**Exhibit 13.1***This Management’s Discussion and Analysis of Financial Condition and Results of Operations shouldbe read in conjunction with the consolidated financial statements, the notes thereto and thehistorical summary appearing elsewhere in this annual report. Historical results and percentagerelationships set forth in the consolidated financial statements, including trends that mightappear, should not be taken as indicative of future operations. The following discussion containsforward-looking statements that involve risks and uncertainties. Our actual results may differmaterially from those discussed in such forward-looking statements as a result of various factors,including those described under the section “Cautionary Statements for Safe Harbor Purposes”included elsewhere in this annual report.***OVERVIEW**GeneralWe are an innovative specialty chemical company that produces and supplies technologies thatimprove the quality and performance of our customers’ products in the global transportation,industrial and consumer markets. Our business is founded on technological leadership. Innovationprovides opportunities for us in growth markets as well as advantages over our competitors. From abase of approximately 1,700 patents, we use our product development and formulation expertise tosustain our leading market positions and fuel our future growth. We create additives, ingredients,resins and compounds that enhance the performance, quality and value of our customers’ products,while minimizing their environmental impact. Our products are used in a broad range ofapplications, and are sold into stable markets such as those for engine oils, specialty drivelinelubricants and metalworking fluids, as well as higher-growth markets such as personal care andover-the-counter pharmaceutical products and performance coatings and inks. Our engineeredpolymers products also are used in a variety of industries, including the construction, sportinggoods, medical products and automotive industries. We are an industry leader in many of themarkets in which our product lines compete.We are geographically diverse, with an extensive global manufacturing, supply chain, technical andcommercial infrastructure. We operate facilities in 29 countries, including production facilitiesin 20 countries and laboratories in 13 countries, in key regions around the world through theefforts of more than 6,700 employees. We sell our products in more than 100 countries and believethat our customers value our ability to provide customized, high-quality, cost-effectiveperformance formulations and solutions worldwide. We also believe that our customers value ourglobal supply chain capabilities.As part of our corporate goal to enhance our “one company” identity and to reflect more accuratelyour positioning in the marketplace, we completed a corporate identity review in the fourth quarterof 2006. We made a final determination in January 2007 that the trade name “Noveon” no longerwould be used to describe the specialty chemicals business segment of our company and that its usewould be discontinued except in connection with the consumer specialties product line. We acquiredthe rights to the Noveon trade name in June 2004 when we acquired Noveon International, Inc.(Noveon International). At the time of acquisition, an appraised value was attached to the Noveontrade name. We recorded a pretax charge of $41.2 million ($25.4 million after-tax) to reduce therelated asset to its estimated fair value. This charge was reflected in the fourth quarter of 2006as we believed at that time we would more likely than not discontinue the use of the Noveon tradename, except in the limited context of our consumer specialties product line.In addition, we made a decision to change the names of our business segments. We believe thatthese names are a better fit with the corporate brand that we are presenting to our markets. Thesename changes do not change the way we manage our segments or the product lines included in thesegments.
 

 
Following are the name changes to our segments:           Former Name   New Name    Lubricant Additives   Lubrizol Additives    Specialty Chemicals   Lubrizol Advanced Materials  On February 7, 2007, we completed the acquisition of a broad line of additive products used in themetalworking markets worldwide from Lockhart Chemical Company (Lockhart), a private company withheadquarters in Gibsonia, Pennsylvania. Lockhart is recognized in the metalworking industry forits application and formulation capabilities and quality products. We purchased Lockhart’s entiremetalworking product line, which includes: natural, synthetic and gelled sulfonates; emulsifierpackages; corrosion inhibitors and lubricity agents; grease additives; oxidates; esters; soap;semi-finished coatings; and rust preventatives. In 2006, these product lines had annualizedrevenues of approximately $20.0 million.In May 2006, we sold the food ingredients and industrial specialties business (FIIS) and the activepharmaceutical ingredients and intermediate compounds business (A&I), both of which were includedin the Lubrizol Advanced Materials segment. A&I and almost all of the FIIS divestiture reportedinto the Noveon consumer specialties product line, while a small portion of the FIIS divestiturereported into the performance coatings product line. We recorded a $15.9 million after-tax loss onthe sale of these divested businesses. During the first quarter of 2006 and in connection with theheld-for-sale classification, we performed an impairment test resulting in a $60.6 millionafter-tax impairment charge in the first quarter of 2006. We have reflected the results of thesedivested businesses in the discontinued operations – net of tax line item in the consolidatedstatements of income for all periods presented.In February 2006, we sold certain assets and liabilities of our Telene® resins business(Telene), which was included in the Lubrizol Advanced Materials segment. We have reflected theresults of Telene in the discontinued operations – net of tax line item in the consolidatedstatements of income for all periods presented, including an after-tax loss on the sale of $0.7million.In December 2005, we sold certain assets, liabilities and stock of our Engine Control Systems (ECS)business and, in September 2005, we sold certain assets and liabilities of our U.S. and U.K.Lubrizol Performance Systems (LPS) operations, both of which were included in the LubrizolAdditives segment. We have reflected the results of these businesses in the discontinuedoperations – net of tax line item in the consolidated statements of income for 2005 and 2004.On June 3, 2004, we completed the acquisition of Noveon International, a leading global producerand marketer of technologically advanced consumer specialties, engineered polymers and performancecoatings used in the industrial and consumer markets. We acquired Noveon International for cash of$920.2 million (inclusive of certain seller expenses of $32.9 million) plus transaction costs of$11.4 million and less cash acquired of $103.0 million. In addition, we assumed $1,103.1 millionof long-term indebtedness from Noveon International.In connection with the acquisition of Noveon International, we targeted non-core businesses withtotal revenues of approximately $500.0 million for disposition. All disposition activities relatedto these businesses were completed by the end of 2006.LUBRIZOL ADDITIVES SEGMENTChallenging industry market forces and conditions continue to influence the Lubrizol Additivesbusiness. A key factor is the low global growth rate for this market, which we believe is in therange of approximately 0% to 1% per year. Additional characteristics of this market are:
 

 
 **•** Consolidation of the additive industry and capacity reductions in recent years, whichhas tightened the supply of lubricant additive components and packages.  **•** Frequent product specification changes primarily driven by original equipmentmanufacturers (OEMs) and the impact of environmental and fuel economy regulations on theOEMs. The specification changes require us to incur product development and testing costs,but also enable us to apply our technology know-how to createproducts and solve problems. We believe our technology, and our expertise in applying it, are key strengths.  **•** Improved engine design, which can result in longer lubricant drain intervals. Longerdrain intervals reduce demand for finished lubricants.  **•** New vehicle production levels, which affect our driveline fluids in particular becausethe initial factory fill is an important market factor in that product line.  **•** In recent years, a general tightening of supplies leading to significant increases inraw material and energy costs.We believe we are the market leader in lubricant additives and intend to remain the leader bycontinuing to invest in this business. Our strategy is to continue to optimize our product linemix with existing production capacity. Our Lubrizol Additives segment represents approximately 64%of consolidated revenues.LUBRIZOL ADVANCED MATERIALS SEGMENTOur Lubrizol Advanced Materials segment’s growth strategy involves a combination of internal growthand acquisitions. Since 2000 and prior to the Noveon International acquisition, we made eightacquisitions with aggregate annual revenues at the time of acquisition of approximately $200.0million.We have a strategy to continue to achieve internal growth in the Lubrizol Advanced Materialssegment by using our strengths, including our technology, formulating skills and broad geographicinfrastructure, to develop and invest in new performance technologies in higher-growth industrialand consumer markets. Key factors to our success continue to be the introduction of new products,development of new applications for existing products, cross-selling of products, the integrationof acquisitions and geographic expansion. Our Lubrizol Advanced Materials segment representsapproximately 36% of consolidated revenues.PRIMARY FACTORS AFFECTING 2006 RESULTS FROM CONTINUING OPERATIONSThe factors that most affected our consolidated 2006 results from continuing operations were: **•** Our ability to raise selling prices to recover raw material cost increases from 2006 andprior years.  **•** Volume increases of 6% in the Lubrizol Advanced Materials segment and just underone-half percent in the Lubrizol Additives segment.  **•** Increased operating costs due to general salary and benefit cost increases and thehiring of growth resources, costs associated with a newly commenced project toimplement a common information systems platform primarily in the Lubrizol AdvancedMaterials segment, the impact of variable accounting for some of our liability-basedincentive compensation plans, the adoption of Statement of Financial Accounting Standards(SFAS) No. 123R “Share-Based Payment” for the accounting of stock-based awards, and a $2.9million pension settlement charge for a non-qualified plan distribution.
 

 
 **•** Pretax impairment charges of $41.2 million associated with the impairment of the Noveontrade name and $10.7 million related to plant and line closures in both the LubrizolAdditives and Lubrizol Advanced Materials segments.  **•** Reduced interest expense – net of $17.7 million as a result of higher interest income of$12.3 million associated with greater cash and short-term investment balances, primarilyrelated to the cash proceeds from the 2006 divestitures and lower interest expense of $5.4million associated with reduced debt levels.  **•** Increased other income of $6.7 million primarily from legal settlements with suppliers.  **•** Reduced effective tax rate primarily due to the favorable provision impacts of foreign operations.Raw material costs increased 14% in 2006 after increasing 18% excluding the impact of acquisitionsin 2005. Our results were affected by how quickly and the extent to which we were able to raiseselling prices in response to raw material, utility and other operating cost increases. Both theLubrizol Additives and Lubrizol Advanced Materials segments implemented price increases throughout2006 in response to continuing increases in these costs. However, we have not yet recovered thefull effect of the cumulative cost increases.**2006 RESULTS OF OPERATIONS COMPARED WITH 2005**Income from continuing operations increased $20.3 million to $181.8 million for 2006 compared to$161.5 million for 2005. The increase in earnings from continuing operations primarily wasattributable to improvements in the combination of price and product mix, higher volume and reducedinterest expense – net, which more than offset higher raw material and utility costs, higherrestructuring and impairment charges and higher selling, technology, administrative and research(STAR) expenses.We recorded restructuring and impairment charges that reduced income from continuing operations by$0.47 per diluted share in 2006, which primarily related to a pretax impairment charge associatedwith the Noveon trade name and the phase-out of a manufacturing facility located in Bromborough,United Kingdom. We incurred restructuring and impairment charges of $0.15 per diluted share in2005, which primarily related to the phase-out of manufacturing facilities located in Bromborough,United Kingdom; Linden, New Jersey; and Mountaintop, Pennsylvania, as well as other workforcereductions.Net income for 2006 includes the factors described above for income from continuing operations andthe impact of discontinued operations. Loss from discontinued operations – net was $76.2 millionin 2006 compared to income from discontinued operations – net of $27.8 million in 2005. The lossfrom discontinued operations – net in 2006 primarily related to a $60.6 million after-taximpairment charge recorded in the first quarter of 2006 to reflect the FIIS business at its fairvalue and a $16.6 million after-tax loss on the sale of divested businesses.**ANALYSIS OF REVENUES**The changes in consolidated revenues are summarized as follows:                 *(In Millions of Dollars)* 2006  2005  $ Change  % Change  Net sales $4,036.4  $3,618.8  $417.6   12%Royalties and other revenues  4.4   3.4   1.0   29%              Total revenues $4,040.8  $3,622.2  $418.6   12%              
 

