UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

 

 

Commission file number: 001-32312

 

Novelis Inc.

(Exact name of registrant as specified in its charter)

 

 

 

Telephone: (404) 814-4200

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer o      Accelerated filer o     Non-accelerated filer þ

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

As of September 30, 2006, the registrant had 74,006,375 common shares outstanding.

 

 

 

TABLE OF CONTENTS

 

 

Novelis Inc.

 

CONDENSED CONSOLIDATED AND COMBINED STATEMENTS OF INCOME (LOSS) AND

COMPREHENSIVE INCOME (LOSS) (unaudited)

(in millions, except per share amounts)

 

 

The accompanying notes to the condensed consolidated and combined financial statements

are an integral part of these condensed statements.

Novelis Inc.

CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited)

(in millions, except number of shares)

 

 

The accompanying notes to the condensed consolidated and combined financial statements

are an integral part of these condensed balance sheets.

Novelis Inc.

 

CONDENSED CONSOLIDATED AND COMBINED STATEMENTS OF CASH FLOWS (unaudited)

(in millions)

 

Novelis Inc.

 

CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY (unaudited)

(in millions, except number of common shares, which is in thousands)

 

 

The accompanying notes to the condensed consolidated and combined financial statements

are an integral part of this condensed statement.

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited)

 

 

Organization and Description of Business

 

Novelis Inc., formed in Canada on September 21, 2004, and its subsidiaries, is the world’s leading aluminum rolled products producer based on shipment volume. We produce aluminum sheet and light gauge products where the end-use destination of the products includes the construction and industrial, beverage and food cans, foil products and transportation markets. As of June 30, 2006, we had operations on four continents: North America; Europe; Asia and South America, through 34 operating plants and three research facilities in 11 countries. In addition to aluminum rolled products plants, our South American businesses include bauxite mining, alumina refining, primary aluminum smelting and power generation facilities that are integrated with our rolling plants in Brazil.

 

References herein to “Novelis”, the “Company”, “we”, “our”, or “us” refer to Novelis Inc. and its subsidiaries unless the context specifically indicates otherwise. References herein to “Alcan” refer to Alcan, Inc.

 

The accompanying unaudited condensed consolidated and combined financial statements should be read in conjunction with our audited consolidated and combined financial statements and accompanying notes in our Annual Report on Form 10-K for the year ended December 31, 2005 filed with the United States Securities and Exchange Commission (SEC) on August 25, 2006. Unless otherwise specifically identified as the “original Form 10-K”, any references to the Form 10-K made throughout this document shall refer to the Form 10-K filed with the SEC on August 25, 2006, as amended. The accompanying (a) consolidated balance sheet as of December 31, 2005, which has been derived from audited financial statements, and (b) unaudited condensed consolidated and combined financial statements have been prepared pursuant to SEC Rule 10-01 of Regulation S-X. Certain information and note disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles in the United States of America (GAAP) have been condensed or omitted pursuant to those rules and regulations, although we believe that the disclosures made are adequate to make the information not misleading.

 

The unaudited results of operations for the interim periods shown in these financial statements are not necessarily indicative of operating results for the entire year. In the opinion of management, the accompanying unaudited condensed consolidated and combined financial statements recognize all adjustments of a normal recurring nature considered necessary to fairly state our financial position as of June 30, 2006 and December 31, 2005; the results of our operations for the three months and six months ended June 30, 2006 and 2005; our cash flows for the six months ended June 30, 2006 and 2005; and changes in our shareholders’ equity for the six months ended June 30, 2006.

 

Certain reclassifications of prior periods’ amounts have been made to conform to the presentation adopted for the current period.

 

Recently Issued Accounting Standards

 

In September 2006, the Staff of the SEC issued Staff Accounting Bulletin (SAB) No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.  SAB No. 108 provides guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of determining whether the current year’s financial statements are materially misstated. SAB No. 108 is effective for fiscal years ending after November 15, 2006. We will adopt SAB No. 108 as of December 31, 2006. We do not expect the adoption of SAB No. 108 to have a material impact on our consolidated financial position, results of operations and cash flows.

