Discussion

      The majority of this segment's sales and operating earnings are derived from technologies to control pollution from mobile sources, including gasoline- and diesel-powered passenger cars, sport-utility vehicles, trucks, buses and off-road vehicles.

      Sales increased primarily from the addition of higher pass-through substrate costs of $32.2 million, an estimated 2% increase in worldwide production of light-duty vehicles and higher volumes in both OEM and retrofit diesel markets. Higher sales were reduced by $15.8 million on lower volumes of emission-control systems for gas turbines used in power-generation applications and by $7.8 million on lower volumes to the surface coatings markets.

      Operating earnings decreased primarily from higher expenses of $11.4 million associated with rework for power-generation applications, higher depreciation, depletion and amortization costs of $5.5 million, a manufacturing consolidation charge of $3.1 million recorded in 2002 and higher research and development costs of $3.0 million.

Outlook

      This segment expects growth in sales and operating earnings as emission-control regulations become stricter around the world and address a much broader range of emission sources. Demand from the automotive market is expected to remain strong in response to the Company's development of several new technologies. Although auto builds are forecasted to be down slightly in 2003, ongoing productivity improvements and increased demand in Asia are expected to support modest growth in this portion of the segment. A significant decline in auto builds could have an unfavorable effect on this segment, depending on the demand for platforms where the segment provides catalysts.

      Stationary source comparisons are expected to be unfavorable for catalysts for emission-control systems for gas turbines used in peak-power-generation applications from higher sales a year ago and a decline in demand. Demand is expected to remain soft for technologies related to peak-power-generation due to the current lack of funding for these projects.

       Sales of advanced catalysts for medium- and heavy-duty diesel trucks increased in the second half of 2002 and are expected to expand in 2003 as new regulations begin to take effect. Investment in research for medium- and heavy-duty diesel continues at an accelerated pace in anticipation of more stringent regulations scheduled to begin phasing in during 2005 and 2007.

       This segment continues to work to reduce its reliance on the automotive market by developing an array of applications not only for medium-and heavy-duty diesel markets, but also for non-automotive markets, including technologies for motorcycles; small engines, such as lawn and garden power equipment; charbroilers; mining and construction; and ozone management.

2001 compared with 2000

      Sales increased 2% to $646.7 million, and operating earnings increased 22% to $142.4 million. Excluding the impact of special and other charges of $15.4 million in 2000, operating earnings increased 8%.

Discussion (excluding the impact of special and other charges in 2000)

      Sales and operating earnings from technologies to control pollution from mobile sources increased 3% and 8%, respectively. In spite of a 5% decline in production of light-duty vehicles in both North America and Europe, earnings increased primarily from higher volumes of auto-emission catalysts in North America.

      Sales and earnings also were favorably impacted by strength in the segment's non-automotive markets, primarily from increased volumes of emission-control systems for gas turbines used in peak-power-generation. These increases were partly offset by the absence of operating earnings of $5.2 million from the segment's metal-joining products business sold in September 2000 and $1.1 million from the segment's silver nitrate business sold in February 2001. Excluding the results of these dispositions, sales and operating earnings would have increased 9% and 14%, respectively.

Process Technologies

      The Process Technologies segment enables customers to make their processes more productive, efficient, environmentally sound and safer through the supply of advanced chemical-process catalysts, additives and sorbents.

2002 Performance

      Sales decreased 5% to $538.8 million, and operating earnings decreased 1% to $93.0 million.

Discussion

      Sales and operating earnings were lower in 2002 primarily from lower volumes to the chemical-process and petroleum-refining markets. These decreases were partially offset by increased demand for Lynx 1000 (trademark) polypropylene catalysts, NaphthaMax (trademark) refining catalysts and petroleum-refining additives which aggregated $37.2 million, plus the full-year inclusion of the fats and oils catalyst business acquired from Sud Chemie in October 2001 and the introduction of a new gas-to-liquids catalyst in 2002. Sales also were reduced by $17.6 million due to lower precious metal prices, which are passed through to chemical-process catalyst customers in Europe.

      Operating earnings were favorably impacted by lower energy and raw material costs of $6.3 million, the elimination of goodwill amortization of $3.6 million related to the adoption of Statement of Financial Accounting Standards No. 142 (SFAS No. 142), "Goodwill and Other Intangible Assets," full-year inclusion of results from the fats and oils catalyst business acquired from Sud Chemie in October 2001 of $2.5 million and favorable impact of foreign exchange of $1.6 million.