 
The increase in revenues in 2006 compared to 2005 primarily was due to a 10% improvement inthe combination of price and product mix and a 2% increase in volume. We experienced volume gainsin all geographic zones except Europe.**ANALYSIS OF VOLUME — 2006 VS. 2005**Volume patterns vary in different geographic zones.The following table shows our 2006 volume by geographic zone as well as the changes compared with2005:           2006      Volume  % Change  North America  46%  1%Europe  27%  (1%)Asia-Pacific / Middle East  22%  6%Latin America  5%  11%        Total  100%  2%        Segment volume variances by geographic zone, as well as the factors explaining the changes insegment revenues for 2006 compared with 2005, are contained under the “Segment Analysis” section.**ANALYSIS OF COSTS AND EXPENSES**                 *(In Millions of Dollars)* 2006  2005  $ Change  % Change  Cost of sales $3,041.9  $2,696.6  $345.3   13%Selling and administrative expenses  381.7   348.4   33.3   10%Research, testing and development expenses  205.5   198.9   6.6   3%Amortization of intangible assets  23.7   23.5   0.2   1%Restructuring and impairment charges  51.9   15.9   36.0   *               Total costs and expenses $3,704.7  $3,283.3  $421.4   13%               *** *Calculation not meaningful*The increase in cost of sales for 2006 compared to 2005 primarily was due to higher averageraw material cost and higher manufacturing expenses. Average raw material cost increased 14% in2006 compared to 2005 primarily due to higher petrochemical raw material cost. Total manufacturingexpenses increased 4% in 2006 compared to 2005, primarily due to higher salaries and benefits,higher utility costs and increased volume. On a per-unit-sold basis, manufacturing costs increased2% in 2006 compared to 2005.Gross profit (net sales less cost of sales) increased $72.3 million, or 8%, in 2006 compared to2005. The increase primarily was due to improvement in the combination of price and product mixand higher volume partially offset by higher average raw material cost. In addition, gross profitwas impacted unfavorably by higher salaries and benefits, an increase in utility costs and anunfavorable currency impact in 2006 when compared to 2005. Although we were successful in raisingselling prices to offset higher cost of sales, our 2006 gross profit percentage (gross profitdivided by net sales) decreased to 24.6% compared to 25.5% in 2005 due to the increase in net salesfrom our pricing responses to escalating raw material costs.Selling and administrative expenses increased $33.3 million, or 10%, in 2006 compared to 2005. Theincrease primarily reflects an increase in salaries and benefits including the addition of growthresources, an increase of $4.5
 

 
million associated with a newly commenced project to implement a common information systemsplatform primarily in the Lubrizol Advanced Materials segment, the unfavorable impact of variableaccounting for some of our liability-based incentive plans, a $2.9 million pension settlementcharge for a non-qualified pension plan distribution and incremental stock-based compensationexpense of $2.4 million associated with the adoption of SFAS No. 123R.The timing and amount of research, testing and development expenses (technology expenses) areaffected by lubricant additives product standards, which change periodically to meet new emissions,efficiency, durability and other performance factors as OEMs improve engine and transmissiondesigns. Technology expenses increased $6.6 million, or 3%, in 2006 compared to 2005 primarily dueto increases in annual salaries and benefits. During 2006 and 2005, approximately 87% of ourtechnology costs were incurred in company-owned facilities and approximately 13% were incurred atthird-party facilities.In 2006, we recorded aggregate restructuring and impairment charges of $51.9 million, or $0.47 perdiluted share, primarily related to the write-down of a trade name in the Lubrizol AdvancedMaterials segment and the phase-out of a manufacturing facility in the Lubrizol Additives segment.The components of the 2006 restructuring and impairment charges are detailed as follows:                   Asset  Other Plant       *(In Millions of Dollars)* Impairments  Exit Costs  Severance  Total  Noveon trade name impairment $41.2  $—  $—  $41.2 Bromborough, U.K. closure  —   4.8   1.9   6.7 Lubrizol Advanced Materials plant andline closures and workforce reductions  3.3   0.2   0.6   4.1 Other  —   —   (0.1)  (0.1)             Total restructuring and impairment charges $44.5  $5.0  $2.4  $51.9              As part of our corporate goal to enhance our “one company” identity and to reflect moreaccurately our positioning in the marketplace, we completed a corporate identity review in thefourth quarter of 2006. We made a final determination in January 2007 that the trade name “Noveon”no longer would be used to describe the specialty chemicals business segment of our company andthat its use would be discontinued except in connection with the consumer specialties product line.We acquired the rights to the Noveon trade name in June 2004 when we acquired NoveonInternational. At the time of acquisition, an appraised value was attached to the Noveon tradename. We calculated a pretax charge of $41.2 million ($25.4 million after-tax) to reduce therelated asset to its estimated fair value. This charge was reflected in the fourth quarter of 2006as we believed at that time we would more likely than not discontinue the use of the Noveon tradename, except in the limited context of the consumer specialties product line.In September 2006, we entered into an agreement to sell the manufacturing facility located inBromborough, United Kingdom. The sale closed in January 2007. In connection with the sale, wereceived net cash proceeds of $5.9 million and recorded a pretax gain of $2.9 million during thefirst quarter of 2007. The gain will be classified as a restructuring credit associated withclosure of the facility. Production from the Bromborough facility was transferred tohigher-capacity Lubrizol facilities in France and the United States. The sale of the facility willavoid approximately $3.0 million to $5.0 million in restructuring costs that would have beenassociated with demolition of the plant facilities on the site. On January 17, 2005, we announcedour plans to phase-out production at the Bromborough facility by the end of 2006. At that time, weestimated that total restructuring costs, including employee severance and other plant closurecosts (including planned demolition costs), would be approximately $15.0 million. Cumulativepretax charges of approximately $12.8 million were incurred through 2006, of which $6.7 millionwere incurred in 2006, to satisfy severance and retention obligations, plant dismantling, siterestoration and other site environmental evaluation costs.
 

 
We have invested approximately $15.3 million in capital related to the Bromborough closurethrough December 31, 2006 for capacity upgrades in France and the United States. We expect toinvest an additional $4.0 million related to these capacity upgrades through the first quarter of2007.In the first quarter of 2005, we decided to close two Lubrizol Advanced Materials performancecoatings production facilities in the United States. One facility, located in Mountaintop,Pennsylvania, was closed in October 2005 and sold in January 2006. We recorded an additional $0.8million in asset impairments and other exit costs and $0.6 million in severance obligations in 2006relating to the other facility located in Linden, New Jersey, which was closed in the third quarterof 2006. Additional asset impairment charges of $2.7 million were recorded in 2006, whichprimarily related to the planned closure of a performance coatings production line in the firstquarter of 2007.In addition, we expect these workforce reductions, facility closures and transfers of production tomore efficient manufacturing locations to generate annual pretax savings of approximately $5.3million for the Lubrizol Advanced Materials segment andapproximately $12.0 million for the Lubrizol Additives segment. Approximately $8.4 million ofthese savings were realized in 2006.The charges for these cost reduction initiatives and impairments are reported as a separate lineitem in the consolidated statements of income, entitled “Restructuring and impairment charges” andare included in the “Total cost and expenses” subtotal on the consolidated statements of income.**ANALYSIS OF OTHER ITEMS AND NET INCOME**                 *(In Millions of Dollars)* 2006 2005 $ Change % Change Other income — net $8.3  $1.6  $6.7   * Interest expense — net  79.3   97.0   (17.7)  (18%)Income from continuing operationsbefore income taxes  265.1   243.5   21.6   9%Provision for income taxes  83.3   82.0   1.3   2%Income from continuing operations  181.8   161.5   20.3   13%Discontinued operations — net of tax  (76.2)  27.8   (104.0)  * Net income $105.6  $189.3  $(83.7)  (44%)  *** *Calculation not meaningful*The increase in other income – net for 2006 compared to 2005 primarily was due to thefavorable legal settlements of insurance and commercial matters of $10.4 million and an increase inthe net gain on the sale of property of $1.3 million, partially offset by an increase in currencytransaction losses of $2.4 million and an increase in the elimination of minority interest of $2.4million due to higher profitability of our joint ventures.The decrease in interest expense – net for 2006 compared to 2005 primarily was due to an increasein interest income of $12.3 million as a result of our increased cash and short-term investmentsfrom the divestiture proceeds and a decrease in interest expense of $5.4 million due to a reductionin our long-term debt balances.Our effective tax rate was 31.4% in 2006 compared to 33.7% in 2005. The decrease in the effectivetax rate primarily was due to the favorable provision impacts of foreign operations.Primarily as a result of the above factors, income from continuing operations per diluted share was$2.62 in 2006 compared to $2.35 in 2005. Loss from discontinued operations per diluted share was$1.10 in 2006 compared to income from discontinued operations per diluted share of $0.40 in 2005.The loss from discontinued operations per diluted share of $1.10 in 2006 consisted of operatingincome of $0.01 per diluted share, excluding an $0.87 per diluted share impairment charge and a$0.24 per diluted share loss on the sale of divested businesses.
 

 
**2005 RESULTS OF OPERATIONS COMPARED WITH 2004**Our 2005 revenues as compared to 2004, excluding the impact of acquisitions, increased primarilydue to improvements in the combination of price and product mix, offset by a slight decrease involume. The increased revenues partially were offset by higher raw material costs and higherutility costs. Primarily as a result of these factors and the impact of acquisitions, gross profitincreased 22% in 2005 compared with 2004. Excluding the impact of acquisitions, gross profitincreased 4% in 2005 compared to 2004.**ANALYSIS OF REVENUES**The changes in consolidated revenues are summarized as follows:                                           Excluding the Impact                   of Acquisitions *(In Millions of Dollars)* 2005  2004  $ Change  % Change  $ Change  % Change  Net sales $3,618.8  $2,860.5  $758.3   27% $333.0   12%Royalties and other revenues  3.4   3.9   (0.5)  (13%)  (0.5)  (13%)                     Total revenues $3,622.2  $2,864.4  $757.8   26% $332.5   12%                     The 2004 acquisitions contributed $425.3 million toward the increase in 2005 consolidatedrevenues compared with 2004. Acquisitions in 2004 included Noveon International and thehyperdispersants business purchased from Avecia.Excluding the impact of acquisitions, the increase in consolidated revenues in 2005 compared to2004 was due to a 12% increase in the combination of price and product mix.**ANALYSIS OF VOLUME — 2005 VS. 2004**Volume patterns vary in different geographic zones.The following table shows our 2005 volume by geographic zone as well as the changes compared with2004:                       Excluding the Impact   2005      of Acquisitions   Volume  % Change  % Change  North America  46%  6%  (6%)Europe  28%  8%  3%Asia-Pacific / Middle East  21%  13%  8%Latin America  5%  6%  2%Total  100%  8%  —Segment volume variances by geographic zone, as well as the factors explaining the changes insegment revenues for 2005 compared with 2004, are contained under the “Segment Analysis” section.
 