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

In September 2006, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, which requires a company that sponsors one or more single-employer defined benefit pension and other postretirement benefit plans (benefit plans) to recognize in its balance sheet the funded status of a benefit plan, which is the difference between the fair value of plan assets and the benefit obligation, as a net asset or liability, with an offsetting adjustment to accumulated other comprehensive income in shareholders’ equity. FASB Statement No. 158 requires additional financial statement disclosure regarding certain effects on net periodic benefit cost. FASB Statement No. 158 requires prospective application and the recognition and disclosure requirements are effective for fiscal years ending after December 15, 2006. We will adopt FASB Statement No. 158 as of December 31, 2006. We are currently evaluating the potential impact of the adoption of FASB Statement No. 158 on our consolidated financial position, results of operations and cash flows.

 

In addition, FASB Statement No. 158 requires that a company measure defined benefit plan assets and obligations at its year-end balance sheet date. We currently use our year-end balance sheet date as our measurement date and, as a result, that new requirement will not affect us.

 

In September 2006, the FASB issued FASB Statement No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value under GAAP, and expands disclosures about fair value measurements. FASB Statement No. 157 applies to other accounting pronouncements that require or permit fair value measurements. The new guidance is effective for financial statements issued for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years. We are currently evaluating the potential impact, if any, of the adoption of FASB Statement No. 157 on our consolidated financial position, results of operations and cash flows.

 

In June 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, which is effective for fiscal years beginning after December 15, 2006. FASB Interpretation No. 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements by prescribing a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FASB Interpretation No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. We are currently evaluating the potential impact of the adoption of FASB Interpretation No. 48 on our consolidated financial position, results of operations and cash flows.

 

We have determined that all other recently issued accounting pronouncements will not have a material impact on our consolidated financial position, results of operations and cash flows or do not apply to our operations.

 

 

All restructuring provisions and recoveries are included in Restructuring charges (recoveries) — net in the accompanying condensed consolidated and combined statements of income (loss) unless otherwise stated

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

below. The following table summarizes the changes in our restructuring liabilities during the six months ended June 30, 2006 (in millions).

 

 

In March 2006, we announced additional actions in the restructuring of our European operations, with the reorganization of our plants in Ohle and Ludenscheid, Germany, including the closing of two non-core business lines located within those facilities. In connection with the reorganization of our Ohle and Ludenscheid plants, we incurred costs of approximately $1 million during the six months ended June 30, 2006, and expect to incur additional costs of $5 million (primarily severance) by the end of 2007.

 

In November 2005, we announced our intent to close our casting alloy facility in Borgofranco, Italy during March 2006. In 2005, we recognized charges of $5 million for asset impairments and $9 million for other exit related costs, including $6 million for environmental remediation expenses relating to this plant closing. We have incurred additional costs of approximately $1 million through June 30, 2006 and expect all activities (including environmental remediation) to be complete by 2009.

 

Subsequent Event

 

On August 31, 2006, we announced a proposed restructuring of our European central management and administration activities in Zurich, Switzerland, to reduce overhead costs and streamline support functions. In addition, we are proposing to exit our Neuhausen research and development center in Switzerland. We expect to incur approximately $6 million of costs associated with these proposed actions.

 

 

In March 2006, we disposed of our aluminum rolling mill in Annecy, France for consideration in the amount of one Euro, and recorded pre-tax charges of $15 million in connection with the sale, which are included in Other (income) expenses — net in the accompanying condensed consolidated statement of income (loss) for the six months ended June 30, 2006. The charges were comprised primarily of $8 million representing our investment in and advances to Annecy, cash payments of $5 million we made in connection with the disposal of the business, and other cash fees and expenses we paid of an additional $2 million.

 

 

Inventories consist of the following (in millions).