Outlook

      Sales and earnings growth in this segment are expected to come from custom process catalysts such as those that enable conversion of gas-to-liquids; high value-add petroleum refining catalysts (primarily NaphthaMax (trademark) and FlexTec (trademark)); petroleum refining additives; and increased market penetration for polypropylene catalysts. Continued cost management, productivity improvements and product technology advances will also contribute to earnings growth. Capacity expansion of a polyolefin catalyst plant will come online in 2003. Overall weakness in the chemical-process market and relatively flat demand in the petroleum refining market are expected to continue for most of 2003.

2001 compared with 2000

      Sales of $568.2 million in 2001 were essentially unchanged compared with the same period in 2000, and operating earnings increased 16% to $94.3 million. Excluding the impact of special and other charges of $5.5 million in 2000, operating earnings increased 9%.

Discussion (excluding the impact of special and other charges in 2000)

      Sales were unchanged compared with 2000 as higher volumes to chemical-process and petroleum-refining markets were offset by significantly lower precious metal prices, which are passed through to chemical-process catalyst customers in Europe. Excluding the impact of these pass-through metal costs, sales would have increased 8% on higher volumes and prices. The higher volumes were driven by strong demand for Lynx 1000 (trademark) catalyst used in the production of polypropylene and NaphthaMax (trademark), which enables petroleum refiners to increase gasoline yields.

      The increase in operating earnings was driven primarily from higher sales volumes that favorably impacted earnings by $7 million, reduced costs from productivity improvements of $5 million, the full-year inclusion of results from the polyolefin catalyst business of Targor GmbH acquired in September 2000 and moderate price increases of $2 million. Earnings in 2001 were held back by higher energy and raw material costs of $9 million.

Appearance and Performance Technologies

      The Appearance and Performance Technologies segment provides pigments, effect materials and performance additives that enable its customers to market enhanced image and functionality in their products. This segment serves a broad array of end markets including coatings, plastics, cosmetics, construction and paper. This segment's products help customers improve the look, performance and overall cost of their products. This segment is also the internal supply source of precursors for some of the Company's advanced refining-process catalysts.

2002 Performance

      Sales increased 3% to $650.8 million, and operating earnings increased 87% to $87.1 million.

Discussion

      Sales and operating earnings were up primarily from increased sales volumes to the coatings, automotive, agricultural, cosmetics/personal care and plastics markets. Operating earnings were also favorably impacted by lower costs from productivity improvements of $21.5 million, the elimination of goodwill amortization of $5.7 million related to the adoption of SFAS No. 142, "Goodwill and Other Intangible Assets," lower energy costs of $4.6 million, the recording of a $7.1 million charge in 2001 relating to asset redeployment actions and productivity initiatives, and selective price increases in the paper market in the range of three to four percent.

Outlook

      Earnings growth within this segment is expected to increase at more normal rates as compared to the exceptional growth experienced in 2002, which was driven by modest sales increases and significant productivity improvements, compared to weak results reported in 2001.

      Sales growth is expected to be somewhat improved over the prior year as slow economic recovery is expected in most of the major markets served. Sales to the paper market are expected to increase gradually with earnings again being favorably impacted by industry-wide price increases and continued productivity improvements. Higher natural gas costs could have an unfavorable impact on earnings. Efforts to focus on higher value end markets and customers for kaolin-based technologies will continue to be a priority.

      Sales and earnings to other major markets served, including coatings, cosmetics/personal care, automotive and agriculture, are expected to grow from ongoing new product development and new market applications plus market diversification opportunities through expansion of the segment's technology bases. Productivity improvement opportunities throughout the business will continue to be an important driver of increased earnings.

2001 compared with 2000

      Sales decreased 7% to $634.4 million, and operating earnings increased 52% to $46.5 million. Excluding the impact of special and other charges of $49.7 million in 2000, operating earnings decreased 42%.

Discussion (excluding the impact of special and other charges in 2000)

      Declines in this segment's sales and operating earnings resulted from weak end markets and significantly higher energy costs of $11.8 million. Most notable was the paper market, where weak pigment demand and industry overcapacity kept prices at depressed levels. Markets for special-effect materials were mixed as lower volumes for technologies used in automotive finishes were partially offset by higher demand for those utilized in cosmetics.

Materials Services

      The Materials Services segment serves the Company's technology segments, their customers and others with precious and base metals and related services. This is a distribution and materials services business that purchases and sells precious metals, base metals and related products and services. It does so under a variety of pricing and delivery arrangements structured to meet the logistical, financial and price-risk management requirements of the Company, its customers and suppliers. Additionally, it offers the related services of precious-metal refining and storage and produces salts and solutions.

