. These uncertainties include, among others, the number of asbestos-related claims that will be filed against the Debtors in the proceeding; the number of future claims that will be estimated in connection with preparing a plan of reorganization; how the Long-Term Settlements will be treated in the bankruptcy proceeding and plan of reorganization, and whether those settlements will be set aside; how claims for punitive damages and claims by persons with no asbestos-related physical impairment will be treated and whether such claims will be allowed; the impact historical settlement values for asbestos claims may have on the estimation of asbestos liability in the bankruptcy proceeding; the results of the estimation proceeding regarding asbestos personal injury claims alleging cancer; the treatment of asbestos property damage claims in the bankruptcy proceeding; and the impact any relevant potential federal legislation may have on the proceeding (see Note 2. Voluntary Reorganization Under Chapter 11 - Potential Federal Legislation Regarding Asbestos Personal Injury Claims). The Corporation has not revised its previously recorded reserve for asbestos liability. The Corporation will continue to review its asbestos liability as the Chapter 11 Cases progress. When a reasonable estimate can be made of the Debtors' probable liability for asbestos claims, if such estimate differs from the existing reserve, the reserve will be adjusted -40- to reflect the estimate, and it is possible that a charge to results of operations will be necessary at that time. It is possible that the Corporation's asbestos liability may vary significantly from the recorded estimate of liability and that this difference could be material to the Corporation's financial position, results of operations and cash flows in the period recorded. ENVIRONMENTAL LITIGATION The Corporation and certain of its subsidiaries have been notified by state and federal environmental protection agencies of possible involvement as one of numerous "potentially responsible parties" in a number of so-called "Superfund" sites in the United States. In most of these sites, the involvement of the Corporation or its subsidiaries is expected to be minimal. The Corporation believes that appropriate reserves have been established for its potential liability in connection with all Superfund sites but is continuing to review its accruals as additional information becomes available. Such reserves take into account all known or estimated, undiscounted costs associated with these sites, including site investigations and feasibility costs, site cleanup and remediation, legal costs, and fines and penalties, if any. In addition, environmental costs connected with site cleanups on Corporation-owned property also are covered by reserves established in accordance with the foregoing. The Debtors have been given permission by the Bankruptcy Court to satisfy environmental obligations up to $12 million. The Corporation believes that neither these matters nor any other known governmental proceeding regarding environmental matters will have a material adverse effect upon its financial position, results of operations or cash flows. -41- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION VOLUNTARY REORGANIZATION UNDER CHAPTER 11 On June 25, 2001 (the "Petition Date"), the parent company (the "Parent Company") of the Corporation and the 10 United States subsidiaries listed below (collectively, the "Debtors") filed voluntary petitions for reorganization (the "Filing") under chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the District of Delaware (the "Bankruptcy Court"). The chapter 11 cases of the Debtors (collectively, the "Chapter 11 Cases") are being jointly administered as In re: USG Corporation et al. (Case No. 01-2094). The Chapter 11 Cases do not include any of the Corporation's non-U.S. subsidiaries. The following subsidiaries filed chapter 11 petitions: United States Gypsum Company; USG Interiors, Inc.; USG Interiors International, Inc.; L&W Supply Corporation; Beadex Manufacturing, LLC; B-R Pipeline Company; La Mirada Products Co., Inc.; Stocking Specialists, Inc.; USG Industries, Inc.; and USG Pipeline Company. This action was taken to resolve asbestos-related claims in a fair and equitable manner, to protect the long-term value of the Debtors' businesses and to maintain the Debtors' leadership positions in their markets. BACKGROUND OF THE FILING U.S. Gypsum, a subsidiary of the Parent Company, is a defendant in asbestos lawsuits alleging both property damage and personal injury. Since 1994, U.S. Gypsum has been named in more than 250,000 asbestos personal injury claims and made cash payments of approximately $575 million (before insurance recoveries) to manage and resolve asbestos-related claims. During 2000 and early 2001, chapter 11 filings by other companies subject to asbestos litigation caused a dramatic increase in U.S. Gypsum's asbestos costs beyond its legitimate liabilities. Plaintiffs in asbestos lawsuits substantially increased their settlement demands to U.S. Gypsum to replace the expected payments of the bankruptcy defendants. Although the Corporation has been and continues to be committed to finding a legislative solution to the increase in asbestos costs, it became apparent in 2001 that a timely resolution to the problem through legislation was not feasible. The Corporation determined that voluntary protection under chapter 11 would be the best alternative for obtaining a fair and final resolution of U.S. Gypsum's asbestos liability and the best way to preserve value for stakeholders. See Part I, Item 1. Note 12. Litigation, for additional information on asbestos litigation. Based on an independent study conducted in 2000 and on U.S. Gypsum's historical experience of litigating asbestos claims in the tort system, the Corporation estimated that U.S. Gypsum's probable liability for costs associated with asbestos cases pending as of December 31, 2000, and expected to be filed through 2003 to be between $889 million and $1,281 million, including defense costs. In the fourth quarter of 2000, U.S. Gypsum recorded a noncash, pretax provision of $850 million, increasing its total accrued reserve for asbestos claims to $1,185 -42- million as of December 31, 2000. Substantially all of this reserve related to personal injury claims and reflected management's expectation that U.S. Gypsum's average cost per case would increase, at least in the short term, due to distortions in the tort system resulting from the bankruptcies of other defendants that led to increased settlement demands from asbestos plaintiffs. Less than 10% of the reserve related to defense and administrative costs. Between January 1, 2001, and the Petition Date, according to the Center for Claims Resolution (the "Center"), U.S. Gypsum was served with more than 26,000 new claims. On a cash basis, U.S. Gypsum's asbestos-related personal injury costs (before insurance) rose from $30 million in 1997 to $162 million in 2000 and, absent the Filing, were expected to exceed $275 million in 2001. Because of the Filing, there is greater uncertainty concerning the