 
**ANALYSIS OF COSTS AND EXPENSES**                                           Excluding the Impact                   of Acquisitions *(In Millions of Dollars)* 2005  2004  $ Change  % Change  $ Change  % Change  Cost of sales $2,696.6  $2,101.7  $594.9   28% $304.0   14%Selling and administrative expenses  348.4   284.8   63.6   22%  9.1   3%Research, testing and developmentexpenses  198.9   184.8   14.1   8%  (5.7)  (3%)Amortization of intangible assets  23.5   16.9   6.6   39%  —   * Write-off of acquired in-process researchand development  —   34.0   (34.0)  *   (34.0)  * Restructuring and impairment charges  15.9   38.1   (22.2)  *   (24.0)  *                      Total costs and expenses $3,283.3  $2,660.3  $623.0   23% $249.4   9%                      *** *Calculation not meaningful*Cost of sales increased due to acquisitions, higher average raw material cost and highermanufacturing expenses. Excluding the impact of acquisitions, average raw material cost increased18% in 2005 compared with 2004. The increase in the material costs during the latter half of 2005largely was driven by supply disruptions caused by the U.S. Gulf coast hurricanes. Material cost,including acquisitions, also included inventory step-up adjustments associated with the increasedvaluation of inventory of $12.5 million in 2004 for the Noveon International and hyperdispersantsacquisitions. The Noveon International portion of the inventory step-up adjustment was $9.8million, or $0.11 per diluted share.Total manufacturing expenses increased 19% (5% excluding the impact of acquisitions) in 2005compared with 2004. Excluding the impact of acquisitions, the increase primarily was due to anincrease in utility costs as well as an unfavorable currency impact. On a per-unit-sold basis,manufacturing costs increased 5% in 2005 compared to 2004, excluding the impact of acquisitions.Gross profit increased $163.4 million, or 22% ($29.0 million, or 4%, excluding the impact ofacquisitions), in 2005 compared with 2004. Excluding the impact of acquisitions, the increaseprimarily was due to higher average selling price, partially offset by higher unit average rawmaterial cost and higher utility costs. Our 2005 gross profit percentage decreased to 25.5% (24.7%excluding the impact of acquisitions) compared to 26.5% in 2004. The decrease primarily was due tohigher raw material costs outpacing our ability to raise selling prices sufficiently to sustaingross profit percentages.Selling and administrative expenses increased $63.6 million, or 22% ($9.1 million, or 3%, excludingthe impact of acquisitions), in 2005 compared with 2004. The increase in selling andadministrative expenses, excluding the impact of acquisitions, primarily was due to an increase insalaries and incentive compensation expense, offset partially by non-recurring litigation expenseof $1.9 million incurred in 2004.Technology expenses, excluding the impact of acquisitions, decreased 3% in 2005 compared with 2004.The decrease primarily was due to the 2004 reduction in workforce. During 2005 and 2004,approximately 87% of our technology costs were incurred in company-owned facilities andapproximately 13% were incurred at third-party facilities.The increased amortization expense in 2005 compared with 2004 primarily was due to the NoveonInternational and hyperdispersants acquisitions in 2004. These two acquisitions resulted in anincrease in gross amortizable intangible assets of approximately $320.3 million with useful livesranging between 3 and 20 years.
 

 
We included a one-time, non-cash charge of $34.0 million, or $0.39 per share, in total costs andexpenses in 2004 to write-off the estimated fair value of acquired in-process research anddevelopment (IPR&D) projects associated with the Noveon International acquisition. Costs toacquire IPR&D projects that have no alternative future use and that have not yet reachedtechnological feasibility at the date of acquisition are expensed upon acquisition. We obtainedappraisals to determine the estimated fair value of IPR&D projects. There were approximately nineprojects acquired in the Noveon International transaction in several different product lines. Theprojects were at varying stages of completeness ranging from the early development stage toprototype testing at the time of acquisition. No further adjustments were made in 2005 to thevaluation in connection with the completion of the Noveon International purchase accounting.In 2005, we recorded restructuring and impairment charges aggregating $15.9 million, or $0.15 perdiluted share, primarily related to the decision to close three manufacturing facilities, as wellas other workforce reductions.The components of the 2005 restructuring and impairment charges are detailed as follows:                   Asset  Other Plant       *(In Millions of Dollars)* Impairments  Exit Costs  Severance  Total  Lubrizol AdvancedMaterials plant closuresand workforce reductions $4.2  $1.0  $3.8  $9.0 Bromborough, U.K. closure  0.7   1.7   3.7   6.1 Corporate / otherworkforce reductions  —   —   0.7   0.7 Noveon Internationalrestructuringliabilities assumed  —   —   0.1   0.1              Total restructuring andimpairment charges $4.9  $2.7  $8.3  $15.9              In May 2005, we announced the reorganization of the Lubrizol Advanced Materials performancecoatings product line. This product line includes businesses acquired from Noveon International aswell as businesses included in our legacy operations. In connection with the reorganization, weeliminated 26 positions in North America and Europe. These reductions were completed during 2005and resulted in a severance charge of $1.9 million in 2005.In the first quarter of 2005, we made the decision and the announcement to close two LubrizolAdvanced Materials performance coatings production facilities in the United States. The aggregaterestructuring charge recorded for these closures for the year ended December 31, 2005 was $6.6million, comprised of $4.2 million in asset impairments, $0.9 million in exit costs and $1.5million in severance costs. We recorded an impairment charge for both plants in the first quarterof 2005 to reduce the related assets to their estimated fair values. The estimated fair value ofthe assets wasdetermined primarily from third-party appraisals. Production from these sites was transferred toother facilities in the United States. One facility, located in Mountaintop, Pennsylvania, wasclosed in October 2005 and sold in January 2006, while the other facility, located in Linden, NewJersey, was closed in the third quarter of 2006. These closures resulted in a workforce reductionof 62 employees. We also recorded European-related restructuring charges in the Lubrizol AdvancedMaterials segment of $0.4 million in severance costs and $0.1 million in other exit costs duringthe fourth quarter of 2005.In December 2004, we decided to close the Lubrizol Additives manufacturing facility in Bromborough,United Kingdom. We announced this decision in January 2005. A $17.0 million impairment charge wasrecorded in December 2004 to reduce the related assets to their estimated fair values. Productionphase-out of this site began in the third quarter of 2005 and was completed in the third quarter of2006. During this phase-out, U.K. production was transferred to facilities in France and theUnited States. There were 70 employees impacted by this closure. The aggregate restructuringcharge recorded for this closure through December 31, 2005 was $6.1 million. Total 2005 chargeswere comprised of $0.7 million in asset impairments, $1.7 million in exit costs and $3.7 million inseverance costs.
 

 
In the second quarter of 2005, we continued a process of identifying further opportunities toincrease efficiency and productivity, reduce costs and support our integration strategy of theNoveon International acquisition. As a result, we reduced headcount in the general andadministrative area of our Ohio headquarters. Through these restructuring efforts, we eliminatedseven positions resulting in a severance-related charge of $0.7 million in 2005. All of theaffected employees had left their positions by June 30, 2005 and the remaining personnel-relatedcosts were paid by the end of 2006.In addition, we realized approximately $18.3 million of pretax savings in 2005 relating to the 2004restructuring programs.The charges for these cost reduction initiatives and impairments are reported as a separate lineitem in the consolidated income statements, entitled “Restructuring and impairment charges” and areincluded in the “Total cost and expenses” subtotal on the consolidated statements of income.**ANALYSIS OF OTHER ITEMS AND NET INCOME**                                           Excluding the Impact                   of Acquisitions *(In Millions of Dollars)* 2005  2004  $ Change  % Change  $ Change  % Change  Other income— net $1.6  $5.4  $(3.8)  *  $(4.5)  * Interestexpense — net  97.0   72.3   24.7   *   (8.8)  * Income from continuing operationsbeforeincome taxes  243.5   137.2   106.3   77%  87.4   64%Provision for income taxes  82.0   50.0   32.0   64%  28.2   56%Income from continuing operations  161.5   87.2   74.3   85%  59.2   68%Discontinuedoperations — net of tax  27.8   6.3   21.5   *   8.7   * Net income $189.3  $93.5  $95.8   102% $67.9   73%  *** *Calculation not meaningful*The change in other income – net in 2005 predominantly was due to the non-recurring 2004 gainof $6.4 million on a currency forward contract to purchase pound sterling related to theacquisition of thehyperdispersants business. We secured the forward contract in December 2003 and completed theacquisition at the end of January 2004.The increase in interest expense – net in 2005, compared with 2004, primarily was due to the NoveonInternational pretax acquisition-related financing costs of $82.0 million, or $0.77 per dilutedshare, in 2005 compared to $56.7 million, or $0.66 per diluted share, in 2004. These costs werecomprised of the interest incurred relating to the permanent financing as well as interest on thebridge loan and assumed Noveon International debt not repaid at the time of the acquisition of$42.6 million, amortization of bridge loan fees of $11.2 million and termination of an interestrate swap of $2.9 million. We obtained permanent financing for the Noveon Internationalacquisition in the third quarter of 2004.We had an effective tax rate of 33.7% in 2005 as compared with 36.4% in 2004. Items driving thedecrease in tax rate included reduced tax costs associated with actual and planned foreigndividends, the more favorable impact of foreign tax rate differences and higher U.S. tax benefitson exports. These factors partially were offset by increased state income taxes and lowernon-taxable currency gains as compared to 2004.As of December 31, 2005, we had U.S. net operating loss carryforwards (NOLs) of $178.4 million.These NOLs are a combination of NOLs acquired from Noveon International, as well as those generatedin 2004 primarily as a result of transaction-related costs.
 