2002 Performance

      Sales decreased 43% to $1.8 billion, and operating earnings decreased 6% to $52.7 million.

Discussion

      Sales for this segment include substantially all of the Company's sales of metals to industrial customers of all segments. Sales also include fees invoiced for services rendered (e.g., refining and handling charges). Because of the logistical and hedging nature of much of this business and the significant precious metal values included in both sales and cost of sales, gross margins tend to be low in relation to the Company's other technology businesses as does capital employed. This effect also dampens the gross margin percentages of the Company as a whole, but improves the return on investment.

      While most customers for the Company's platinum-group-metal catalysts purchase the metal from Materials Services, some choose to deliver metal from other sources prior to the manufacture of the catalysts. In such cases, precious metal values are not included in sales. The mix of such arrangements and the extent of market price fluctuations can significantly affect the reported level of sales and cost of sales. Consequently, there is no direct correlation between year-to-year changes in reported sales and operating earnings.

      Operating earnings were down as a result of lower volumes and lower results from the recycling (refining) of platinum group metals of $11.0 million. Operating earnings in both years were favorably affected by several items that triggered recognition of events reflecting operations from prior periods. In 2002, operating earnings were favorably impacted by $22.0 million of income related to platinum-group-metal transactions realized previously but deferred pending the resolution of certain contractual provisions, an insurance settlement gain ($11.0 million), the receipt of cash related to the settlement of litigation for a customer receivable recorded in 1997 that was previously written off ($3.0 million) and $5.5 million from the realization of a previously unrecognized contractual benefit. In 2001, operating earnings were favorably impacted by the recovery of metal from an unexpected industrial customer bankruptcy ($6.2 million) and the restructuring of a professional services contract ($3.3 million). Sales decreased from lower platinum-group-metal prices and lower volumes.

Outlook

      The results of this segment are likely to be below recent historical levels rather than the exceptional results reported in 2000 and the higher levels of 2001. Overall weakness projected in the basic industrial markets will adversely impact the recycling and refining of platinum group metals, as well as the volume of metal sales. Uncertainty also exists with respect to the volume and customer mix impact of a change in producer channels to market. While a sustainable level of base business is anticipated, the benefits of potential market volatility combined with other market factors represents an upside for this segment. Volatility not only increases the spreads on transactions, but also provides opportunities to benefit from strong and prudent physical positions (see the "Commodity Price Risk" section on page 28 for further details).

2001 compared with 2000

      Sales decreased 11% to $3.2 billion, and operating earnings decreased 57% to $56.1 million.

Discussion

      Operating earnings and sales were down due to significantly lower platinum-group-metal prices and lower volumes. The decrease in earnings was partially offset by increased earnings in the recycling (refining) of platinum group metals of $7.1 million and the reversal of certain expense accruals that are no longer necessary due to the recovery of metal from an unexpected industrial customer bankruptcy ($6.2 million) and the restructuring of a professional services contract ($3.3 million).

Acquisitions

Consolidated Gross Profit

      Gross profit as a percentage of sales was 17.4% in 2002, compared with 13.0% in 2001 and 13.2% in 2000. The increase in 2002 was primarily related to a $1.3 billion decrease in sales from lower precious metal prices. The decrease in 2001 was primarily driven by lower margins earned in the Materials Services segment. Sales from this segment decreased 11% in 2001 to $3.2 billion and provided a gross profit of 3%, while 2001 sales from all other reportable segments decreased 2% to $1.8 billion and provided a gross profit of 31%. As described earlier, the lower margins on Materials Services sales are driven by the inclusion of the value of precious metals in both sales and cost of sales.

Selling, Administrative and Other Expenses

      Selling, administrative and other expenses were $350.1 million in 2002, compared to $336.0 million in 2001 and $382.3 million in 2000. The increase in 2002 was primarily due to increased information technology expenses of $5.7 million, increased research and development expenses of $3.9 million, increased administrative rent expenses of $2.6 million and increased professional fees of $2.4 million. The decrease in 2001 was primarily due to the absence of special and other charges of $23.8 million reported in 2000 and lower compensation costs.