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

In November 2004, the FASB issued FASB Statement No. 151, Inventory Cost, which amends the guidance in Accounting Research Bulletin (ARB) No. 43, Chapter 4, “Inventory Pricing”, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted materials by requiring those items to be recognized as current period charges. Additionally, FASB Statement No. 151 requires that fixed production overheads be allocated to conversion costs based on the normal capacity of the production facilities. FASB Statement No. 151 is effective prospectively for inventory costs incurred in fiscal years beginning after June 15, 2005. We adopted FASB Statement No. 151 on January 1, 2006, and its adoption did not have a material effect on our consolidated financial position, results of operations or cash flows.

 

 

Property, plant and equipment — net, consists of the following (in millions).

 

 

Subsequent Event

 

On August 21, 2006, we entered into a preliminary agreement to transfer our rights to develop and operate two hydroelectric power plants in South America with generating capacity of 155 megawatts. This transfer is subject to regulatory approval by the National Electric Energy Agency prior to execution. We received an advance cash payment of approximately $15 million upon signing of the preliminary agreement; however, this payment must be refunded if the transfer is not approved. If approved, the transaction will be concluded and we will recognize a pre-tax gain of approximately $12 million.

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

The following table summarizes the ownership structure and our ownership percentage of the non-consolidated affiliates we account for using the equity method. We have no material investments in affiliates accounted for under the cost method.

 

 

We do not control these affiliates, but have the ability to exercise significant influence over their operating and financial policies. The following table summarizes the combined results of operations of our equity method affiliates (on a 100% basis, in millions).

 

 

Included in our condensed consolidated and combined financial statements are transactions and balances arising from business we conduct with these non-consolidated affiliates, which we classify as related party transactions and balances. The following table describes the nature and amounts of transactions that we had with these non-consolidated related parties during the three months and six months ended June 30, 2006 and 2005 (in millions).

 

 

 

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

The table below describes the period-end account balances that we have with these non-consolidated affiliates, shown as related party balances on our accompanying condensed consolidated balance sheets (in millions). We have no other material related party balances.

 

 

 

 

We entered into a preliminary agreement to transfer the common and preferred shares of our 25% interest in Petrocoque S.A. Industria e Comercio (Petrocoque) to an existing shareholder for approximately $20 million. In accordance with Petrocoque’s by-laws and shareholders’ agreement, any transfer of shares is subject to a right of first refusal whereby the other remaining shareholders can acquire our shares based on their proportional ownership percentage. If the remaining shareholders do not exercise their right of first refusal and the sale is consummated, we anticipate closing this transaction in November 2006 and recognizing a pre-tax gain of approximately $14 million.

 

 

Accrued expenses and other current liabilities consist of the following (in millions).

 

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

 

Long-term debt consists of the following (in millions).

 

 

 

 

Floating Rate Term Loan B

 

In connection with our spin-off from Alcan, we entered into senior secured credit facilities providing for aggregate borrowings of up to $1.8 billion. These facilities consist of: (1) a $1.3 billion seven-year senior secured Term Loan B facility, bearing interest at London Interbank Offered Rate (LIBOR) plus 1.75%, all of which was borrowed on January 10, 2005; and (2) a $500 million five-year multi-currency revolving credit and letters of credit facility.

 

Unamortized debt issuance costs related to the senior secured credit facilities are included in Other long-term assets in our accompanying condensed and consolidated balance sheets, and were $23 million as of June 30, 2006.

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

Through June 30, 2006, we satisfied the 1% per annum principal amortization requirement through fiscal year 2010, as well as $424 million of the principal amortization requirement for 2011. No further minimum principal payments are due until 2011. As of June 30, 2006, there was $798 million outstanding under this facility. Additionally, in September 2006, we made an additional principal repayment of $87 million, and as of September 30, 2006, there was $711 million outstanding under this facility.

 

Our senior secured credit facilities include customary affirmative and negative covenants, as well as financial covenants relating to our maximum total leverage ratio, minimum interest coverage ratio, and minimum fixed charge coverage ratio.