liability associated with asbestos cases. As a result, it is the Corporation's view that no change should be made at this time to the previously recorded reserve for asbestos claims, except to reflect certain minor asbestos-related costs incurred since the Filing. However, it is possible that the cost of resolving asbestos claims in the Chapter 11 Cases will be greater than that set forth in the high end of the range estimated in 2000. Counsel for the Official Committee of Asbestos Personal Injury Claimants and counsel for the legal representative for future asbestos personal injury claimants, appointed in the Chapter 11 Cases, have indicated that they believe that the liabilities for pending and future asbestos claims exceed the value of Debtors' assets, and, therefore, are significantly greater than both the reserved amount and the high end of the range estimated in 2000. As the Chapter 11 Cases proceed, and the court addresses the issues relating to estimation of Debtors' asbestos liabilities, the Debtors likely will gain more information from which a reasonable estimate of the Debtors' probable asbestos liability may be determined. If such estimate differs from the existing reserve, the reserve will be adjusted to reflect the estimate, and it is possible that a charge to results of operations will be necessary at that time. It is also possible that, in such a case, the Debtors' asbestos liability may vary significantly from the recorded estimate of liability and that this difference could be material to the Corporation's financial position, results of operations and cash flows in the period recorded. CONSEQUENCES OF THE FILING The Debtors are operating their businesses without interruption as debtors-in-possession subject to the provisions of the Bankruptcy Code. All vendors are being paid for all goods furnished and services provided after the Filing. However, as a consequence of the Filing, pending litigation against the Debtors as of the Petition Date is stayed, and no party may take any action to pursue or collect pre-petition claims except pursuant to an order of the Bankruptcy Court. Three creditors' committees, one representing asbestos personal injury claimants, another representing asbestos property damage claimants, and a third representing general unsecured creditors, were appointed as official committees in the Chapter 11 Cases and, in accordance with the provisions of the Bankruptcy Code, will have the right to be heard on all matters that come before the Bankruptcy Court. The -43- Bankruptcy Court also appointed the Honorable Dean M. Trafelet as the legal representative for future asbestos claimants in the Debtors' bankruptcy proceeding. Mr. Trafelet was formerly a judge of the Circuit Court of Cook County, Illinois. The Debtors expect that the appointed committees, together with Mr. Trafelet, will play important roles in the Chapter 11 Cases and the negotiation of the terms of any plan of reorganization. Debtors intend to address all pending and future asbestos personal injury claims as well as all other pre-petition claims in a plan or plans of reorganization confirmed by the Bankruptcy Court. Debtors expect that the plan will include the creation of one or more independently administered trusts under Section 524(g) of the Bankruptcy Code, which will be funded by Debtors to allow payment of present and future asbestos personal injury claims and demands. Debtors also expect that the plan of reorganization will address Debtors' liability for asbestos property damage claims, whether by including those liabilities in a Section 524(g) trust or by other means. It is anticipated that, as a result of creation and funding of the Section 524(g) trust(s), the Bankruptcy Court will issue a permanent injunction barring the assertion of present and future asbestos claims against Debtors, their successors, and their affiliates, and channeling those claims to the trust(s) for payment in whole or in part. Section 524(g) contains specific requirements for issuance of such a permanent injunction, including the requirement that the trust must own, or have the right to own upon the occurrence of contingencies specified in the plan of reorganization, a majority of the voting shares of the debtor or its parent. Section 524(g) also requires that the plan be approved by 75% of the voting asbestos claimants whose claims are addressed by the trust. Similar plans of reorganization containing Section 524(g) trusts have been confirmed in the chapter 11 cases of other companies with asbestos liabilities, but there is no guarantee that the Bankruptcy Court in Debtors' Chapter 11 Cases will approve creation of a Section 524(g) trust or issue a permanent injunction channeling to the trust all asbestos claims against Debtors, and/or their successors and affiliates. In addition, if federal legislation addressing asbestos personal injury claims is passed, which is extremely speculative at this time, such legislation may affect the manner in which asbestos personal injury claims are to be addressed in Debtors' Chapter 11 Cases and may affect whether the Debtors establish a trust under Section 524(g). (see Potential Federal Legislation Regarding Asbestos Personal Injury Claims, below) Pursuant to the Bankruptcy Code, the Debtors had the exclusive right to propose a plan of reorganization for 120 days following the Petition Date, unless extended. The Bankruptcy Court has granted requests by the Debtors to extend the period of exclusivity, which currently runs through September 1, 2003. The Debtors intend to seek one or more additional extensions depending upon developments in the Chapter 11 Cases. If the Debtors fail to file a plan of reorganization during such extension period, or if such plan is not accepted by the requisite numbers of creditors and equity holders entitled to vote on the plan, other parties in interest in the Chapter 11 Cases may be permitted to -44- propose their own plan(s) of reorganization for the Debtors. While it is the Debtors' intention to seek a full recovery for their creditors, it is not possible to predict how the plan of reorganization will treat asbestos and other pre-petition claims and what impact any plan may have on the value of the shares of the Corporation's common stock and other outstanding securities. Under the Bankruptcy Code, a plan of reorganization, including a plan creating a Section 524(g) trust, may be confirmed without the consent of non-asbestos creditors and equity security holders if certain requirements of the Code are met. There is no assurance that there will be sufficient assets to satisfy the Debtors' pre-petition liabilities in whole or in part, and the pre-petition creditors of some Debtors may be treated differently from the pre-petition creditors of other Debtors. The payment rights and other entitlements of pre-petition creditors and USG shareholders may be substantially altered by any plan or plans of reorganization confirmed in the Chapter 11 Cases. Pre-petition creditors may receive under the plan of reorganization less than 100% of the face value of their claims, and the interests of the Corporation's equity