 
Primarily as a result of the above factors, our income from continuing operations per diluted sharewas $2.35 in 2005 compared to $1.56 in 2004. Income from discontinued operations per diluted sharewas $0.40 in 2005 compared to $0.11 in 2004. Income from discontinued operations in 2005 included$0.28 per diluted share of operating income from the FIIS and A&I businesses, $0.10 per dilutedshare related to LPS and ECS, of which $0.04 was attributable to the gain on sale, and $0.02 perdiluted share in operating income related to the Telene resins business. Restructuring andimpairment charges recorded in 2005 reduced earnings by $0.15 per diluted share. Earnings in 2004included a one-time write-off for IPR&D projects from the Noveon International acquisition of $0.38per diluted share, a purchase adjustment associated with the increased valuation of NoveonInternational-acquired inventory of $0.11 per diluted share, restructuring charges of $0.46 perdiluted share, acquisition-related financing costs of $0.66 per diluted share and a gain on aforeign currency forward contract of $0.07 per diluted share.**SEGMENT ANALYSIS**We primarily evaluate performance and allocate resources based on segment operating income, definedas revenues less expenses identifiable to the product lines included within each segment, as wellas projected future returns. Segment operating income will reconcile to consolidated income fromcontinuing operations before income taxes by deducting corporate expenses and corporate otherincome (expense) that are not attributable to the operating segments, restructuring and impairmentcharges and net interest expense.The proportion of consolidated revenues and segment operating income attributed to each segment wasas follows:               2006 2005 2004**Revenues**:            Lubrizol Additives  64%  63%  70%Lubrizol Advanced Materials  36%  37%  30%             **Segment Operating Income**:            Lubrizol Additives  65%  64%  75%Lubrizol Advanced Materials  35%  36%  25%
 

 
**OPERATING RESULTS BY SEGMENT**                                                   2005 vs. 2004                       Excluding the Impact               2006 vs. 2005  of Acquisitions *(In Millions of Dollars)* 2006  2005  2004  $ Change  % Change  $ Change  % Change    Revenues:                            Lubrizol Additives $2,600.5  $2,280.0  $1,998.6  $320.5   14% $281.4   14%Lubrizol Advanced Materials  1,440.3   1,342.2   865.8   98.1   7%  51.1   6%                        Total $4,040.8  $3,622.2  $2,864.4  $418.6   12% $332.5   12%                                                     Gross Profit:                            Lubrizol Additives $581.3  $531.2  $508.4  $50.1   9% $22.8   4%Lubrizol Advanced Materials  413.2   391.0   250.4   22.2   6%  6.2   2%                        Total $994.5  $922.2  $758.8  $72.3   8% $29.0   4%                                                     Operating Income:                            Lubrizol Additives $306.1  $266.6  $240.9  $39.5   15% $25.7   11%Lubrizol Advanced Materials  167.6   150.9   78.6   16.7   11%  18.1   23%                        Total $473.7  $417.5  $319.5  $56.2   13% $43.8   14%                        **LUBRIZOL ADDITIVES SEGMENT*****2006 COMPARED WITH 2005***Revenues increased 14% in 2006 when compared to 2005. The increaseprimarily was due to improvement in the combination of price and product mix, while a slightincrease in volume was offset by a slight unfavorable impact of currency.Volume patterns vary in different geographic zones. The following table shows our volume bygeographic zone in 2006 as well as the changes compared with 2005:           2006    Volume % Change North America  38%  1%Europe  30%  (3%)Asia-Pacific / Middle East  26%  2%Latin America  6%  6%         Total  100%  —          Volume increased slightly in 2006 compared to 2005; however, excluding the impact ofnonrecurring, temporary business gains in 2005, volume increased 2% in 2006 compared to 2005.The decrease in volume in Europe was due in part to a change in a customer sourcing from Europe toNorth America. The volume growth in the Asia-Pacific / Middle East region primarily resulted fromgrowth in China, which represents our third largest country in terms of volume sold despite thefact that a majority of the 2005 temporary business gains occurred in this region. The volumegrowth in Latin America primarily was driven by stronger demand by our major internationalcustomers.Segment gross profit increased 9% in 2006 compared to 2005 as we continued to recover from marginerosion that occurred in 2005 and prior years. The Lubrizol Additives segment implemented a seriesof price increases in 2006
 

 
and 2005 in response to continued raw material and utility costincreases. The effective dates of the selling price increases varied by geographic zone. Thegross profit increase primarily was due to an improvement in the combination of price and productmix partially offset by a 19% increase in average material cost in 2006 as compared to 2005.Manufacturing costs on a per-unit-sold basis increased 3% in 2006 compared to 2005. The increasewas due in part to higher utility costs as well as higher operating supplies and outside servicespartially offset by lower depreciation expense, employee benefits and a reclassification of certainexpenses from manufacturing to STAR due to a change in organization structure in our Europeanoperations. In addition, manufacturing costs were impacted favorably by approximately $5.2 millionin 2006 as we curtailed production activity at our Bromborough, U.K. plant in accordance with ourpreviously announced timetable to close this facility.The gross profit percentage declined to 22.4% in 2006 compared with 23.3% in 2005. The decline ingross profit percentage primarily was due to continuing raw material cost increases throughout mostof 2006 outpacing the timing of price increases.STAR expenses increased 7% in 2006 compared to 2005. This increase primarily was due to anincrease in selling and administrative expenses of $14.8 million. The higher selling andadministrative costs primarily resulted from the impact of reclassifying to STAR certain expensesthat previously were classified as manufacturing resulting from a change in organization structurein our European operations, increases in base and variable compensation and a change in the timingof annual salary increases. The balance of the change in STAR expenses was due to an increase intechnical expenses of $3.5 million primarily associated with technical programs within ourdriveline and industrial oils additives packages.Other income was impacted favorably by $11.7 million primarily due to legal settlements ofinsurance and commercial matters as well as the gain on sale of certain properties.Segment operating income (revenues less expenses attributable to the product lines aggregatedwithin each segment) increased 15% in 2006 compared to the prior year due to the factors discussedabove.***2005 COMPARED WITH 2004***Segment revenues increased 14% in 2005 compared to 2004, due to a 12%improvement from the combination of price and product mix, and a 1% increase in both volume andcurrency.Volume patterns vary in different geographic zones. The following table shows our volume bygeographic zone in 2005 as well as the changes compared with 2004:           2005    Volume % Change North America  38%  (5%)Europe  31%  3%Asia-Pacific / Middle East  25%  9%Latin America  6%  2%         Total  100%  1%         Total volume increased 1% in 2005 compared to 2004. Our results reflect some spot business ortemporary business gains during 2005. This increase partially was offset by the final piece oflost business of a major international customer in the second half of 2004 and the impact onvolumes of the higher concentration associated with the new passenger car technical standard GF-4as compared to GF-3. Excluding these three specific factors, volume increased 3% globally and 1%in North America compared to 2004.Higher volume in Europe in 2005 compared with 2004 primarily was due to increases in our engineadditives product line due to improved product mix and market share gains. The Asia-Pacific /Middle East region benefited from
 

 
overall expanded growth in that market, particularly China, aswell as spot business gains. Excluding the spot business gains, volumes increased 5% inAsia-Pacific / Middle East.The Lubrizol Additives segment implemented a series of price increases in 2005 in response tocontinued raw material cost increases as well as higher prices for natural gas and electricity usedin our plants. The effective dates of the price increases varied by geographic zone.Segment gross profit increased $22.8 million, or 4%, in 2005 compared to 2004. The increaseprimarily was due to the cumulative impact of the selling price increases as well as an increase involume, largely offset by higher average raw material cost and to a lesser extent, higher utilitycosts. In 2005, average unit raw material cost increased 22% compared to 2004. Manufacturingexpenses increased 3% in 2005; however, on a per-unit-sold basis, manufacturing expenses increasedonly 1% as compared to the prior year. The increase in manufacturing expenses was driven by higherutilities and maintenance costs in 2005 partially offset by lower employee benefit expense andlower environmental accruals.Gross profit as a percentage of net sales for the segment was 23.3% for 2005 compared with 25.5% in2004. The decline primarily was due to the time lag between the effective date of selling priceincreases in the wake of continuing raw material cost increases and raw material costs risingproportionally faster than selling prices.STAR expenses decreased 1% in 2005 compared to 2004, primarily due to lower technical expenses of$3.1 million. The decrease in technical expenses primarily was due to lower outside technicalexpenses impacted by delays in the industry specifications for new lubricant additive programs.Segment operating income increased 11% in 2005 compared with 2004 due to the factors discussedabove.**LUBRIZOL ADVANCED MATERIALS SEGMENT*****2006 COMPARED WITH 2005***Revenues for the Lubrizol Advanced Materials segment increased 7% in 2006compared with 2005. The increase was due to a 6% increase in volume and a 1%improvement in the combination of price and product mix. The improvement in the combination ofprice and product mix primarily occurred in our Noveon consumer specialties product line.Volume patterns vary in different geographic zones. The following table shows our volume bygeographic zone in 2006 as well as the changes compared with 2005:           2006    Volume % Change North America  65%  1%Europe  18%  4%Asia-Pacific / Middle East  13%  28%Latin America  4%  32%         Total  100%  6%         Our engineered polymers and Noveon consumer specialties product lines both had increases involume in North America in 2006 compared to 2005. The increase in our engineered polymers productline was due to increased customer demand in both ourEstane® thermoplastic polyurethanebusiness (Estane) and ourTempRite® engineered polymers business (TempRite). TempRitebenefited from continued conversions from metals to plastics. The increase in the Noveon consumerspecialties product line primarily was due to increased customer demand in our personal care andhome care business and tolling sales to the buyer of our FIIS business. Our performance coatingsproduct line had
 

 
a slight decrease in volume in North America in 2006 compared to 2005, which webelieve primarily was due to the continued migration of the textile industry from North America toChina.Our engineered polymers and performance coatings product lines had increases in Europe in 2006compared to 2005. The increase in our performance coatings product line primarily was due tocustomer demand and market share gains in the textiles market and customer demand in the paints andcoatings market. The increase in our engineered polymers product line was due to market-sharegains in our Estane business and business gains in our TempRite business resulting from continuedconversions from metals to plastics. Our Noveon consumer specialties product line had a decreasein volume in Europe in 2006 compared to 2005 primarily attributableto our AMPS® specialtymonomers business. The increase in Asia-Pacific / Middle East volume for 2006primarily was due to higher customer demand and market-share gains in both our Estane business andperformance coatings product line, predominately in the textiles market, and higher customer demandin our Noveon consumer specialties product line. We also experienced higher customer demand in theTempRite business, particularly in the Middle East and India.Segment gross profit increased $22.2 million, or 6%, in 2006 compared to 2005. The increase insegment gross profit in 2006 primarily was the result of higher revenues due to the increase involume and improvement in the combination of price and product mix partially offset by higheraverage raw material cost and manufacturing costs. Average raw material cost increased 4% in 2006compared to 2005. Manufacturing costs primarily were higher due to increased utility costs, theimpact of reclassifying certain expenses from STAR to manufacturing as a result of a change inorganizational structure in our European operations and higher volume.The gross profit percentage for this segment was 28.7% in 2006 compared to 29.1% in 2005. Thedecrease in gross profit percentage in 2006 was due to higher average raw material cost partiallyoffset by an improvement in the combination of price and product mix.STAR expenses increased $9.0 million, or 4%, in 2006 compared to 2005. The increase in STAR wasdue to higher salaries and incentive compensation and increased hiring to support growthinitiatives partially offset by the impact of reclassifying certain expenses from STAR tomanufacturing as a result of a change in organizational structure in our European operations andreductions in bad debt expense.Segment operating income increased $16.7 million in 2006 compared to 2005. The increase in segmentoperating income primarily was due to the increase in segment gross profit as described above,partially offset by the increase in STAR expenses.***2005 COMPARED WITH 2004***In 2005, revenues for the Lubrizol Advanced Materials segment increased55% compared with 2004 primarily due to the 2004 acquisitions of Noveon International and thehyperdispersants business. Excluding the impact of acquisitions, segment revenues increased 6% in2005 compared with 2004 due to a 10% improvement in the combination of price and product mixpartially offset by a 4% decrease in volume. The improvements in price and product mix occurredrelatively evenly across all three of our product lines as we had implemented price increases tooffset rising raw material costs.
 