 

On October 16, 2006, we amended the financial covenants to our senior secured credit facilities. In particular, we amended our maximum total leverage, minimum interest coverage, and minimum fixed charge coverage ratios through the quarter ending March 31, 2008. If we had not amended these financial covenants, we would have been in violation of the minimum interest coverage ratio as of and for the quarter ended June 30, 2006. We also amended and modified other provisions of the senior secured credit facilities to permit more efficient ordinary-course operations, including increasing the amounts of certain permitted investments and asset-backed securitizations, permitting nominal quarterly dividends, and the transfer of an intercompany loan to another subsidiary. In return for these amendments and modifications, we paid aggregate fees of approximately $3 million to lenders who consented to the amendments and modifications, and agreed to continue paying the higher applicable margins on our senior secured credit facilities and the higher unused commitment fees on our revolving credit facilities that were instated with the fourth waiver and consent agreement dated May 11, 2006. These increases will continue until such time as the compliance certificate for the fiscal quarter ending March 31, 2008 has been delivered.

 

The amended maximum total leverage, minimum interest coverage and minimum fixed charge coverage ratios for the period ended June 30, 2006 are 5.25 to 1; 2.5 to 1; and 1 to 1, respectively. We are in compliance with these financial covenants for the period ended June 30, 2006. In addition, as described below, we previously obtained waivers from our lenders related to our inability to timely file our SEC reports.

 

7.25% Senior Notes

 

On February 3, 2005, we issued $1.4 billion aggregate principal amount of senior unsecured debt securities (Senior Notes). Unamortized debt issuance costs related to the Senior Notes are included in Other long-term assets in our accompanying condensed consolidated balance sheets and were $25 million as of June 30, 2006.

 

Under the indenture that governs the Senior Notes, we are subject to certain restrictive covenants applicable to incurring additional debt and providing additional guarantees, paying dividends beyond certain amounts and making other restricted payments, sales and transfers of assets, certain consolidations or mergers, and certain transactions with affiliates. We were in compliance with these covenants as of June 30, 2006. However, as discussed below under the caption “Impact of Late SEC Filings on our Debt Agreements”, we have received a notice of default under the indenture related to our failure to timely file this quarterly report on Form 10-Q.

 

The indenture governing the Senior Notes and the related registration rights agreement required us to file a registration statement for the notes and exchange the original, privately placed notes with registered notes. The registration statement was declared effective by the SEC on September 27, 2005. Under the indenture and the related registration rights agreement, we were required to complete the exchange offer for the Senior Notes by November 11, 2005. We did not complete the exchange offer by that date. As a result, we began to accrue additional special interest at a rate of 0.25% from November 11, 2005. The indenture and the registration rights agreement provide that the rate of additional special interest increases by 0.25% during each subsequent

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

90-day period until the exchange offer closes, with the maximum amount of additional special interest being 1.00% per year. On August 8, 2006, the rate of additional special interest increased to 1.00%. On October 17, 2006, we extended the offer to exchange the Senior Notes to December 15, 2006. We expect to file a post-effective amendment to the registration statement and complete the exchange as soon as practicable following the date we are current on our reporting requirements. We will cease paying additional special interest once the exchange offer is completed.

 

Korean Bank Loans

 

In December 2004, Novelis Korea Limited (Novelis Korea), formerly Alcan Taihan Aluminium Limited, entered into a $70 million floating rate long-term loan which was subsequently swapped into a 4.55% fixed rate KRW 73 billion loan due in December 2007. In February 2005, Novelis Korea entered into a $50 million floating rate long-term loan which was subsequently swapped into a 5.30% fixed rate KRW 51 billion loan due in February 2008.

 

In the first quarter of 2006, we repaid our KRW 30 billion ($30 million) 5.75% fixed rate loan originally due October 2008. In May 2006, a portion of the $50 million (KRW 51 billion) 5.30% fixed rate loan was refinanced into a KRW 19 billion ($20 million) short-term floating rate loan which was paid in June 2006. We were in compliance with all debt covenants related to our Korean bank loans as of June 30, 2006.