security holders are likely to be substantially diluted or cancelled in whole or in part. It is also not possible to predict at this time how the plan of reorganization will treat intercompany indebtedness, licenses, transfers of goods and services and other intercompany arrangements, transactions, and relationships that were entered into before the Petition Date. These arrangements, transactions, and relationships may be challenged by various parties in the Chapter 11 Cases, and the outcome of those challenges, if any, may have an impact on the treatment of various claims under any plan of reorganization. Whether the Corporation's equity has significant value and Debtors' non-asbestos creditors recover the full value of their claims depend upon the outcome of the analysis of the amount of Debtors' assets and liabilities, especially asbestos liabilities, that must be funded under the plan. Counsel for the Official Committee of Asbestos Personal Injury Claimants and counsel for the legal representative for future asbestos personal injury claimants have advised the court that is presiding over the Chapter 11 Cases that they believe Debtors' asbestos liabilities exceed the value of Debtors' assets and that Debtors are insolvent. The Debtors have advised the court that they believe they are solvent if their asbestos liabilities are fairly and appropriately valued. Toward that end, the Debtors filed a motion with the court requesting the court to begin proceedings to estimate the value of Debtors' asbestos personal injury liabilities. In response to the Debtors' motion requesting an estimation of asbestos personal injury liabilities, the court issued an order and memorandum opinion on February 19, 2003, setting forth a procedure for estimating Debtors' liability for asbestos personal injury claims alleging cancer. (See Part I, Item 1. Note 12. Litigation, for additional information on this procedure.) The court has not set a timetable for this process. Thus, Debtors do not know when estimation of Debtors' liability for these cancer claims will occur, what the outcome of that -45- proceeding will be, what impact that proceeding will have on estimating Debtors' liability for asbestos personal injury claims alleging other diseases, and whether the estimation proceeding will lead to a negotiated resolution of Debtors' asbestos personal injury liabilities. Debtors also cannot predict at this time the estimated cost of resolving asbestos property damage claims (See Part I, Item 1. Note 12. Litigation, for additional information.) If the amount of the Debtors' asbestos liabilities cannot be resolved through negotiation or is not addressed by legislation (see Potential Federal Legislation Regarding Asbestos Personal Injury Claims, below), the outcome of the estimation proceedings regarding Debtors' liability for cancer claims, as provided in the Court's order, likely will be a significant component of determining Debtors' asbestos personal injury liability, Debtors' solvency, and the recovery of Debtors' pre-petition creditors and equity security holders under any plan or plans of reorganization. As a result of this uncertainty, it is not possible at this time to predict the timing or outcome of the Chapter 11 Cases, the terms and provisions of any plan or plans of reorganization, or the effect of the chapter 11 reorganization process on the claims of pre-petition creditors of the Debtors or the interests of the Corporation's equity security holders. There can be no assurance as to the value of any distributions that might be made under any plan or plans of reorganization with respect to such pre-petition claims, equity interests, or other outstanding securities. Recent developments in the Corporation's bankruptcy proceeding are discussed in Part I, Item 1. Note 12. Litigation. POTENTIAL FEDERAL LEGISLATION REGARDING ASBESTOS PERSONAL INJURY CLAIMS The Corporation has for many years actively supported proposals for federal legislation addressing asbestos personal injury claims. On July 10, 2003, the Judiciary Committee of the United States Senate narrowly approved the Fairness in Asbestos Injury Resolution Act of 2003 (Senate Bill 1125, the "FAIR Bill"), which is intended to establish a nationally administered trust to compensate asbestos personal injury claimants. This bill has not been approved by the Senate, has not been introduced in the House of Representatives, and is not law. Under the terms of the FAIR Bill as approved by the Judiciary Committee, companies that have been defendants in asbestos personal injury litigation, as well as insurance companies, are to contribute amounts to a national trust on a periodic basis to fund payment of claims filed by asbestos personal injury claimants who qualify for payment under the FAIR Bill based on an allocation methodology specified in the FAIR Bill. The FAIR Bill also provides, among other things, that the national fund would terminate if the administrator could not certify that 95% of the previous year's eligible claimants had been paid, in which case the claimants and defendants would return to the tort system on a retroactive basis. There are many other provisions in the FAIR Bill that would affect its impact on the Corporation and its Chapter 11 Cases. It is not possible to determine whether the FAIR Bill will ever be presented for a vote or passed by the full Senate or the House of Representatives, or whether -46- the FAIR Bill will be signed into law. Nor is it possible at this time to predict the final terms or cost of any bill that might become law or its impact on the Corporation or the Chapter 11 Cases. The Corporation anticipates that, during the legislative process, the terms of the FAIR Bill as approved by the Judiciary Committee will change and that any such changes may be material to the FAIR Bill's impact on the Corporation. It is possible that the level of funding required from insurers and defendants, including the Corporation, would increase. Many organized labor organizations, including the AFL-CIO, have indicated their opposition to the FAIR Bill, and the American Insurance Association, a national organization of insurance companies, has also expressed opposition to the FAIR Bill in the form passed by the Judiciary Committee. In light of such opposition, as well as other factors, there is no assurance that any legislation will be enacted. Enactment of the FAIR Bill or other legislation addressing the financial contributions of USG Corporation for asbestos personal injury claims would have a material impact on the Corporation's Chapter 11 Cases. Legislation such as the FAIR Bill would have a material impact on the amount of the Corporation's asbestos personal injury liability that must be addressed in Debtors' Chapter 11 Cases. Such legislation may also affect the manner in which such liability may be addressed in Debtors' Chapter 11 Cases. As noted above (see Consequences of the Filing, above), the amount of Debtors' asbestos personal injury liability is a principal factor in determining the payment rights and other entitlements of the Corporation's pre-petition creditors and its shareholders. At this