Equity Earnings

      Absent the impairment charge discussed below, equity in earnings of affiliates was $16.2 million in 2002, compared with equity earnings of $29.1 million in 2001 and $24.2 million in 2000. The decrease was primarily from lower earnings from Engelhard-CLAL, a 50%-owned precious-metal-fabrication joint venture, from gains reported in the prior year related to a change in the mix of platinum group metals used in its operations and lower volumes due to the absence of divested business units. The increase in 2001 was primarily due to higher earnings from Engelhard-CLAL primarily on gains related to a change in the mix of platinum group metals used in its operations. Higher equity earnings were also reported in 2001 for Heesung-Engelhard, a 49%-owned environmental catalyst joint venture in South Korea.

      In the third quarter of 2002, the Company recorded an impairment charge of $57.7 million associated with its Engelhard-CLAL joint venture (see Note 9, "Investments," for further detail).

Loss/Gain on Investments, Net

      In the second quarter of 2002, the Company recorded an impairment charge of $6.7 million ($4.1 million after tax) associated with its Plug Power Inc. investment (see Note 9, "Investments," for further detail).

      In the first quarter of 2000, the Company recorded a loss of $6.0 million ($4.1 million after tax) associated with the divestiture of the International Dioxide, Inc. business unit.

      In the third quarter of 2000, the Company sold its metal-joining products business located in Warwick, Rhode Island and recorded a gain of $24.8 million ($17.0 million after tax).

Interest

      Interest expense was $27.4 million in 2002, compared with $47.3 million in 2001 and $64.8 million in 2000. Interest expense in 2002 and 2001 decreased due to decreased borrowings and lower short-term interest rates.

      Interest income was $2.0 million in 2002, $3.3 million in 2001 and $2.1 million in 2000.

      The Company capitalized interest of $3.0 million in 2002 and 2001, and $3.9 million in 2000.

Taxes

      The worldwide income tax expense was $66.5 million in 2002, compared with $79.7 million in 2001 and $77.4 million in 2000. The effective income tax rate was 22.5% in 2002 (excluding the equity investment impairment of $57.7 million), 26.1% in 2001 and 31.5% in 2000.

       The decrease in the worldwide effective tax rate in 2002 was primarily the result of higher percentage depletion deductions. Additionally, the rate was favorably impacted by the recognition of foreign tax items and research and development tax credits in excess of previous estimates, and a shift in the geographical mix of earnings. The decrease in the worldwide effective tax rate in 2001 was primarily due to the recognition of foreign tax credits generated in previous years and the recognition of favorable tax variances from the foreign sales corporation and percentage depletion deductions (see Note 13, "Income Taxes," for further detail of variances).

      Net deferred tax assets are more likely than not realizable. Their utilization is dependent upon the ability to generate the appropriate types of income (e.g., foreign source income) in the periods in which temporary differences turnaround or in periods prior to the expiration of applicable carryforward items.

Financial Condition and Liquidity

      Working capital was $179.8 million at December 31, 2002, compared with a deficit of $7.1 million at December 31, 2001. The current ratio was 1.1 in 2002 and 1.0 in 2001. The year-end market value of the Company's precious metals accounted for under the LIFO method exceeded carrying cost by $58.3 million at December 31, 2002, compared with $111.1 million at December 31, 2001. The decrease in excess value reflects lower market values and the impact of slightly reduced inventory levels (See Note 7, "Inventories," for further detail).

      The Company's total debt decreased to $596.6 million at December 31, 2002 from $626.9 million at December 31, 2001. The percentage of total debt to total capitalization decreased to 36% at December 31, 2002 from 38% at December 31, 2001, primarily due to decreased borrowings and increased retained earnings.

      The Company currently has a $400 million, five-year committed credit facility that expires in May 2006 and a $400 million, 364-day committed credit facility that expires in May 2003, with a group of major U.S. and overseas banks. Unused, uncommitted lines of credit were $471 million at December 31, 2002.

      The Company has filed a shelf registration for $300 million of corporate debt. Plans to issue long-term debt in 2003 are under consideration by management.