 

Interest Rate Swaps

 

As of June 30, 2006, we had entered into interest rate swaps to fix the 3-month LIBOR interest rate on a total of $200 million of the floating rate Term Loan B debt at effective weighted average interest rates and amounts expiring as follows: 3.8% on $100 million through February 3, 2007; and 3.9% on $100 million through February 3, 2008. We are still obligated to pay any applicable margin, as defined in our senior secured credit facilities, in addition to these interest rates. As of June 30, 2006, 75% of our debt was fixed rate and 25% was variable rate.

 

Impact of Late SEC Filings on our Debt Agreements

 

The restatement of our unaudited condensed consolidated and combined financial statements for the quarters ended March 31, 2005 and June 30, 2005 (filed on May 16, 2006) resulted in delays in the filing of our quarterly report on Form 10-Q for the quarter ended September 30, 2005 (filed on May 16, 2006), our Annual Report on Form 10-K for the year ended December 31, 2005 (filed on August 25, 2006), our quarterly report on Form 10-Q for the quarter ended March 31, 2006 (filed on September 15, 2006) and this quarterly report on Form 10-Q.

 

The terms of our senior secured credit facilities require that we deliver unaudited quarterly and audited annual financial statements to our lenders within specified periods of time. Due to the delays, we obtained a series of waiver and consent agreements from the lenders under the facility to extend the various filing deadlines. The fourth waiver and consent agreement, dated May 10, 2006, extended the Form 10-Q filing deadlines for the first, second and third quarters of 2006 to October 31, 2006, November 30, 2006, and December 29, 2006, respectively. These extended filing deadlines were subject to acceleration to 30 days after the receipt of an effective notice of default under the indenture governing our Senior Notes relating to our inability to timely file such periodic reports with the SEC. We received an effective notice of default with respect to this Form 10-Q on August 24, 2006. However, on August 11, 2006, we entered into a fifth waiver and consent agreement which extended the accelerated filing deadline caused as a result of the receipt of the effective notice of default with respect to this Form 10-Q to October 22, 2006 and extended any accelerated filing deadlines that would be caused as a result of the receipt of an effective notice of default under the

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

Senior Notes with respect to our Form 10-Q for the third quarter of 2006 to the earlier of 30 days after the receipt of any such notice of default and December 29, 2006 (as applicable).

 

To date, fees related to the five waiver and consent agreements total $6 million, including $3 million and $4 million which were incurred during the three months and six months ended June 30, 2006, respectively. These fees are being amortized over the remaining life of the related borrowing in Interest expense and amortization of debt issuance costs — net using the “effective interest amortization” method. Unamortized fees related to these waiver and consent agreements are included in Other long-term assets in our accompanying condensed consolidated balance sheets and total $4 million as of June 30, 2006.

 

The October 16, 2006 amendment to our senior secured credit facilities extends the higher applicable margins and unused commitment fee that were instated in connection with the fourth waiver and consent agreement. Specifically, we agreed to a 1.25% applicable margin for Term Loans maintained as Base Rate Loans, a 2.25% applicable margin for Term Loans maintained as Eurocurrency Rate Loans, a 1.50% applicable margin for Revolver Loans maintained as Base Rate Loans, a 2.50% applicable margin for Revolver Loans maintained as Eurocurrency Rate Loans and a 62.5 basis point commitment fee on the unused portion of the revolving credit facility, until such time as the compliance certificate for the fiscal quarter ending March 31, 2008 has been delivered.

 

Under the indenture governing the Senior Notes, we are required to deliver to the trustee a copy of our periodic reports filed with the SEC within the time periods specified by SEC rules. As a result of an effective notice of default from the trustee on August 24, 2006 we were required to file this Form 10-Q by October 23, 2006 in order to prevent an event of default. By filing this quarterly report on Form 10-Q and furnishing a copy to the trustee, we cured this default.