time, however, the outcome of the legislative process is extremely speculative, and there can be no assurance that national legislation will be enacted or what the terms of any such legislation might be. During this process, the Corporation anticipates that the Chapter 11 Cases, including the proceedings regarding estimation of the Corporation's asbestos personal injury liabilities, will continue. (See Consequences of the Filing, above, and Part I, Item 1. Note 12. Litigation.) CHAPTER 11 FINANCING On July 31, 2001, a $350 million debtor-in-possession financing facility (the "DIP Facility") was approved by the Bankruptcy Court to supplement liquidity and fund operations during the reorganization process. The DIP Facility was provided by a syndicate of lenders led by JPMorgan Chase Bank (formerly The Chase Manhattan Bank) as agent. In January 2003, the Corporation reduced the size of the DIP Facility to $100 million and subsequently terminated the DIP Facility in June 2003. These actions were taken at the election of the Corporation due to the levels of cash and marketable securities on hand and to eliminate costs associated with the DIP Facility. The DIP Facility was used largely for the issuance of standby letters of credit needed to support business operations. The Corporation believes that cash and marketable securities on hand and future cash available from operations will provide sufficient liquidity to allow its businesses to operate in the normal course without interruption for the duration of the chapter 11 proceedings. See Available Liquidity below for additional information on the DIP Facility. -47- ACCOUNTING IMPACT The Corporation is required to follow AICPA Statement of Position 90-7 ("SOP 90-7"), "Financial Reporting by Entities in Reorganization under the Bankruptcy Code." Pursuant to SOP 90-7, the Corporation's pre-petition liabilities that are subject to compromise are reported separately on the consolidated balance sheet. Virtually all of the Corporation's pre-petition debt is currently in default and was recorded at face value and classified within liabilities subject to compromise. U.S. Gypsum's asbestos liability also is classified within liabilities subject to compromise. See Part I, Item 1. Note 2. Voluntary Reorganization Under Chapter 11, which includes information related to financial statement presentation, the debtor-in-possession statements and detail of liabilities subject to compromise and chapter 11 reorganization expenses. CONSOLIDATED RESULTS NET SALES Net sales in the second quarter of 2003 were $914 million, up 3% from $885 million in the second quarter of 2002. For the first six months of 2003, net sales totaled $1,776 million, up 4% from $1,714 million in the comparable 2002 period. North American Gypsum and Building Products Distribution reported increased net sales in the second quarter and first six months of 2003, while net sales for Worldwide Ceilings were down slightly for each period. COST OF PRODUCTS SOLD Cost of products sold in the second quarter and first six months of 2003 were up 9% and 8%, respectively, versus the respective 2002 periods. Key factors for these increases were rising costs related to energy, raw materials, employee benefits and insurance premiums. SELLING AND ADMINISTRATIVE EXPENSES Year-on year variations in selling and administrative expenses were minimal. For the second quarter, the expenses amounted to $81 million (8.9% of net sales), compared with $80 million (9.0% of net sales) in 2002. For the first six months, these expenses were $161 million (9.1% of net sales), versus $162 million (9.5% of net sales) a year ago. CHAPTER 11 REORGANIZATION EXPENSES Chapter 11 reorganization expenses consist of the following (dollars in millions):
THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, ---------------------------------------------------------------------- 2003 2002 2003 2002 ---------------------------------------------------------------------- Legal and financial advisory fees $ 5 $ 9 $ 9 $ 13 Bankruptcy-related interest income (2) (2) (4) (4) ------------------------------------------------------------------------------------------------------------------------- Total chapter 11 reorganization expenses 3 7 5 9 =========================================================================================================================
-48- OPERATING PROFIT Operating profit declined 38% to $50 million in the second quarter of 2003 and was down 34% to $85 million for first six months of 2003 versus the respective 2002 periods primarily due to the increased levels of cost of products sold. INTEREST EXPENSE Interest expense of $2 million and $3 million was incurred in the second quarter and first six months of 2003, respectively. Under SOP 90-7, virtually all of the Corporation's outstanding debt is classified as liabilities subject to compromise, and interest expense on this debt has not been accrued or recorded since the Petition Date. For the second quarter and first six months of 2003, contractual interest expense not accrued or recorded on pre-petition debt totaled $18 million and $36 million, respectively. Although no post-petition accruals are required to be made for such contractual interest expense, debtholders may seek to recover such amounts in the Chapter 11 Cases. INTEREST INCOME Interest income was $1 million in the second quarter and $2 million in the first six months of 2003. INCOME TAXES Income taxes amounted to $23 million and $36 million in the second quarter and first six months of 2003, respectively, compared with $33 million and $54 million in the corresponding 2002 periods. The effective tax rates were 39.9% and 42.3% for the first six months of 2003 and 2002, respectively. The decrease in the effective tax rate was primarily due to the benefit of a tax rate change applicable to one of the Corporation's foreign subsidiaries. CUMULATIVE EFFECT OF ACCOUNTING CHANGES On January 1, 2003, the Corporation adopted Statement of Financial Accounting Standards ("SFAS") No. 143, "Accounting for Asset Retirement Obligations." This standard requires the recording of the fair value of a liability for an asset retirement obligation in the period in which it is incurred. The Corporation's asset retirement obligations include reclamation requirements as regulated by government authorities related principally to assets such as the Corporation's mines, quarries, landfills, ponds and wells. The impact of adopting SFAS No. 143 was an increase in the Corporation's assets and liabilities of $14 million and $30 million, respectively. A noncash, after-tax charge of $16 million ($27 million pretax) was reflected on the consolidated statement of earnings as a cumulative effect of a change in accounting principle as of January 1, 2003. On January 1, 2002, USG Corporation adopted SFAS No. 142, "Goodwill and Other Intangible Assets." In accordance with the provisions of SFAS No. 142, the Corporation determined that goodwill for its North American Gypsum segment was impaired and recorded a noncash, nontaxable impairment charge of $96 million. This charge, which includes a $6 million deferred currency translation write-off, is reflected on the Corporation's consolidated statement of earnings as a cumulative effect of a change in accounting principle as of January 1, 2002. -49- NET EARNINGS (LOSS) Net earnings of $31 million, or $0.73 per share, were reported for the second quarter of 2003 compared with $48 million, or $1.11 per share, for the second quarter of 2002. For the first six months of 2003, net earnings totaled $37 million, or $0.86 per share, compared with a net loss of $22 million, or $0.52 per share, for the first six months of 2002. CORE BUSINESS RESULTS (dollars in millions)
THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, ---------------------------------------- 2003 2002 2003 2002 ---------------------------------------- NET SALES: NORTH AMERICAN GYPSUM: U.S. Gypsum Company $ 512 $ 503 $ 1,008 $ 986 CGC Inc. (gypsum) 62 56 119 106 Other subsidiaries* 35 34 63 64 Eliminations (43) (42) (82) (80) ----------------------------------------------------------------------------------- Total 566 551 1,108 1,076 ----------------------------------------------------------------------------------- WORLDWIDE CEILINGS: USG Interiors, Inc. 114 117 224 228 USG International 42 44 82 86 CGC Inc. (ceilings) 12 11 22 21 Eliminations (14) (14) (27) (29) ----------------------------------------------------------------------------------- Total 154 158 301 306 ----------------------------------------------------------------------------------- BUILDING PRODUCTS DISTRIBUTION: L&W Supply Corporation 325 306 620 581 ----------------------------------------------------------------------------------- Eliminations (131) (130) (253) (249) ----------------------------------------------------------------------------------- Total USG Corporation 914 885 1,776 1,714 =================================================================================== OPERATING PROFIT (LOSS): NORTH AMERICAN GYPSUM: U.S. Gypsum Company 36 68 66 114 CGC Inc. (gypsum) 7 7 12 13 Other subsidiaries* 4 6 7 12 ----------------------------------------------------------------------------------- Total 47 81 85 139 ----------------------------------------------------------------------------------- WORLDWIDE CEILINGS: USG Interiors, Inc. 7 11 13 18 USG International 1 (2) 2 (5) CGC Inc. (ceilings) 1 2 2 3 ----------------------------------------------------------------------------------- Total 9 11 17 16 ----------------------------------------------------------------------------------- BUILDING PRODUCTS DISTRIBUTION: L&W Supply Corporation 16 13 24 20 ----------------------------------------------------------------------------------- Corporate (18) (17) (36) (37) Chapter 11 reorganization expenses (3) (7) (5) (9) Eliminations (1) (1) - (1) ----------------------------------------------------------------------------------- Total USG Corporation 50 80 85 128 ===================================================================================
*Includes USG Mexico, S.A. de C.V., a building products business in Mexico, Gypsum Transportation Limited, a shipping company in Bermuda, and USG Canadian Mining Ltd., a mining operation in Nova Scotia. -50- NORTH AMERICAN GYPSUM Net sales of $566 million increased 3% from the second quarter of 2002, while operating profit of $47 million was down 42%. First six months net sales of $1,108 million reflect an increase of 3% from a year ago, while operating profit of $85 million fell 39%. For the second quarter of 2003, U.S. Gypsum reported a 2% increase in net sales, but a 47% decrease in operating profit versus the second quarter of 2002. The increase in net sales largely reflected record second quarter shipments of complementary products such as SHEETROCK(R) brand joint compounds, DUROCK(R) brand cement board and FIBEROCK(R) brand gypsum fiber panels. However, results for SHEETROCK(R) brand gypsum wallboard were adversely affected by lower selling prices and higher manufacturing costs, while shipments were unchanged. U.S. Gypsum sold 2.6 billion square feet of SHEETROCK(R) brand gypsum wallboard during the second quarters of both 2003 and 2002. U.S. Gypsum's wallboard plants operated at 90% of capacity in the second quarter of 2003 versus 95% for the same period in 2002. The lower 2003 utilization rate reflects increases in wallboard capacity at several U.S. Gypsum plants as a result of process improvements. Industry shipments of gypsum wallboard were up approximately 3% from the second quarter of 2002. U.S. Gypsum's nationwide average realized price for gypsum wallboard was $100.47 per thousand square feet in the second quarter of 2003. This price was down 2% from $102.13 in the second quarter of 2002, but up 3% from $97.13 in the first quarter of 2003. The higher manufacturing costs for gypsum wallboard primarily reflected higher energy and wastepaper costs. The increase in energy costs related to wallboard manufacturing accounted for a $10 million increase to cost of products sold in the second quarter of 2003. Higher energy and material costs also had an adverse affect on profit margins for U.S. Gypsum's complementary products. The gypsum business of Canada-based CGC Inc. reported an 11% increase in second quarter net sales, while operating profit of $7 million was unchanged from year ago. Most of the increase in CGC's net sales was attributable to strengthening of the Canadian dollar versus the U.S. dollar. However, the favorable currency impact on operating profit was offset by higher operating costs. WORLDWIDE CEILINGS Second quarter 2003 net sales of $154 million fell 3%, while operating profit declined to $9 million from $11 million for the second quarter of 2002. For the first six months of 2003, net sales of $301 million were down 2%, while operating profit increased to $17 million from $16 million a year ago. USG Interiors, Inc., the Corporation's domestic ceilings business, reported second quarter declines in net sales and operating profit. Net sales were down primarily due to continued lower levels of demand for commercial ceiling -51- products. The decline in profitability was largely due to lower shipments, an increase in the cost of steel, and higher energy costs. Profit margins for USG Interiors remain under pressure due to these cost increases, which have been partially offset by higher selling prices and improved operating efficiencies. Net sales for USG International were down $2 million versus the second quarter of 2002. However, operating profit of $1 million was reported for the second quarter of 2003 compared with an operating loss of $2 million in the prior-year period. Profitability for USG International improved following the shutdown of the Aubange, Belgium, ceiling tile plant and other downsizing activities in the fourth quarter of 2002. The ceilings business of CGC Inc. reported a $1 million increase in net sales and a $1 million decrease in operating profit for the second quarter of 2003. BUILDING PRODUCTS DISTRIBUTION L&W Supply Corporation, the leading specialty building products distribution business in the United States, reported second quarter net sales of $325 million and operating profit of $16 million, representing increases