 
Volume patterns vary in different geographic zones. The following table shows our volume bygeographic zone in 2005 as well as the changes compared with 2004:                 Excluding the Impact  2005   of Acquisitions  Volume % Change % Change North America  68% 28% (7%)Europe  19% 40% 2%Asia-Pacific / Middle East  10% 44% (3%)Latin America  3% 32% —         Total  100% 31% (4%)         Excluding the impact of acquisitions, all three product lines showed volume decreases in NorthAmerica. These decreases primarily were due to our exiting certain low-margin business,deterioration in the textiles market and some market-share loss as a result of competitive activityin response to our price increases. The volume increase in Europe primarily was in our Noveonconsumer specialties product line and was due to increased sales in our AMPS specialty monomersbusiness.Segment gross profit increased $140.5 million, or 56% (increased $6.2 million, or 2%, excluding theimpact of acquisitions), in 2005 compared with 2004. Excluding the impact of acquisitions, theincrease in segment gross profit in 2005 resulted from higher revenues due to an improvement in thecombination of price and product mix partially offset by lower volume and higher raw material costsand utility expenses. Average raw material cost increased 12% in 2005 compared with 2004. Rawmaterial cost for 2004 included the impact of $7.5 million of inventory step-up amortization fromacquisition accounting. Excluding the impact of the step-up in 2004, average raw material costincreased 13% in 2005 compared with 2004. Manufacturing expenses increased 9% in 2005 comparedwith 2004 primarily due to higher spending related to utilities. Average unit manufacturingexpense increased 14% due to the combination of lower volumes and higher utility and operatingexpenses.Gross profit as a percentage of net sales was 29.1% (28.0% excluding the impact of acquisitions) in2005 compared with 29.0% in 2004. Excluding the impact of the inventory step-up amortization, thegross profit percentage for 2004 was 29.8%. The decrease in gross profit percentage in 2005 wasdue to higher average raw material cost and higher manufacturing costs partially offset by animprovement in the combination of price and product mix.STAR expenses increased $62.9 million, or 40%, in 2005 (decreased $11.4 million, or 7%, excludingthe impact of acquisitions) compared with 2004. Excluding the impact of acquisitions, the decreasein STAR expenses primarily was due to reduced corporate administrative and technical servicesprovided to the segment, the consolidation of some segment administrative functions into corporatefunctions and savings from a restructuring in our performance coatings product line.Segment operating income increased $72.3 million in 2005 (increased $18.1 million, excluding theimpact of acquisitions) compared with segment operating income of $78.6 million in 2004. Excludingthe impact of acquisitions, the increase in segment operating income primarily was due to theincrease in segment gross profit and lower STAR expenses.**RETURN ON AVERAGE SHAREHOLDERS’ EQUITY**Return on average shareholders’ equity was 6.5% in 2006, 12.2% in 2005 and 7.6% in 2004. Thereturn on average shareholders’ equity is calculated as current year net income divided by therolling 12-month average of shareholders’ equity for the current and prior years. The earnings(loss) impact of discontinued operations, restructuring and
 

 
impairment charges and the write-off of acquired IPR&D in 2004 lowered the return on averageshareholders’ equity by approximately 5.6%, 0.8% and 4.7% in 2006, 2005 and 2004, respectively.**WORKING CAPITAL, LIQUIDITY AND CAPITAL RESOURCES****SELECTED MEASURES OF LIQUIDITY AND CAPITAL RESOURCES**The following table summarizes ourfinancial performance indicators of liquidity:           2006 2005 Cash and short-term investments (in millions of dollars) $575.7  $262.4 Working capital (in millions of dollars) $1,204.3  $907.4 Current ratio  2.9   2.4 Debt as a % of capitalization  47.5%  51.6%Net debt as a % of capitalization  36.1%  47.3% **SUMMARY OF CASH FLOWS**The following table summarizes the major components of cash flows:             *(In Millions of Dollars)* 2006  2005  2004  Cash provided by (used for):            Operating activities $334.8  $362.2  $331.6 Investing activities  151.4   (106.8)  (1,088.8)Financing activities  (183.9)  (312.8)  808.5 Effect of exchange-rate changes on cash  11.0   (16.1)  25.9           Net increase (decrease) in cash and short-term investments $313.3  $(73.5) $77.2           OPERATING ACTIVITIESThe decrease in cash provided by operating activities in 2006 compared with 2005 primarily relatesto a decrease in payables and accrued expenses, including the payment of accounts payable ofapproximately $27.0 million that were retained at the closing of the FIIS divestiture andunfavorable timing of accounts payable disbursements in 2006 compared to 2005. In addition, weexperienced higher inventory levels due to increased raw material costs, as well as an increase infinished goods inventory caused by lower year-end shipment volumes.We manage our levels of inventories and accounts receivable on the basis of average days sales ininventory and average days sales in receivables. We establish our target for accounts receivableby taking into consideration the weighted average of our various terms of trade for each segment.We establish our target for days sales in inventory with the goal of minimizing our investment ininventories while at the same time ensuring adequate supply for our customers. Despite theincrease in working capital due to higher average selling price and higher inventory costs, weimproved our days outstanding in accounts receivable and days in inventory.INVESTING ACTIVITIESOur capital expenditures in 2006 were $130.9 million, as compared with $136.7 million and $133.2million in 2005 and 2004, respectively. Capital expenditures for the Lubrizol Additives segmentprimarily are made to maintain existing manufacturing capacity. Approximately 30% of the capitalexpenditures in the Lubrizol Advanced Materials segment related to increasing capacity. In 2007,we estimate annual capital expenditures will be approximately $175.0 million to $180.0 million.The higher level of estimated capital expenditures in 2007 is driven by our plans to
 

 
build production capacity for our Lubrizol Advanced Materials product lines in China, North Americaand Europe to meet growing demand, as well as to bring both segments onto a common information systemsplatform.The sales of FIIS and A&I were completed on May 1, 2006 and May 23, 2006, respectively. Inconsideration for these divested businesses, we received net cash proceeds of approximately $254.8million and $10.4 million, respectively. The FIIS sale resulted in a taxable gain, which wasoffset by our remaining net operating loss carryforwards. The sale of Telene was completed inFebruary 2006 for net cash proceeds of $6.2 million.FINANCING ACTIVITIESCash used for financing activities of $183.9 million in 2006 primarily consisted of repayments oflong-term debt and the payment of dividends, partially offset by proceeds from the exercise ofstock options. This compares to $312.8 million used for financing activities in 2005, whichprimarily consisted of net repayments of long-term debt of $280.4 million and the payment ofdividends, partially offset by borrowings under our euro revolving credit facility and proceedsfrom the exercise of stock options.Other than the €85.0 million outstanding under our euro revolving credit facility, we have no otherdebt that is prepayable without incurring a penalty.CAPITALIZATION AND CREDIT FACILITIESAt December 31, 2006, our total debt outstanding of $1,541.7 million consisted of 67% fixed-ratedebt and 33% variable-rate debt, including $400.0 million of fixed-rate debt that effectively hasbeen swapped to a variable rate. Our weighted-average interest rate as of December 31, 2006 wasapproximately 5.8%.Our net debt to capitalization ratio at December 31, 2006 was 36.1%. Net debt represents totalshort-term and long-term debt, excluding original issue discounts and unrealized gains and losseson derivative instruments designated as fair-value hedges of fixed-rate debt, reduced by cash andshort-term investments. Capitalization is calculated as shareholders’ equity plus net debt. Totaldebt as a percent of capitalization was 47.5% at December 31, 2006.Our ratio of current assets to current liabilities was 2.9 and 2.4 at December 31, 2006 and 2005,respectively.On September 20, 2006, we amended our five-year unsecured committed U.S. bank credit agreement toreduce the revolving credit facility from $500.0 million to $350.0 million and extend the maturitydate to September 2011. In addition, as of September 20, 2006, our direct and indirect domesticsubsidiaries were released as guarantors under the credit agreement, and we no longer are subjectto any investment or acquisition restrictions. This credit facility allows us to borrow atvariable rates based upon the U.S. prime rate or LIBOR plus a specified credit spread. As ofDecember 31, 2006, we had no outstanding borrowings under this agreement.In addition, at December 31, 2006, two of our wholly owned foreign subsidiaries had a €250.0million revolving credit facility that matures in September 2010. This credit agreement permitsthese foreignsubsidiaries to borrow at variable rates based on EURIBOR plus a specified credit spread. We haveguaranteed all obligations of the borrowers under the credit agreement. On September 20, 2006, weamended this credit agreement such that we no longer are subject to any investment or acquisitionrestrictions. No other terms or conditions of the agreement were modified. As of December 31,2006, we had outstanding borrowings of €85.0 million under this agreement.The cash balance of $575.7 million at December 31, 2006 will be used to fund ongoing operations,pay down debt, pursue acquisition opportunities and buy back shares sufficient to offset futuredilution from our stock-based incentive compensation plans. Given the call premium on ourlong-term debt, it is unlikely that we will reduce debt significantly before our next scheduledmaturity in late 2008. Therefore, it is possible that we will carry excess cash until our nextscheduled maturity.
 