 

On July 26, 2006, we entered into a Commitment Letter with Citigroup Global Markets Inc. for backstop financing facilities in an amount up to $2.855 billion. We paid fees of approximately $4 million in conjunction with this commitment. The Commitment Letter was originally set to expire on October 2, 2006; however, it was amended to expire on October 31, 2006.

 

Lines of Credit /Short Term Borrowings

 

As of June 30, 2006, $62 million of our $500 million revolving credit facility was utilized for short-term loans in the United Kingdom and another $5 million was utilized for letters of credit. As of June 30, 2006, we had approximately $300 million available under our $500 million revolving credit facility. As of June 30, 2006, the weighted average interest rate on our short-term borrowings was 6.72% (2.69% as of December 31, 2005).

 

Commitment fees related to the unused portion of the $500 million revolving credit facility, prior to the fourth waiver and consent agreement dated May 10, 2006, ranged between 0.375% and 0.5% per annum, depending on certain financial ratios we achieve. As discussed above, in connection with the fourth waiver and consent agreement, these commitment fees increased to 0.625%. Under the terms of the October 16, 2006 amendment to our senior secured credit facilities, these higher fees will remain in effect until such time as the compliance certificate for the fiscal quarter ending March 31, 2008 has been delivered.

 

As of June 30, 2006, all of our $25 million unsecured line of credit facility in Brazil was available for use.

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

A summary of the components of other comprehensive income (loss) is as follows (in millions).

 

 

Accumulated other comprehensive loss, net of income tax effects, consists of the following (in millions).

 

 

 

On January 1, 2006, we adopted FASB Statement No. 123 (Revised), Share-Based Payment, which is a revision to FASB Statement No. 123, Accounting for Stock-Based Compensation. FASB Statement No. 123 (Revised) requires the recognition of compensation expense for a share-based award over an employee’s requisite service period based on the award’s grant date fair value, subject to adjustment.

 

We adopted FASB Statement No. 123 (Revised) using the modified prospective method. The modified prospective method requires companies to record compensation cost beginning with the effective date based on the requirements of FASB Statement No. 123 (Revised) for all share-based payments granted after the effective date. All awards granted to employees prior to the effective date of FASB Statement No. 123 (Revised) that remain unvested at the adoption date will continue to be expensed over the remaining service period.

 

The cumulative effect of the accounting change, net of tax, as of January 1, 2006 was approximately $1 million, and was not considered material as to require presentation as a cumulative effect of accounting change in our condensed consolidated statements of income (loss). Accordingly, the expense recognized as a result of adopting FASB Statement No. 123 (Revised) was included in Selling, general and administrative expenses in our condensed consolidated statement of income (loss) in the first quarter of 2006.

 

Prior to the adoption of FASB Statement No. 123 (Revised), we presented all tax benefits of deductions resulting from the exercise of stock options within operating cash flows in the condensed consolidated and combined statements of cash flows. Beginning on January 1, 2006, we changed our cash flow presentation in accordance with FASB Statement No. 123 (Revised), which requires that the cash flows resulting from tax benefits for deductions in excess of compensation cost recognized be classified within financing cash flows. During the three months and six months ended June 30, 2006, there were no tax payments made that were reduced by excess tax benefits.

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

Stock Options

 

On January 5, 2005, our board of directors adopted the Novelis Conversion Plan of 2005 (the Conversion Plan) to allow for all Alcan stock options held by employees of Alcan who became our employees following our spin-off from Alcan to be replaced with options to purchase our common shares. While new options may be granted under the Conversion Plan, none were granted through June 30, 2006. All options expire ten years from their date of grant. All converted options that were vested on the spin-off date continued to be vested. Unvested options as of the spin-off date vest in four equal annual installments beginning on January 6, 2006, the first anniversary of the spin-off date. However, in October 2006 we amended the Conversion Plan to allow the immediate vesting of all options upon the death or retirement of the optionee. In the case of an unsolicited change of control of Novelis, all options will vest immediately.