of 6% and 23%, respectively, from the second quarter of 2002. For the first six months of 2003, net sales of $620 million and operating profit of $24 million increased 7% and 20%, respectively, versus the first six months of 2002. Second quarter results for L&W Supply reflected record shipments of gypsum wallboard (up 8% versus the second quarter of 2002), improved operating efficiencies and increased sales of complementary building products, primarily drywall metal, joint treatment, ceiling products and roofing. As of June 30, 2003, L&W Supply operated 183 locations in the United States distributing a variety of gypsum, ceilings and related building materials. MARKET CONDITIONS AND OUTLOOK The outlook for the Corporation's markets for the remainder of the year is mixed. Industry demand for gypsum wallboard is expected to remain strong due to continued high demand for new homes and favorable levels of activity in the residential remodeling market. Despite the strong level of demand, the gypsum wallboard industry continues to experience a large amount of excess capacity. Industry utilization rates are expected to remain in the mid-80% range while pricing pressures continue. Nonresidential construction, the principal market for the Corporation's ceiling products and a major market for its distribution business, is expected to remain weak. In addition, the Corporation, like many other companies, faces cost pressures in areas such as energy and raw material costs, employee benefits and insurance premiums. In this environment, the Corporation is focusing its management attention and investments on improving customer service, manufacturing costs and operating efficiencies, as well as selectively investing to grow its businesses. In addition, the Corporation will -52- diligently continue its attempt to resolve the chapter 11 proceedings, consistent with the goal of achieving a fair, comprehensive and final resolution to its asbestos liability. LIQUIDITY AND CAPITAL RESOURCES WORKING CAPITAL Working capital (current assets less current liabilities) as of June 30, 2003, amounted to $994 million, and the ratio of current assets to current liabilities was 3.39-to-1. As of December 31, 2002, working capital amounted to $955 million, and the ratio of current assets to current liabilities was 3.18-to-1. Cash, cash equivalents, restricted cash and marketable securities as of June 30, 2003, amounted to $788 million, compared with $830 million as of December 31, 2002. During the first six months of 2003, net cash flows used for operating activities totaled $4 million. Net cash flows used for investing activities totaled $95 million and consisted of $57 million for the purchases of marketable securities, net of sales or maturities, $36 million for capital expenditures and $2 million for the acquisition of a business. During the first six months of 2003, the Corporation increased its investments in marketable securities to $238 million as of June 30, 2003 ($172 million in long-term marketable securities and $66 million in short-term marketable securities). The Corporation's marketable securities are classified as available-for-sale securities and reported at fair market value with unrealized gains and losses excluded from earnings and reported in accumulated other comprehensive income (loss) on the consolidated balance sheet. Receivables increased to $369 million as of June 30, 2003, from $284 million as of December 31, 2002, largely reflecting a 17% increase in net sales for the month of June 2003 as compared with December 2002. Inventories and payables also were up from December 31, 2002, primarily due to the increased level of business. Inventories increased to $287 million from $270 million, and accounts payable increased to $200 million from $170 million. Accrued expenses declined to $189 million from $243 million as of December 31, 2002, primarily due to payments associated with accrued employee benefits and compensation. DEBT As of June 30, 2003, total debt amounted to $1,007 million, of which $1,005 million was included in liabilities subject to compromise. These amounts were unchanged from the December 31, 2002 levels and do not include any accruals for post-petition contractual interest expense. (See Part I, Item 1. Note 2. Voluntary Reorganization Under Chapter 11 - Interest Expense.) AVAILABLE LIQUIDITY As of June 30, 2003, the Corporation had on a consolidated basis $788 million of cash (including $21 million of restricted cash as explained below) and marketable securities, of which $165 million was held by non-Debtor subsidiaries. -53- In January 2003, the Corporation reduced the size of the DIP Facility to $100 million and subsequently terminated the DIP Facility in June 2003. These actions were taken at the election of the Corporation due to the levels of cash and marketable securities on hand and to eliminate costs associated with the DIP Facility. The DIP Facility was used largely for the issuance of standby letters of credit needed to support business operations. As of June 30, 2003, $15.2 million of standby letters of credit remained outstanding under the DIP Facility. Following the termination of the DIP Facility, the Corporation has been required to cash collateralize 105% of these outstanding letters of credit until the letters of credit either expire or are returned by the beneficiary. The Corporation expects the collateral related to the DIP Facility to be released during the third quarter of 2003. In June 2003, the Corporation entered a three-year, $100 million credit agreement with LaSalle Bank to be used exclusively to support the issuance of standby letters of credit. As of June 30, 2003, $4.5 million of standby letters of credit, which are cash collateralized at 103%, had been issued under this facility to replace those to be surrendered by the beneficiaries in connection with the termination of the DIP Facility. As of June 30, 2003, a total of $21 million in cash collateral was posted to back up letters of credit as indicated above and was reported as restricted cash on the consolidated balance sheet. CAPITAL EXPENDITURES Capital spending amounted to $36 million in the first six months of 2003 compared with $38 million in the corresponding 2002 period. As of June 30, 2003, remaining capital expenditure commitments for the replacement, modernization and expansion of operations amounted to $53 million, compared with $56 million as of December 31, 2002. During the bankruptcy proceeding, the Corporation expects to have limited ability to access capital other than its own cash, marketable securities and future cash flows to fund potential future growth opportunities such as new products, acquisitions and joint ventures. Nonetheless, the Corporation expects to be able to maintain a program of capital spending aimed at maintaining and enhancing its businesses. EXIT ACTIVITIES 2002 DOWNSIZING PLAN: In the fourth quarter of 2002, the Corporation recorded a nontaxable charge of $11 million related to the shutdown of the Aubange, Belgium, ceiling tile plant and other downsizing activities in Europe to address the continuing weakness of the commercial ceilings market in Europe. The charge was included in cost of products sold and reflected severance of $6 million related to a workforce reduction of over 50 positions (salaried and hourly), equipment writedowns of $3 million and other reserves of $2 million. The other reserves -54- primarily related to lease cancellations, inventories and receivables. As of June 30, 2003, 53 employees were terminated. The Aubange, Belgium, plant ceased operations in December 2002. The reserve for the 2002 downsizing plan was included in accrued expenses on the consolidated balance sheets. Charges against the reserve included the $3 million write-off of equipment in 2002 and payments totaling $6 million in the first six months of 2003. All payments associated with the 2002 downsizing plan are being funded with cash from operations. 