      Operating activities provided net cash of $302.3 million in 2002 compared with $345.8 million in 2001 and $180.1 million in 2000. The variance in cash flows from operating activities primarily occurred in the Materials Services segment and reflects changes in metal positions used to facilitate requirements of the Company, its metal customers and suppliers (see Note 23, "Supplemental Information," for Materials Services variances). Materials Services routinely enters into a variety of arrangements for the sourcing of metals. Generally, transactions are hedged on a daily basis (see Note 1, "Summary of Significant Accounting Policies," for further detail). Hedging is accomplished primarily through forward, future and option contracts. However, in closely monitored situations for which exposure levels have been set by senior management, the Company from time to time holds large unhedged industrial commodity positions that are subject to future market price fluctuations. These positions are included in committed metal positions along with hedged metal holdings. The bulk of hedged metal obligations represent spot short positions. As these positions generate cash, their cash effect is included in the financing activities section of the Company's "Consolidated Statements of Cash Flows." Other than in closely monitored situations, these positions are hedged with forward purchases. In addition, the aggregate fair value of derivatives in a loss position are reported in hedged metal obligations (derivatives in a gain position are included in committed metal positions). Materials Services works to ensure that the Company and its customers have an uninterrupted source of metals, primarily platinum group metals, utilizing supply contracts and commodities markets around the world. Committed metal positions include significant advances made for the purchase of precious metals that have been delivered to the Company but for which the final purchase price has not yet been determined (see discussion in "Credit Risk" section on page 22 for further detail).

      The variance in cash flows from investing activities is primarily related to changes in capital expenditures, proceeds received from the sale of the Company's metal-joining products business in September 2000, the acquisition of certain operating assets of Shuozhou Anpeak Kaolin Co., Ltd. in November 2002, the acquisition of the fats and oils catalyst business of Sud Chemie in October 2001 and the acquisition of the Targor polyolefin catalyst business in September 2000.

      The variance in cash flows from financing activities was impacted by the repayment of long-term debt in 2001 and 2000, cash received from the exercise of stock options, particularly in 2001, a change in hedged metal obligations in 2000 and increased purchases of treasury stock in 2002 and 2001.

      The following table represents the Company's contractual obligations as of December 31, 2002:

      In the normal course of business, the Company incurs obligations with regard to contract completion and product performance. Under certain circumstances, these obligations are supported through the issuance of letters of credit. At December 31, 2002, the aggregate outstanding amount of letters of credit supporting such obligations amounted to $132.3 million, of which $122.7 million will expire in less than one year (of which $80.0 million will not be renewed), $1.3 million will expire in two to three years, $0.2 million will expire in four to five years, and $8.1 million will expire after five years. In the opinion of management, such obligations will not significantly affect the Company's financial position or results of operations as the Company anticipates fulfilling its performance obligations.

      At December 31, 2002, the Company did not have any guarantees of any unconsolidated subsidiary obligations.

      The Company has consistently derived considerable cash flow from operations, which has been used, along with both short- and long-term debt, to pay for capital expenditures, acquisitions, dividends and other corporate requirements. The continuation of these levels of cash flow is expected, but is subject to the risk factors listed elsewhere in this report (particularly in the Forward-Looking Statements section on page 26). In addition, the Company has always maintained investment-grade credit ratings that it considers important for cost-effective and ready access to the credit markets. Management fully expects to be able to obtain future funding from both short- and long-term debt for cash requirements in excess of cash flow from operations. In the event that any of these sources prove to be below expectations, the Company has access to committed lines of credit aggregating $800 million as of December 31, 2002. Management intends to renew $400 million of this committed line of credit that expires in May 2003.

Credit Risk

      The Company believes that its financial instruments do not represent a concentration of credit risk because the Company deals with a variety of major banks worldwide and its accounts receivable are spread among a number of major industries, customers and geographic areas. A centralized credit committee reviews significant credit transactions and risk-management issues before granting of credit, and an appropriate level of reserves is maintained. In addition, the Company monitors the financial condition of its customers to help ensure collections and to minimize losses.

      The Company may enter into transactions in which it advances funds after receipt of metal as provisional payment for the metal which is to be finally priced under market-based pricing formulae that will result in a determination of that price. If the final price is less than the provisional price paid, the supplier will be obligated to return the difference to the Company. Therefore, if the market price (and the anticipated final price) falls below the provisional price, the Company is exposed to the potential credit risk associated with the possibility of non-payment by the supplier, although no payment is due until after the final price is determined. As of December 31, 2002, the aggregate market value of metals purchased under a contract for which a provisional price had been paid had fallen below the amounts advanced by a total of $332.2 million. This excess may grow or may be eliminated based on market price changes. In March 2003 an agreement was reached that, when performed, including receipt of cash by the Company which is anticipated before the end of the second quarter, will result in the elimination of this excess. The Company expects that no loss will be incurred due to non-performance.

Capital Expenditures, Commitments and Contingencies

      Capital projects are designed to maintain capacity, expand operations, improve efficiency or protect the environment. Capital expenditures amounted to $113.3 million in 2002, $168.9 million in 2001 and $136.6 million in 2000. Capital expenditures in 2003 are expected to be approximately $140.0 million. For information about commitments and contingencies, see Note 20, "Environmental Costs" and Note 21, "Litigation and Contingencies."