 

As of June 30, 2006, there were 2,650,947 options outstanding at a weighted average exercise price of $21.61, and 877,033 of these options were exercisable at a weighted average exercise price of $21.26. No new options have been issued since the adoption of the Conversion plan. As such, no changes have occurred in our assumptions to measure the options at fair value.

 

The table below shows our stock option activity for the six months ended June 30, 2006 (all amounts actual).

 

 

We used the Black-Scholes valuation model to determine the fair value of the options outstanding. The fair value of each option was estimated using the following weighted average assumptions.

 

 

Total compensation cost recognized for stock options issued to employees was $1 million for each of the three months ended June 30, 2006 and 2005, and $2 million and $1 million for the six months ended June 30, 2006 and 2005, respectively. These amounts were included in Selling, general and administrative expenses.

 

Compensation to be Settled in Cash

 

Upon adoption of FASB Statement No. 123 (Revised), we determined that all of our compensation plans settled in cash are considered liability based awards. As such, liabilities for awards under these plans are

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

required to be measured at each reporting date until the date of settlement. Various valuation methods were used to determine the fair value of these awards, as discussed below.

 

Prior to January 1, 2006, we applied the intrinsic value based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations in accounting for stock-based compensation plans settled in cash. We incurred a liability when the vesting of the award became probable under the guidance provided by FASB Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans. When variable plan awards were granted, we measured compensation expense as the amount by which the quoted market value of the shares of our stock covered by the grant exceeded the option price or value specified, by reference to a market price or otherwise, subject to any appreciation limitations under the plan. Changes, either increases or decreases, in the quoted market value of those shares between the date of grant and the measurement date resulted in a prospective change in the measurement of compensation expense for the right or award.

 

Stock Price Appreciation Unit Plan

 

Prior to the spin-off, some Alcan employees who later transferred to Novelis held Alcan stock price appreciation units (SPAUs). These units entitled them to receive cash equal to the excess of the market value of an Alcan common share on the exercise date of a SPAU over the market value of an Alcan common share on its grant date. On January 6, 2005, these employees received 418,777 Novelis SPAUs to replace their 211,035 Alcan SPAUs at a weighted average exercise price of $22.04. None of the SPAUs have been exercised, but as of June 30, 2006, 115,419 SPAUs were exercisable at a weighted average exercise price of $21.53. As of June 30, 2006, there was $1.7 million of unamortized compensation cost related to non-vested SPAUs, which is expected to be recognized over a remaining vesting period of 2.5 years.

 

Upon adoption of FASB Statement No. 123 (Revised), we changed from the intrinsic value method to the Black-Scholes valuation model to estimate the fair value of the SPAUs granted to employees.

 

The table below shows our SPAU activity for the six months ended June 30, 2006 (all amounts actual).

 

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

The fair value of each SPAU outstanding as of June 30, 2006 was estimated using the following weighted average assumptions:

 

 

Total Shareholder Returns Performance Plan

 

Some Alcan employees who later transferred to Novelis were entitled to receive cash awards under the Alcan Total Shareholder Returns Performance Plan (TSR). TSR was a cash incentive plan which rewarded eligible employees based on the relative performance of Alcan’s common share price and cumulative dividend yield performance compared to other corporations included in the Standard & Poor’s Industrials Index, measured over three-year periods starting on October 1, 2002 and 2003. On January 6, 2005, these employees immediately ceased participating in and accruing benefits under the TSR. The current three-year performance periods, namely 2002 to 2005 and 2003 to 2006, were truncated as of the date of the spin-off. The accrued awards for all of the TSR participants were converted into 452,667 Novelis restricted share units (RSUs). At the end of each performance period, each holder of RSUs will receive net proceeds based on the price of Novelis common shares at that time, including declared dividends. On October 15, 2005, an aggregate of $7 million was paid to employees who held RSUs that had vested on September 30, 2005. As of June 30, 2006, there were 120,897 RSUs and related dividends outstanding that vested on September 30, 2006 and were paid on October 13, 2006 in the amount of $2.8 million. As of June 30, 2006, there was $0.4 million of unamortized compensation cost related to non-vested RSUs, which was expensed during the third quarter of 2006.