2001 RESTRUCTURING PLAN: In the fourth quarter of 2001, the Corporation recorded a charge of $12 million pretax ($10 million after-tax) related to a restructuring plan that included the shutdown of a gypsum wallboard plant in Fremont, Calif., a drywall steel plant in Prestice, Czech Republic, a ceiling tile plant in San Juan Ixhuatepec, Mexico, a ceiling tile manufacturing line in Greenville, Miss., and other restructuring activities. Included in the $12 million pretax charge was $8 million for severance related to a workforce reduction of more than 350 positions (primarily hourly positions), $2 million for the write-off of property, plant and equipment, and $2 million for line shutdown and removal and contract cancellations. The 2001 restructuring was intended to allow the Corporation to optimize its manufacturing operations. A total of 348 employees were terminated, and 26 open positions were eliminated, and a ceiling tile manufacturing line at Greenville, Miss., and the plants in San Juan Ixhuatepec, Mexico, and Prestice, Czech Republic, were shut down. The Fremont, Calif., plant ceased production in the second quarter of 2002. Annual savings from the full implementation of the 2001 restructuring initiatives are estimated at $11 million. The reserve for the 2001 restructuring plan was included in accrued expenses on the consolidated balance sheets. Charges against the reserve in 2001 included the $2 million write-off of property, plant and equipment and payments totaling $2 million. An additional $3 million of payments were made and charged against the reserve in 2002. The remaining $5 million of payments were made and charged against the reserve in the first quarter of 2003. All payments associated with the 2001 restructuring plan were funded with cash from operations. See Part I, Item 1. Note 3. Exit Activities for additional information related to payments and reserve balances. OTHER MATTERS LEGAL CONTINGENCIES As a result of the Filing, all pending asbestos lawsuits against U.S. Gypsum and other subsidiaries are stayed, and no party may take any action to pursue or collect on such asbestos claims absent specific authorization of the Bankruptcy Court. See Part I, Item 1. Note 2. Voluntary Reorganization Under Chapter 11 and Note 12. Litigation for recent developments in the Corporation's reorganization proceedings. See Part I. Item 1. Note 12. Litigation for additional information on asbestos litigation. -55- The Corporation and certain of its subsidiaries have been notified by state and federal environmental protection agencies of possible involvement as one of numerous "potentially responsible parties" in a number of so-called "Superfund" sites in the United States. The Corporation believes that neither these matters nor any other known governmental proceeding regarding environmental matters will have a material adverse effect upon its results of operations or financial position. See Part I, Item 1. Note 12. Litigation for additional information on environmental litigation. CRITICAL ACCOUNTING POLICIES The preparation of the Corporation's financial statements requires management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses during the periods presented. The Corporation's 2002 Annual Report on Form 10-K, which was filed on February 27, 2003, includes a summary of the critical accounting policies the Corporation believes are the most important to aid in understanding its financial results. There have been no material changes to these critical accounting policies that impacted the Corporation's reported amounts of assets, liabilities, revenues or expenses during the first half of 2003. Effective in 2003, critical accounting policies also include the following: Adoption of SFAS No. 143: On January 1, 2003, the Corporation adopted SFAS No. 143, "Accounting for Asset Retirement Obligations." This standard requires the recording of the fair value of a liability for an asset retirement obligation in the period in which it is incurred. The Corporation's asset retirement obligations include reclamation requirements as regulated by government authorities related principally to assets such as the Corporation's mines, quarries, landfills, ponds and wells. The accounting for asset retirement obligations requires a number of estimates by management as to the timing of asset retirements, the cost of retirement obligations, discount and inflation rates used in the determination of fair values and the methods of remediation associated with the Corporation's asset retirement obligations. The Corporation generally utilizes assumptions and estimates reflective of the most likely remediation method on a site by site basis. See Part I, Item 1. Note 6. Adoption of SFAS No. 143 for additional information related to the impact of this change in accounting principle. FORWARD-LOOKING STATEMENTS This report contains forward-looking statements related to management's expectations about future conditions. The effects of the Filing and the conduct, outcome and costs of the Chapter 11 Cases, as well as the ultimate costs associated with the Corporation's asbestos litigation, may differ from management's expectations. Actual business or other conditions may also differ significantly from management's expectations and accordingly affect the Corporation's sales and profitability or other results. Actual results may differ due to various other factors, including economic conditions such as the levels -56- of construction activity, interest rates, currency exchange rates and consumer confidence; competitive conditions such as price and product competition; shortages in raw materials; increases in raw material and energy costs; possible impact of asbestos-related legislation; and the unpredictable effects of the global war on terrorism upon domestic and international economies and financial markets. The Corporation assumes no obligation to update any forward-looking information contained in this report. ITEM 4. CONTROLS AND PROCEDURES (a) Evaluation of disclosure controls and procedures. The Corporation's chief executive officer and chief financial officer, after evaluating the effectiveness of the Corporation's "disclosure controls and procedures" (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934), have concluded that, as of the end of the fiscal quarter covered