Dividends and Capital Stock

      The annualized common stock dividend rate at the end of 2002, 2001 and 2000 was $0.40 per share.

Japan Fraud Update/Peru Update

      See Note 21, "Litigation and Contingencies," for a discussion of Japan and Peru.

Special and Other Charges

      See Note 5, "Special and Other Charges," for a discussion of the Company's special and other charges.

Other Matters

      See Note 1, "Summary of Significant Accounting Policies," for a discussion of new accounting pronouncements.

Critical Accounting Policies

      Certain key policies are explained below to assist in understanding the Company's consolidated financial statements. More detailed explanations may be found elsewhere in the MD&A section and in Note 1, "Summary of Significant Accounting Policies."

Sales

      A significant portion of consolidated net sales represent the sale of platinum group metals to industrial customers who buy the metals from Materials Services in connection with products manufactured by the Environmental and Process Technologies segments. Accordingly, almost all of these sales are reported in the Materials Services segment, with a limited amount included in Environmental and Process Technologies' reported sales. Because metal price levels may vary widely, there is no consistent relationship between consolidated sales and gross profit.

      Because the timing of the purchase of spot metals often does not coincide with the timing of the subsequent sales to industrial users, Materials Services needs to hedge price risk, usually by selling forward (i.e., for future delivery) to investment-grade trading entities, industrial companies or on futures exchanges. If a surplus of physical metal develops, Materials Services may also sell spot and buy forward to balance the risk position. Other than hedges entered into with industrial customers, sales related to these hedging transactions are not included in reported sales, as they are not meaningful in an industrial context.

      Customers of the Environmental and Process Technologies segments who purchase products that improve efficiency and yields are often unable to precisely predict the dates that catalysts will be required. Accordingly, they may request that product that has already been ordered, manufactured and prepared for shipment at the agreed upon date be temporarily held by the Company until that customer's manufacturing facility is prepared to accept the new charge of catalyst. In cases where the customer requests the Company to hold the goods, agrees to be invoiced and to pay the invoices on normal terms as well as to accept title to the goods, the Company will recognize the sale prior to shipment. Great care is exercised to make sure that these sales are only recognized in accordance with the applicable revenue recognition guidance.

Mark-to-market

      Materials Services procures physical metal from third parties for resale and enters into forward contracts and other relatively straight-forward hedging derivatives that are recorded as either assets or liabilities at their fair value. By acting in its capacity as a distributor and materials service provider to the Company's technology businesses and their customers and by taking closely monitored unhedged positions as described below, Materials Services takes on the attributes of a dealer in metals. Both spot metal and derivative instruments used in hedging (i.e., forwards, futures, swaps and options) are stated at fair value. The Company values platinum, palladium, gold and silver based on the daily closing NYMEX settlement prices. There are no so-called "terminal" markets for rhodium, ruthenium and iridium, so the Company's own published Industrial Bullion (EIB) prices are used. However, these are compared to other reference prices published in Metals Week, an independent trade journal. Values for base metals come from the closing prices of the LME (London Metals Exchange).

      In closely monitored situations, for which exposure levels and transaction size limits have been set by senior management, the Company holds unhedged metal positions that are subject to future market fluctuations. Such positions may include varying levels of derivative instruments. At times, these positions can be significant. All unhedged metal transactions are monitored and marked to market daily. The portion of this metal that has not been hedged is therefore subject to price risk and is disclosed in Note 10, "Committed Metal Positions and Hedged Metal Obligations."

      The fair values of Materials Services' various spot and derivative positions are included in committed metal positions on the asset side of the Consolidated Balance Sheet and hedged metal obligations on the liability side. The credit (performance) risk associated with the fair value of derivatives in a gain position is greatly mitigated through the selection of investment-grade counterparties.

Precious metals

      Most of the platinum group metals used by Environmental and Process Technologies to manufacture products are provided in advance by the customers. The customers often purchase these metals from Materials Services, but they may also be shipped in from other sources.

      Certain quantities of precious metals are carried at historical cost using the LIFO method, which provides a better matching of current costs with current revenues. Because most of the metal was acquired some time ago, the market value of this metal, while fluctuating from year to year, has generally been substantially above cost. While this excess of market over cost is useful in evaluating the consolidated balance sheet from a credit perspective, the annual changes are not reflected in the income statement except to the extent that periodic liquidations of LIFO layers produce book profits. LIFO liquidation profits are separately disclosed and not included in the operating earnings of the technology segments.