 
CONTRACTUAL CASH OBLIGATIONSThe following table shows our contractual cash obligations under debt agreements, leases,non-cancelable purchase commitments and other long-term liabilities at December 31, 2006:                       Payments Due by Period *(In Millions of Dollars)* Total  2007  2008 - 2009  2010 - 2011  2012 and After  Total debt (1) $1,549.1  $3.7  $582.6  $112.7  $850.1 Interest (2)  954.6   80.9   150.1   103.0   620.6 Operating leases  62.3   17.1   23.0   13.6   8.6 Non-cancelable purchase commitments (3)  178.0   77.9   86.6   9.2   4.3 Other long-term liabilities (4)(5)  88.8   64.1   8.6   0.6   15.5                 Total contractual cash obligations $2,832.8  $243.7  $850.9  $239.1  $1,499.1                  (1) Total debt includes both the current and long-term portions of debt as reported in Note7 to the consolidated financial statements, excluding original issue discounts andunrealized gains on derivative instruments designated as fair-value hedges of fixed-ratedebt. (2) Represents estimated contractual interest payments for fixed-rate debt only. We arenot able to estimate reasonably the cash payments for interest associated withvariable-rate debt due to the significant estimation required relating to both marketinterest rates as well as projected principal payments. (3) Non-cancelable purchase commitments primarily include raw materials purchased undertake-or-pay contracts, drumming, warehousing and service contracts, utility purchaseagreements, terminal agreements and toll processing arrangements. (4) Other long-term liabilities disclosed in the table represent long-term liabilitiesreported in our consolidated balance sheet at December 31, 2006 under “noncurrentliabilities,” excluding pension, postretirement, postemployment, environmental and othernon-contractual liabilities. (5) We are required to make minimum contributions to our U.S. defined benefit pension planspursuant to the minimum funding requirements of the Internal Revenue Code of 1986, asamended, and the Employee Retirement Income Security Act of 1974, as amended. Fundingrequirements for plans outside the United States are subject to applicable localregulations. In 2007, we expect to make employer contributions of approximately $57.7million to the qualified plans to satisfy these minimum statutory funding requirements. In2007, we expect to make payments of approximately $1.8 million relating to our unfundedpension plans. The expected payments associated with the unfunded plans represent anactuarial estimate of future assumed payments based upon retirement and payment patterns.Actual amounts paid could differ from this estimate. In addition, non-pensionpostretirement benefit payments are expected to approximate $4.6 million in 2007. We haveincluded these expected contributions of $64.1 million in the above table. Due touncertainties regarding significant assumptions involved in estimating future requiredcontributions to our defined benefit pension and other plans, such as interest rate levels,the amount and timing of asset returns and future restructurings, if any, we are not ableto reasonably estimate our contributions beyond 2007.In addition, at December 31, 2006, we had $45.7 million of contingent obligations understandby letters of credit issued in the ordinary course of business to financial institutions,customers and insurance companies to secure short-term support for a variety of commercialtransactions, insurance and benefit programs.We had $1,541.7 million of debt outstanding at December 31, 2006 compared to $1,670.8 millionoutstanding at December 31, 2005. Our total debt as a percent of capitalization has decreased from51.6% at December 31, 2005 to 47.5% at December 31, 2006. We believe our future operating cashflows will be sufficient to cover our debt repayments, other contractual obligations, capitalexpenditures and dividends. In addition, we have untapped borrowing capacity that can provide uswith additional financial resources. We currently have a shelf registration statement filed withthe Securities and Exchange Commission (SEC) under which $359.8 million of debt securities,preferred shares or common shares may be issued. In addition, as of December 31, 2006, wemaintained cash and short-term investment balances of $575.7 million and had $304.3 millionavailable under our U.S. revolving credit facility and €165.0 million available under our eurorevolving credit facility.
 

 
GUARANTEESOn May 1, 2006, we sold the FIIS business to SPM Group Holdings, LLC, now known as EmeraldPerformance Materials, LLC (Emerald). As a result of the sale, Emerald became responsible for asupplier contract with SK Corporation (SK). We have provided a guarantee to SK for the timelyperformance of Emerald’s payment obligations. SK may make a demand for payment of outstandingobligations under this guarantee, which extends to January 31, 2008, provided they are unable tocollect payment from Emerald using commercially reasonable efforts. The guarantee is revocable byus upon 60 days’ prior written notice. Because of the existing revocation clause, we estimate thatthe maximum liability under the guarantee would be approximately $15.2 million. However, webelieve that it is highly unlikely that an event would occur requiring us to pay any moniespursuant to the guarantee. Accordingly, no liability has beenreflected in our consolidated balance sheet at December 31, 2006.INDEMNIFICATIONSIn connection with the sale of the FIIS business, we have provided indemnifications to Emerald withrespect to the business sold. These indemnifications have been associated with the price andquantity of raw material purchases, permit costs, costs incurred due to the inability to obtainpermits and environmental matters. We believe that losses incurred in any of these matters wouldnot have a material effect on our business, financial condition or results of operations. Forthose indemnification agreements where a payment by us is probable and estimable, a liability hasbeen recorded as of December 31, 2006.**CRITICAL ACCOUNTING POLICIES**The preparation of financial statements and related disclosures in accordance with accountingprinciples generally accepted in the United States of America requires us to make judgments,assumptions and estimates at a specific point in time that affect the amounts reported in theaccompanying consolidated financial statements and related notes. In preparing these financialstatements, we have utilized available information including our past history, industry standardsand the current economic environment, among other factors, in forming our estimates and judgmentsof certain amounts included in the consolidated financial statements, giving due consideration tomateriality. It is possible that the ultimate outcome as anticipated by management in formulatingour estimates inherent in these financial statements may not materialize. Application of thecritical accounting policies described belowinvolves the exercise of judgment and the use of assumptions as to future uncertainties and,as a result, actual results could differ from these estimates. In addition, other companies mayutilize different estimates, which may impact the comparability of our results of operations tosimilar businesses.ACCOUNTING FOR RESERVES AND CONTINGENCIESOur accounting policies for reserves and contingencies cover a wide variety of business activities,including reserves for potentially uncollectible receivables, slow-moving or obsolete inventory,legal and environmental exposures and tax exposures. We accrue these reserves when our assessmentsindicate that it is probable that a liability has been incurred or an asset will not be recoveredand an amount can be reasonably estimated. We review these estimates quarterly based on currentlyavailable information. Actual results may differ from our estimates and our estimates may berevised upward or downward, depending upon the outcome or changed expectations based on the factssurrounding each exposure. We discuss annually with the audit committee of our board of directorsour reserves and contingencies, as well as our policies and processes for evaluating them.ACCOUNTING FOR SALES DISCOUNTS AND REBATESSales discounts and rebates are offered to certain customers to promote customer loyalty and toencourage greater product sales. These rebate programs provide that upon the attainment ofpre-established volumes or the attainment of revenue milestones for a specified period, thecustomer receives credits against purchases. We estimate the provision for
 

 
rebates based upon the specific terms in each agreement at the time of shipment and an estimate ofthe customer’s achievement of the respective revenue milestones. Customer claims, returns andallowances and discounts are accrued based upon our history of claims and sales returns andallowances. The estimated provisions significantly could be affected if future occurrences andclaims differ from these assumptions and historical trends.DETERMINATION OF NET PERIODIC PENSION COSTEach year we review with our actuaries the actuarial assumptions used in the determination of netperiodic pension cost, as prescribed by SFAS No. 87, “Employers Accounting for Pensions.” Thedetermination of net periodic pension cost is based upon a number of actuarial assumptions. Thetwo most critical assumptions are the expected return on plan assets and the discount rate fordetermining the funded status. Other assumptions include the rate of compensation increase anddemographic factors such as retirement age, mortality and turnover. We review the criticalassumptions for our U.S. pension plans with the audit committee of our board of directors. Our netperiodic pension cost for all pension plans was $49.8 million in 2006, $40.9 million in 2005 and$34.9 million in 2004. The net periodic pension cost included a settlement loss of $2.9 million,$0.3 million and $7.7 million in 2006, 2005 and 2004, respectively. In accordance with generallyaccepted accounting principles, actual results that differ from the assumptions are accumulated andamortized over future periods and, therefore, affect expense recognized and obligations recorded infuture periods.In developing our assumption for the expected long-term rate of return on plan assets, weconsidered historical returns and the future expectations for returns for each asset class, as wellas the target asset allocation of the pension portfolio. In 2006, we lowered our assumption forthe U.S. pension plans by 25 basis points to 8.25% (7.48% on a weighted-average basis for allplans) based on our investment mix and projected market conditions. We believe 8.25% represents areasonable return that could be achieved over the long term using our current asset allocation. AtDecember 31, 2006, our U.S. pension plans’ assets had an investment mix that approximated 73% inequity securities and 27% in debt securities.A change in the rate of return of 100 basis points would have the following effects on 2007 netperiodic pension cost:           100 Basis Point *(In Millions of Dollars)* Increase  Decrease  U.S. pension plans $(2.7) $2.7 International pension plans  (1.9)  1.9        All pension plans $(4.6) $4.6        The selection of a discount rate for pension plans is required to determine the value offuture pension obligations and represents our best estimate of our cost in the marketplace tosettle all pension obligations through annuity purchases. We determined the discount rate basedupon current market indicators, including yields from dedicated bond portfolios that provide for ageneral matching of bond maturities with the projected benefit cash flows from our plans. Thededicated bond portfolios consist of non-callable corporate bonds that are at least AA- quality.The 2006 year-end discount rate assumption for our U.S. pension plans was set at 6.25%, which is anincrease from 5.75% used in 2005. On a worldwide basis, the 2006 weighted-average discount rateutilized increased to 5.67% from 5.28% used in 2005.A change in the discount rate of 100 basis points would have the following effects on 2007 netperiodic pension cost:
 

 
           100 Basis Point *(In Millions of Dollars)* Increase  Decrease  U.S. pension plans $(3.0) $7.0 International pension plans  (5.2)  3.4        All pension plans $(8.2) $10.4        The accumulated benefit obligation for all pension plans worldwide exceeds the value of planassets by $67.1 million. This represents a $45.5 million improvement in funded status from the$112.6 million in the total unfunded accumulated benefit obligation reported in 2005. Theaccumulated benefit obligation exceeded the plan assets for the U.S. pension plans by $30.3 millionand the non-U.S. plans by $36.8 million in 2006. The primary driver behind the $45.5 milliondecrease in the unfunded benefit obligations was a result of favorable investment returns during2006.Changes in pension plan assumptions are expected to decrease pension expense for most pension plansworldwide in 2007. The 2007 pension expense is expected to be approximately $40.2 million,excluding the impact of any settlement charges. The expected decrease in pension expense in 2007,excluding the impact of settlement charges, primarily is due to an increase in expected returns onassets due to the increase in fair value of plan assets at December 31, 2006, a reduction in theamortization of actuarial losses and the increase in the discount rate for all plans, offset by anincrease in interest cost associated with an increase in the projected benefit obligation.DETERMINATION OF POSTRETIREMENT BENEFIT COSTAnnually, we review with our actuaries the key economic assumptions used in calculatingpostretirement benefit cost as prescribed by SFAS No. 106, “Employers’ Accounting forPostretirement Benefits Other than Pensions.” Postretirement benefits include health care and lifeinsurance plans. The determination of postretirement benefit cost is based upon a number ofactuarial assumptions, including the discount rate for determining the accumulated postretirementbenefit obligation, the assumed health care cost trend rates and the ultimate health care trendrate. Except for the U.S. plans, the same discount rate selected for the pension plans generallyis used for calculating the postretirement benefit obligation by country. Net non-pensionpostretirement benefit (credit) cost was ($1.1) million in 2006, $2.4 million in 2005 and $5.8million in 2004.A change in the discount rate of 100 basis points would have the following effects on 2007postretirement benefit cost:           100 Basis Point *(In Millions of Dollars)* Increase  Decrease  U.S. pension plans $(0.4) $0.4 International pension plans  (0.1)  0.1        All pension plans $(0.5) $0.5        A change in the assumed health care cost trend rate of 100 basis points would have thefollowing effects on 2007 postretirement benefit cost:           100 Basis Point *(In Millions of Dollars)* Increase  Decrease  U.S. postretirement plans $1.1  $(1.0)International postretirement plans  0.3   (0.2)       All postretirement plans $1.4  $(1.2)       
 