by this report on Form 10-Q, the Corporation's disclosure controls and procedures were adequate and designed to ensure that material information relating to the Corporation and its consolidated subsidiaries would be made known to them by others within those entities. (b) Changes in internal control over financial reporting. There was no change in the Corporation's "internal control over financial reporting" (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934) identified in connection with the evaluation required by Rule 13a-15(d) of the Securities Exchange Act of 1934 that occurred during the fiscal quarter covered by this report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, the Corporation's internal control over financial reporting. -57- REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors of USG Corporation: We have reviewed the accompanying consolidated balance sheet of USG Corporation and subsidiaries as of June 30, 2003 and the related consolidated statements of earnings and cash flows for the three month and six month periods ended June 30, 2003 and 2002. These interim financial statements are the responsibility of the Corporation's management. We conducted our reviews in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and of making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to such consolidated financial statements for them to be in conformity with accounting principles generally accepted in the United States of America. We have previously audited, in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet of USG Corporation and subsidiaries as of December 31, 2002, and the related consolidated statements of income, stockholders' equity, and cash flows for the year then ended (not presented herein); and in our report dated February 3, 2003 (February 19, 2003 as to paragraphs 13, 14 and 15 of Note 18), we expressed an unqualified opinion on those consolidated financial statements and included explanatory paragraphs concerning (i) the Corporation's Chapter 11 bankruptcy filing, (ii) matters that raised substantial doubt about the Corporation's ability to continue as a going concern, and (iii) transitional disclosures related to the change in accounting for goodwill. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2002 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. As discussed in Note 2 to the consolidated financial statements, USG Corporation and certain subsidiaries voluntarily filed for Chapter 11 bankruptcy protection on June 25, 2001. The accompanying consolidated financial statements do not purport to reflect or provide for the consequences of the bankruptcy proceedings. In particular, such financial statements do not purport to show (a) as to assets, their realizable value on a liquidation basis or their availability to satisfy liabilities; (b) as to pre-petition liabilities, the amounts that may be allowed for claims or contingencies, or the status and priority thereof; (c) as to stockholder accounts, the effect of any changes that may be made in the -58- capitalization of the Corporation; or (d) as to operations, the effect of any changes that may be made in its business. The accompanying consolidated financial statements have been prepared assuming that the Corporation will continue as a going concern. As discussed in Notes 2 and 12 to the consolidated financial statements, there is significant uncertainty as to the resolution of the Corporation's asbestos litigation, which, among other things, may lead to possible changes in the composition of the Corporation's business portfolio, as well as changes in the ownership of the Corporation. This uncertainty raises substantial doubt about the Corporation's ability to continue as a going concern. Management's plans in regard to these matters are also described in Notes 2 and 12 to the financial statements. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ DELOITTE & TOUCHE LLP DELOITTE & TOUCHE LLP Chicago, Illinois July 28, 2003 -59- PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS See Part I, Item 1. Note 12. Litigation for information concerning the asbestos and related bankruptcy litigation and environmental litigation. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS (a) In accordance with the Corporation's notice and proxy statement dated April 4, 2003, the matter set forth in paragraph (b) below was submitted to a vote of stockholders at its May 14, 2003 annual meeting of stockholders. (b) The four director-nominees who received the highest vote totals, who were each re-elected to a three-year term of office, and whose terms in office will expire in 2006 were: Keith A. Brown, James C. Cotting, W. Douglas Ford and John B. Schwemm. The directors whose terms of office continued after the annual meeting of stockholders were: Robert L. Barnett, Lawrence M. Crutcher, William C. Foote, David W. Fox, Valerie B. Jarrett, Marvin E. Lesser and Judith A. Sprieser.
Votes Abstentions Votes Withheld and Broker For or Against Non-Votes ---------------------------------------------- Election of Directors: Keith A. Brown 39,380,766 353,906 - James C. Cotting 39,383,189 351,483 - W. Douglas Ford 39,383,526 351,146 - John B. Schwemm 39,367,743 366,929 -
(c) The following proposal was recommended by the Corporation's Board of Directors and was approved by a majority of the shares voted.
Votes Abstentions Votes Withheld and Broker For or Against Non-Votes ---------------------------------------- Ratification of Appointment of Deloitte & Touche LLP as Independent Public Accountants 39,407,053 183,957 143,662
-60- ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: 10. Master Letter of Credit Agreement, Rider to Master Letter of Credit Agreement, and Related Pledge Agreement, Acknowledgement Agreement if Collateral Held at LaSalle Bank National Association Trust Department, LaSalle Bank National Association Trust Department Internal, Pledge Agreement between USG Corporation and LaSalle Bank National Association, dated June 11, 2003. 15. Letter from Deloitte & Touche LLP regarding unaudited financial information. 31.1 Certifications of USG Corporation's Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certifications of USG Corporation's Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certifications of USG Corporation's 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 Certifications of USG Corporation's 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: On April 24, 2003, USG Corporation filed with the SEC a Form 8-K for the purpose of disclosing, under "Item 12. Results of Operations and Financial Condition", its press release containing earnings information for its first quarter of 2003. -61- 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. USG CORPORATION By /s/ William C. Foote ---------------------------------- William C. Foote, Chairman, Chief Executive Officer and President By /s/ Richard H. Fleming ---------------------------------- Richard H. Fleming Executive Vice President and Chief Financial Officer, By /s/ D. Rick Lowes ---------------------------------- D. Rick Lowes, Vice President and Controller, August 5, 2003 -62-