Kaolin mining operations

      In order to provide kaolin-based products to the Company's customers and the Process Technologies segment, the Company engages in kaolin mining operations that are integrated into the manufacturing processes. The Company owns and leases land containing kaolin deposits on a long-term basis. The Company does not own any mining reserves or conduct any mining operations with respect to platinum, palladium or other metals. The kaolin mining process includes exploration, topsoil and overburden removal, extraction of kaolin and the subsequent reclamation of mined areas. In order to match the costs of the mining process with revenues associated with kaolin-based products, certain mining process costs are expensed by the Company over the life of the related estimated mineable reserves.

Pensions and other postretirement/postemployment costs

      The Company's employee pension and other postretirement/postemployment benefit costs and obligations are dependent on its assumptions used by actuaries in calculating such amounts. These assumptions include discount rates, salary growth, expected returns on plan assets, retirement rates, mortality rates and other factors. The discount rate assumption is based on investment yields available at the Company's measurement date of September 30 on AA-rated corporate long-term bond yields. The salary growth assumptions reflect our long-term actual experience, the near-term outlook and assumed inflation. The health care cost trend assumptions are developed based on historical cost data, the near-term outlook, and an assessment of likely long-term trends. Retirement rates are based primarily on actual plan experience. Mortality rates are based on published data. Actual results that differ from our assumptions are accumulated and amortized over future periods and, therefore, generally affect recognized expense and recorded obligation in such future periods. While we believe that the assumptions used are appropriate, significant differences in actual experience or significant changes in assumptions would affect our pension and other postretirement/postemployment benefit costs and obligations. Based on a review of the current environment, we have lowered our long-term rate of return assumption from 10% in 2001 to 9.7% in 2002. In 2003, we have further lowered this assumption to 8.9%. The Company has determined that its net pension cost is projected to be approximately $19 million in 2003, compared to $12 million in 2002 and $8 million in 2001. The plan assets have earned a rate of return substantially less than 10% in the last two years. Should this trend continue, the Company would be required to reconsider its assumed expected rate of return on plan assets. If the Company were to lower this rate, future pension expense would likely increase. See Note 15, "Benefits," for further detail regarding costs and assumptions.

Forward-Looking Statements

      This document contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to analyses and other information that are based on forecasts of future results and estimates of amounts not yet determinable. These statements also relate to the future prospects, developments and business strategies. These forward-looking statements are identified by their use of terms and phrases such as "anticipate," "believe," "could," "estimate," "expect," "intend," "may," "plan," "predict," "project," "will" and similar terms and phrases, including references to assumptions. These forward-looking statements involve risks and uncertainties that may cause the Company's actual future activities and results of operations to be materially different from those suggested or described in this document.

      Among the risks and uncertainties that could cause actual results to differ materially are the following:

• competitive pricing or product development activities that could affect the demand for our products, particularly competing catalyst and kaolin producers
  
• the Company's ability to achieve and execute internal business plans
  
• worldwide political instability as the Company operates primarily in the United States, the European community, the Asia-Pacific region, the Russian Federation, South Africa and South America
  
• alliances and geographic expansions developing differently than anticipated
  
• fluctuations in the supply and prices of precious and base metals and fluctuations in the relationships between forward prices to spot prices
  
• government legislation and/or regulation (particularly on environmental issues), including tax obligations
  
• technology, manufacturing and legal issues
  
• the impact of any economic downturns and inflation
  
• interest rate risk, foreign currency exchange rate risk, commodity price risk and credit risk (these are discussed further in the Company's MD&A section)
  
• the impact of higher energy and raw material costs, and the availability of natural gas and rare earth elements
  
• the success of research and development activities and the speed with which regulatory authorizations and product launches may be achieved
  
• the impact of increased health care costs and/or the resultant impact on employee relations
  
• contingencies related to actual or alleged environmental contamination to which the Company may be a party
  
• the impact of acquisitions, divestitures and restructurings
  
• overall demand for the Company's products, including demand from the worldwide automotive and chemical-process markets
  
• product quality/performance issues
• exposure to product liability and other types of lawsuits
  
• the impact of physical inventory losses, particularly with regard to precious and base metals
  
• the loss of business from property and casualty exposure

      Investors are cautioned not to place undue reliance upon these forward-looking statements, which speak only as of their dates. The Company disclaims any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Market Risk Sensitive Transactions

      The Company is exposed to market risks arising from adverse changes in interest rates, foreign currency exchange rates and commodity prices. In the normal course of business, the Company uses a variety of techniques and instruments, including derivatives, as part of its overall risk management strategy. The Company enters into derivative agreements with a diverse group of major financial and other institutions with individually determined credit limits to reduce exposure to the risk of nonperformance by counterparties.