 
ACCOUNTING FOR BUSINESS COMBINATIONSWe allocate the purchase price of business combinations to assets acquired and liabilities assumedbased on their relative fair value at the date of acquisition pursuant to the provisions of SFASNo. 141, “Business Combinations.” In estimating the fair value of the tangible and intangibleassets and liabilities acquired, we consider information obtained during our due diligence processand utilize various valuation methods including market prices, where available, appraisals,comparisons to transactions for similar assets and liabilities and present value of estimatedfuture cash flows. We are required to make subjective estimates in connection with thesevaluations and allocations.ACCOUNTING FOR IMPAIRMENT OF LONG-LIVED ASSETSWe review the carrying value of our long-lived assets, including property and equipment, wheneverevents or changes in circumstances indicate that the carrying value of the assets may not berecoverable. An impairment loss exists when estimated undiscounted future cash flows expected toresult from the use of the asset, including disposition, are less than the carrying value of theasset. The measurement of the impairment loss to be recognized is based on the difference betweenthe fair value and the carrying amounts of the assets. Fair value isgenerally is determined basedupon a discounted cash flow analysis. In order to determine if an asset has been impaired, assetsare grouped and tested at the lowest level for which identifiable, independent, cash flows areavailable.The determination of both undiscounted and discounted cash flows requires us to make significantestimates and considers the expected course of action at the balance sheet date. Subsequentchanges in estimated undiscounted and discounted cash flows arising from changes in anticipatedactions could impact the determination of whether an impairment exists, the amount of theimpairment charge recorded and whether the effects could materially impact our consolidatedfinancial statements.DISCONTINUED OPERATIONS The results of a component of our business that either has been disposed of or is classified asheld for sale are reported in discontinued operations in accordance with the requirements of SFASNo. 144. We classify a component of our business as held for sale if it meets the followingcriteria as of each balance sheet date: **•** We commit to a plan to sell the disposal group.  **•** The disposal group is available for immediate sale in its present condition, subjectonly to the terms that are usual and customary for sales of such disposal groups.  **•** An active program to locate a buyer and other actions required to complete the plan tosell have been initiated.  **•** The sale of the disposal group is probable and the transfer is expected to qualify forrecognition as a completed sale within one year.  **•** The disposal group is being marketed actively for sale at a price that is reasonable inrelation to its current fair value.  **•** Actions necessary to complete the plan indicate that it is unlikely that significantchanges to the plan will be made or that the plan will be withdrawn.The results of operations of all entities that have been disposed of or are classified as held forsale have been classified in the (loss) income from discontinued operations — net of tax line itemin the consolidated statements of income forall periods presented. The 2006, 2005 and 2004 cash flow statements are presented on aconsolidated basis, including both continuing operations and discontinued operations.
 

 
ACCOUNTING FOR IMPAIRMENT OF GOODWILL AND INTANGIBLE ASSETSGoodwill represents the excess of purchase price and related costs over the value assigned to thenet tangible and identifiable intangible assets of businesses acquired. In accordance with SFASNo. 142, “Goodwill and Other Intangible Assets,” goodwill is to be tested annually and betweenannual tests if events occur or circumstances change that would more likely than not reduce thefair value of an operating segment below its carrying amount. We have elected October 1 as theannual evaluation date to test for potential goodwill impairment. The annual goodwill impairmenttest requires us to make a number of assumptions and estimates concerning future levels of earningsand cash flow, which are based upon our strategic plans. The combination of a discounted cash flowanalysis and terminal value model is used to determine the fair value of each reporting unit.While we use available information to prepare estimates and to perform the impairment evaluation,actual results could differ significantly resulting in future impairment and losses related torecorded goodwill balances. No impairment of goodwill was identified in the annual impairment testcompleted in 2006. (See Note 6 to the consolidated financial statements.)Intangible assets resulting from business acquisitions, including customer lists, purchasedtechnology, trademarks, patents, land-use rights and non-compete agreements, are amortized on astraight-line method over periods ranging from 3 to 40 years. Under SFAS No. 142, intangibleassets determined to have indefinite lives are not amortized, but are tested for impairment atleast annually. We have elected October 1 as the annual evaluation date to test for potentialimpairment of indefinite lived intangible assets. The combination of a discounted cash flowanalysis and terminal value model is used to determine whether the fair value of an intangibleasset exceeds its carrying amount. As part of the annual impairment test, the non-amortizedintangible assets are reviewed to determine if the indefinite status remains appropriate.We completed a corporate identity review in the fourth quarter of 2006 and made a finaldetermination in January 2007 that the trade name “Noveon” no longer would be used to describe thespecialty chemicals business segment of our company and that its use would be discontinued exceptin connection with the consumer specialties product line. As a result, an impairment charge forthe Noveon trade name was recognized in accordance with SFAS No. 142. We calculated a pretaxcharge of $41.2 million ($25.4 million after-tax) to reduce the related asset to its estimated fairvalue. This charge was reflected in the fourth quarter of 2006 as we believed at that time wewould more likely than not discontinue the use of the Noveon trade name, except in the limitedcontext of the consumer specialties product line.ASSET-RETIREMENT OBLIGATIONSWe account for asset retirement obligations in accordance with SFAS No. 143, “Accounting for AssetRetirement Obligations” and Financial Accounting Standards Board (FASB) Interpretation (FIN) No.47, “Accounting for Conditional Asset-Retirement Obligations — an interpretation of FASB StatementNo. 143.” FIN No. 47 requires the recognition of a liability for the fair value of a legalobligation to perform asset-retirement obligations (AROs) that are conditional on a future event ifthe amount can be reasonably estimated. We have identified AROs related to certain of our leasedfacilities and to asbestos remediation activities that may be required at other company-ownedfacilities in the future. We record liabilities for AROs at the time that they are identified andwhen they can be reasonably estimated. Due to the long-term, productive nature of some of ourmanufacturing operations, absent plans or expectation of plans to initiate asset retirementactivities, we are unable to reasonably estimate the fair value of such asbestos remediationliabilities since the potential settlement dates cannot be determined at this time.NEW ACCOUNTING STANDARDS**SFASNo. 158**In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pensionand Other Postretirement Plans — an amendment of FASB Statements No. 87, 88, 106, and 132(R).”This statement requires an
 

 
employer to recognize a plan’s funded status in its statement offinancial position, measure a plan’s assets and obligations as of the end of the employer’s fiscalyear and recognize the changes in a plan’s funded status in comprehensive income in the year inwhich the changes occur. SFAS No. 158’s requirement to recognize a plan’s funded status and newdisclosure requirements are effective for us as of December 31, 2006. The requirement to measureplan assets and benefit obligations as of the date of our fiscal year-end statement of financialposition is effective for fiscal years ending after December 15, 2008. Currently, we measure planassets and benefit obligations as of the date of our fiscal year-end. We adopted the requiredprovisions of SFAS No. 158 on December 31, 2006.The incremental effects of adopting SFAS No. 158 on our consolidated balance sheet at December 31,2006 were as follows:               Balance Before     Balance After  Applying SFAS No. 158 Applying  SFAS No. 158 Adjustments SFAS No. 158   Current assets:            Other current assets $104.9  $(6.9) $98.0 Noncurrent assets:            Other assets $61.0  $1.0  $62.0 Intangible assets — net $326.6  $(3.8) $322.8              Total assets $4,395.9  $(9.7) $4,386.2              Current liabilities:            Accrued expenses and other current liabilities $286.8  $1.0  $287.8 Noncurrent liabilities:            Pension obligations $130.1  $88.4  $218.5 Other postretirement benefit obligations $96.3  $(14.3) $82.0 Deferred income taxes $116.2  $(27.3) $88.9              Total liabilities $2,578.3  $47.8  $2,626.1              Accumulated other comprehensive income (loss) $4.6  $(57.5) $(52.9)              Total shareholders’ equity $1,764.9  $(57.5) $1,707.4 **SFASNo. 157**In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This statement definesfair value, establishes a framework for measuring fair value in accordance with generally acceptedaccounting principles (GAAP) and expands disclosure about fair value measurements. SFAS No. 157does not expand the use of fair value measures in financial statements, but simplifies and codifiesrelated guidance within GAAP. SFAS No. 157 establishes a fair value hierarchy using observablemarket data as the highest level and an entity’s own fair value assumptions as the lowest level.SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 and interim periodswithin those years. SFAS No. 157 requires adoption prospectively as of the beginning of the fiscalyear in which this statement is initially applied, with the exception of certain financialinstruments in which adoption is applied retrospectively as of the beginning of the fiscal year inwhich this statement is initially applied. We currently are evaluating the impact of this recentlyissued standard on our consolidated financial statements.**SABNo. 108**In September 2006, the SEC released Staff Accounting Bulletin (SAB) No. 108, “Considering theEffects of Prior Year Misstatements when Quantifying Misstatements in Current Year FinancialStatements.” This bulletin provides
 

 
guidance on how the effects of prior-year uncorrectedfinancial statement misstatements should be considered in quantifying a current-year misstatement.SAB No. 108 requires registrants to quantify misstatements using both an income statement(rollover) and balance sheet (iron curtain) approach and evaluate whether either approach resultsin a misstatement that, when all relevant quantitative and qualitative factors are considered, ismaterial. If prior-year errors that previously had been considered immaterial now are consideredmaterial based on either approach, no restatement is required so long as management properlyapplied its previous approach and all relevant facts and circumstances were considered. If prioryears are not restated, a cumulative-effect adjustment is recorded in opening accumulated earningsas of the beginning of the fiscal year of adoption. SAB No. 108 is effective for us for the fiscalyear ending December 31, 2006. Our adoption of this standard did not have an impact on ourconsolidated financial statements.**FINNo. 48**In July 2006, the FASB issued FIN No. 48, “Accounting for Uncertainty in Income Taxes,” thatprescribes a recognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken in a tax return. UnderFIN No. 48, a contingent tax asset only will be recognized if it is more likely than not that a taxposition ultimately will be sustained. After this threshold is met, a tax position is reported atthe largest amount of benefit that is more likely than not to be realized. FIN No. 48 alsoprovides guidance on derecognition, classification, interest and penalties, accounting in interimperiods and disclosure. FIN No. 48 is effective for fiscal years beginning after December 15,2006. FIN No. 48 requires the cumulative effect of applying the provisions to be reportedseparately as an adjustment to the opening balance of retained earnings in the year of adoption.We currently are evaluating the impact of this recently issued Interpretation on our consolidatedfinancial statements.**SFASNo. 154**In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections.” Thisstandard establishes new standards on accounting for changes in accounting principles. Pursuant tothe new rules, all such changes must be accounted for by retrospective application to the financialstatements of prior periods unless it is impracticable to do so. SFAS No. 154 completely replacesAccounting Principles Board (APB) Opinion No. 20, “Accounting Changes,” and SFAS No. 3, “ReportingAccounting Changes in Interim Financial Statements,” though it carries forward the guidance inthose pronouncements with respect to accounting for changes in estimates, changes in the reportingentity and the correction of errors. This statement is effective for accounting changes andcorrections of errors beginning January 1, 2006. Our adoption of this standard did not have amaterial impact on our consolidated financial statements.**SFASNo. 123R**In December 2004, the FASB issued SFAS No. 123R. This standard requires compensation costs relatedto share-based payment transactions to be recognized in the financial statements. With limitedexceptions, the amount of compensation cost is measured based on the grant-date fair value of theequity or liability instruments issued. In addition, liability awards are remeasured eachreporting period. Compensation cost is recognized over the period that an employee providesservice in exchange for the award. This standard replaces SFAS No. 123, “Accounting forStock-Based Compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued toEmployees,” and applies to all awards granted, modified, repurchased or cancelled after July 1,2005. In April 2005, the SEC amended the compliance date of SFAS No. 123R through an amendment ofRegulation S-X. We adopted SFAS No. 123R on January 1, 2006. The adoption of SFAS No. 123Rincrementally increased before-tax compensation expense by approximately $2.4 million during 2006.**SFASNo. 151**In November 2004, the FASB issued SFAS No. 151, “Inventory Costs,” to clarify the accounting forabnormal amounts of idle facility expense, freight, handling costs and wasted material. Thisstandard requires that such items be recognized as current-period charges. The standard alsoestablishes the concept of “normal capacity” and requires the allocation of fixed-productionoverhead to inventory based on the normal capacity of the production facilities. Any
 

 
unallocatedoverhead must be recognized as an expense in the period incurred. This standard was effective forinventory costs incurred beginning January 1, 2006. The adoption of this standard did not have amaterial impact on our consolidated financial statements.**CAUTIONARY STATEMENTS FOR SAFE HARBOR PURPOSES**This Management’s Discussion and Analysis of Financial Condition and Results of Operations containsforward-looking statements within the meaning of the federal securities laws. As a general matter,forward-looking statements are those focused upon future plans, objectives or performance asopposed to historical items and include statements of anticipated events or trends and expectationsand beliefs relating to matters not historical in nature. Forward-looking statements are subjectto uncertainties and factors relating to our operations and business environment, all of which aredifficult to predict and many of which are beyond our control. These uncertainties and factorscould cause our actual results to differ materially from those matters expressed in or implied byany forward-looking statements, although we believe our expectations reflected in thoseforward-looking statements are based upon reasonable assumptions. For this purpose, any statementscontained herein that are not statements of historical fact should be deemed to be forward-lookingstatements.We believe that the following factors, among others, could affect our future performance and causeour actual results to differ materially from those expressed or implied by forward-lookingstatements made in this annual report:**•** The cost, availability and quality of raw materials, especially petroleum-based products. **•** Our ability to sustain profitability of our products in a competitive environment. **•** The demand for our products as influenced by factors such as the global economic environment, longer-term technologydevelopments and the success of our commercial development programs. **•** The risks of conducting business in foreign countries, including the effects of fluctuations in currency exchange ratesupon our consolidated results and political, social, economic and regulatory factors. **•** The extent to which we are successful in expanding our business in new and existing markets and in identifying,understanding and managing the risks inherent in those markets. **•** The effect of required principal and interest payments on our ability to fund capital expenditures and acquisitions andto meet operating needs. **•** Our ability to identify, complete and integrate acquisitions for profitable growth and operating efficiencies. **•** Our success at continuing to develop proprietary technology to meet or exceed new industry performance standards andindividual customer expectations. **•** Our ability to implement a new common information systems platform primarily into our Lubrizol Advanced Materialssegment successfully, including the management of project costs, its timely completion and realization of its benefits. **•** Our ability to continue to reduce complexities and conversion costs and modify our cost structure to maintain andenhance our competitiveness. **•** Our success in retaining and growing the business that we have with our largest customers. **•** The cost and availability of energy, especially natural gas and electricity. **•** The effect of interest rate fluctuations on our net interest expense. **•** The risk of weather-related disruptions to our Lubrizol Additives production facilities located near the U.S. Gulfcoast.
 

 
**•** Significant changes in government regulations affecting environmental compliance.**QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**We operate manufacturing and blending facilities, laboratories and offices around the world andutilize fixed-rate and variable-rate debt to finance our global operations. As a result, we aresubject to business risks inherent in non-U.S. activities, including political and economicuncertainties, import and export limitations, and market risks related to changes in interest ratesand foreign currency exchange rates. We believe the political and economic risks related to ourforeign operations are mitigated due to the stability of the countries in which our largest foreignoperations are located.In the normal course of business, we use derivative financial instruments including interest rateand commodity hedges and forward foreign currency exchange contracts to manage our market risks.Our objective in managing our exposure to changes in interest rates is to limit the impact of suchchanges on our earnings and cash flow. Our objective in managing the exposure to changes inforeign currency exchange rates is to reduce volatility on our earnings and cash flow associatedwith such changes. Our principal currency exposures are the euro, the pound sterling, the Japaneseyen and certain Latin American currencies. Our objective in managing our exposure to changes incommodity prices is to reduce the volatility on earnings of utility expense. We do not holdderivatives for trading purposes.We measure our market risk related to our holdings of financial instruments based on changes ininterest rates, foreign currency rates and commodity prices utilizing a sensitivity analysis. Thesensitivity analysis measures the potential loss in fair value, cash flow and earnings based on ahypothetical 10% change (increase and decrease) in interest, currency exchange rates and commodityprices. We use current market rates on our debt and derivative portfolios to perform thesensitivity analysis. Certain items such as lease contracts, insurance contracts and obligationsfor pension and other postretirement benefits are not included in the analysis.Our primary interest rate exposures relate to our cash and short-term investments, fixed-rate andvariable-rate debt and interest rate swaps. The calculation of potential loss in fair value isbased on an immediate change in the net present values of our interest rate-sensitive exposuresresulting from a 10% change in interest rates. The potential loss in cash flow and income beforetax is based on the change in the net interest income/expense over a one-year period due to animmediate 10% change in rates. A hypothetical 10% increase in interest rates would have had afavorable impact and a hypothetical 10% decrease in interest rates would have had an unfavorableimpact on fair values of $41.1 million and $42.7 million at December 31, 2006 and 2005,respectively. In addition, a hypothetical 10% increase in interest rates would have had anunfavorable impact and a hypothetical 10% decrease in interest rates would have had a favorableimpact on cash flows and income before tax of $1.6 million and $1.8 million in 2006 and 2005,respectively.Our primary currency exchange rate exposures are to foreign currency-denominated debt, intercompanydebt, cash and short-term investments and forward foreign currency exchange contracts. Thecalculation of potential loss in fair value is based on an immediate change in the U.S. dollarequivalent balances of our currency exposures due to a 10% shift in exchange rates. The potentialloss in cash flow and income before tax is based on the change in cash flow and income before taxover a one-year period resulting from an immediate 10% change in currency exchange rates. Ahypothetical 10% increase in currency exchange rates would have had an unfavorable impact and ahypothetical 10% decrease in currency exchange rates would have had a favorable impact on fairvalues of $3.5 million at December 31, 2006. In addition, a hypothetical 10% increase in currencyexchange rates would have had a favorable impact and a hypothetical 10% decrease in currencyexchange rates would have had an unfavorable impact on fair values of $6.8million at December 31, 2005. Further, a hypothetical 10% increase in currency exchange rateswould have had an unfavorable impact and a hypothetical 10% decrease in currency exchange rateswould have had a favorable impact on cash flows of $21.1 million and $21.4 million and on incomebefore tax of $4.0 million and $4.4 million in 2006 and 2005, respectively.
 

 
Our primary commodity hedge exposures relate to natural gas and electric utility expenses. Thecalculation of potential loss in fair value is based on an immediate change in the U.S. dollarequivalent balances of our commodity exposures due to a 10% shift in the underlying commodityprices. The potential loss in cash flow and income before tax is based on the change in cash flowand income before tax over a one-year period resulting from an immediate 10% change in commodityprices. A hypothetical 10% increase in commodity prices would have had a favorable impact and ahypothetical 10% decrease in commodity prices would have had an unfavorable impact on fair values,cash flows and income before tax of $1.3 million and $0.9 million in 2006 and 2005, respectively.
 

 
**MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING**The management of The Lubrizol Corporation and its subsidiaries (the Company) is responsible forestablishing and maintaining adequate internal control over financial reporting. The LubrizolCorporation’s internal control system was designed to provide reasonable assurance to the Company’smanagement and board of directors regarding the preparation and fair presentation of publishedfinancial statements.All internal control systems, no matter how well designed, have inherent limitations. Therefore,even those systems determined to be effective can provide only reasonable assurance with respect tofinancial statement preparation and presentation.The Lubrizol Corporation’s management assessed the effectiveness of the Company’s internal controlover financial reporting as of December 31, 2006. In making this assessment, management used thecriteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO)in *Internal Control—Integrated Framework.*Based on this assessment, management believes that, asof December 31, 2006, the Company’s internal control over financial reporting is effective based onthose criteria.Management’s assessment of the effectiveness of internal control over financial reporting as ofDecember 31, 2006 has been audited by Deloitte & Touche LLP, an independent registered publicaccounting firm, who expressed an unqualified opinion as stated in their report, a copy of which isincluded in this annual report. /s/ James L. Hambrick