Interest rate risk

      The Company uses a sensitivity analysis to assess the market risk of its debt-related financial instruments and derivatives. Market risk is defined here as the potential change in the fair value of debt resulting from an adverse movement in interest rates. The fair value of the Company's total debt was $616.6 million at December 31, 2002 and $624.8 million at December 31, 2001 based on average market quotations of price and yields provided by investment banks. A 100 basis-point increase in interest rates could result in a reduction in the fair value of total debt of $18.8 million at December 31, 2002 compared with $17.7 million at December 31, 2001.

      The Company also uses interest rate derivatives to help achieve its fixed and floating rate debt objectives. In 2001, the Company entered into two interest rate swap agreements with a total notional value of $100 million to effectively change a fixed rate debt obligation into a floating rate obligation. The total notional amount of these agreements is equal to the face value of the designated debt instrument. The swap agreements are expected to settle in August 2006, the maturity date of the corresponding debt issuance.

      Approximately 76% and 78% of the Company's borrowings had variable interest rates as of December 31, 2002 and 2001, respectively.

Foreign currency exchange rate risk

      The Company uses a variety of strategies, including foreign currency forward contracts, to minimize or eliminate foreign currency exchange rate risk associated with substantially all of its foreign currency transactions, including metal-related transactions denominated in other than U.S. dollars.

      The Company uses a sensitivity analysis to assess the market risk associated with its foreign currency transactions. Market risk is defined here as the potential change in fair value resulting from an adverse movement in foreign currency exchange rates. A 10% adverse movement in foreign currency rates could result in a net loss of $13.3 million at December 31, 2002 compared with $8.6 million at December 31, 2001 on the Company's foreign currency forward contracts. However, since the Company limits the use of foreign currency derivatives to the hedging of contractual and anticipated foreign currency payables and receivables, this loss in fair value for those instruments generally would be offset by a gain in the value of the underlying payable or receivable.

      A 10% adverse movement in foreign currency rates could result in an unrealized loss of $40.9 million at December 31, 2002 compared with $48.6 million at December 31, 2001 on the Company's net investment in foreign subsidiaries and affiliates. However, since the Company views these investments as long term, the Company would not expect such a loss to be realized in the near term.

Commodity price risk

      In closely monitored situations, for which exposure levels and transaction size limits have been set by senior management, the Company from time to time holds large, unhedged industrial commodity positions that are subject to market price fluctuations. Such positions may include varying levels of derivative commodity instruments. All unhedged industrial commodity transactions are monitored and marked to market daily. All other industrial commodity transactions are hedged on a daily basis, using forward, future, option or swap contracts to substantially eliminate the exposure to price risk. These positions are also marked to market daily.

      The Company performed a "value-at-risk" analysis on all of its metal-related commodity assets and liabilities. The "value-at-risk" calculation is a statistical model that uses historical price and volatility data to predict market risk on a one-day interval with a 95% confidence level. While the "value-at-risk" models are relatively sophisticated, the quantitative information generated is limited by the historical information used in the calculation. For example, the volatility in the platinum and palladium markets in 2001 and 2000 was greater than historical norms. Therefore, the Company uses this model only as a supplement to other risk management tools and not as a substitute for the experience and judgment of senior management and dealers who have extensive knowledge of the markets and adjust positions and revise strategies as the markets change. Based on the "value-at-risk" analysis in the context of a 95% confidence level, the maximum potential one-day loss in fair value was approximately $6.0 million as of December 31, 2002 compared with $3.4 million as of December 31, 2001. The actual one-day changes in fair value of the Company's metal-related commodity assets and liabilities never exceeded the average of the "value-at-risk" amounts as of the yearly open and close for each of the Company's 2002 and 2001 fiscal years.

      The Company is also exposed to commodity price risk related to its purchase of natural gas that is used in the manufacture of its products. At December 31, 2002, a uniform one-dollar increase in the price of natural gas would result in a decrease in operating earnings of approximately $10.5 million for the year ending December 31, 2003.

ENGELHARD CORPORATION
CONSOLIDATED STATEMENTS OF EARNINGS

See accompanying Notes to Consolidated Financial Statements.