 

The table below shows our RSU activity for the six months ended June 30, 2006. RSUs granted represent the unit equivalent of dividends earned during the period (all amounts actual).

 

 

Deferred Share Unit Plan For Non-Executive Directors

 

On January 5, 2005, Novelis established the Deferred Share Unit Plan for Non-Executive Directors under which non-executive directors receive 50% of their compensation payable in the form of directors’ deferred share units (DDSUs) and the other 50% in the form of either cash, additional DDSUs or a combination of these two (at the individual election of each non-executive director). The number of DDSUs is determined by dividing the quarterly amount payable, as elected, by the average closing prices of a common share on the Toronto Stock Exchange (TSX) and New York Stock Exchange (NYSE) on the last five trading days of each

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

quarter. Additional DDSUs representing the equivalent of dividends declared on common shares are credited to each holder of DDSUs.

 

The DDSUs are redeemable in cash and/or in shares of our common stock following the participant’s retirement from the board. The redemption amount is calculated by multiplying the accumulated balance of DDSUs by the average closing price of a common share on the TSX and NYSE on the last five trading days prior to the redemption date.

 

The table below shows our DDSU activity for the six months ended June 30, 2006 (all amounts actual).

 

 

Novelis Founders Performance Awards

 

In March 2005, Novelis established a plan to reward certain key executives with Performance Share Units (PSUs) if Novelis share price improvement targets were achieved within specific time periods. There are three equal tranches of PSUs, and each has a specific share price improvement target. For the first tranche, the target applies for the period from March 24, 2005 to March 23, 2008. For the second tranche, the target applies for the period from March 24, 2006 to March 23, 2008. For the third tranche, the target applies for the period from March 24, 2007 to March 23, 2008. If awarded, a particular tranche will be paid in cash on the later of six months from the date the specific share price target is reached or twelve months after the start of the performance period, and will be based on the average of the daily stock closing prices on the NYSE for the last five trading days prior to the payment date. Upon a participant’s termination due to retirement, death or disability, all PSUs awarded prior to the termination will be paid at the same time as for active participants. For any other termination, all PSUs will be forfeited.

 

Upon adoption of FASB Statement No. 123 (Revised), we changed our valuation technique to the Monte Carlo method due to the fact that the Novelis Founders Performance Awards contain a market condition for vesting of the award. The Monte Carlo method utilizes multiple input variables that determine the probability of satisfying the market condition stipulated in the award and calculates the fair value of each award. Key assumptions used to determine the fair value of PSUs as of June 30, 2006 were as follows.

 

 

Weighted average expected stock price volatility is a weighted measure of the historical volatility and the implied volatility of the closest to at-the-money publicly traded Novelis call options, with weights determined by the remaining life of the longest term call options. Due to limited trading activity and the short contractual term of Novelis call options, we did not give any weight to implied volatility in the valuation of PSUs. The annual expected dividend yield is based on historical and anticipated dividend payments. The risk-free interest rate reflects the 2-year daily U.S. Treasury yield curve rate as of the valuation date. The fair value of the PSUs is amortized over the derived service period of each award, which is up to three years, subject to

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

acceleration in the event the vesting condition is met (as defined above). The liability for the first tranche was accrued over its term, was valued on March 24, 2006, and was paid in cash in April 2006 for $3 million.

 

Recognition Agreements

 

On September 25, 2006, we entered into Recognition Agreements (Agreements) with certain executive officers and other key employees (Executives) to retain and reward them for continued dedication towards corporate objectives. Under the terms of the Agreements, Executives that remain continuously employed by us through the vesting dates of December 31, 2007 and December 31, 2008 are entitled to receive one-half of their total awards on each vesting date payable in shares of Novelis common stock, subject to shareholder approval of the Novelis Inc. 2006 Incentive Plan (Plan). If the Plan (or a similar plan) is not approved, the equivalent value of the awards will be paid in cash.

 

The number of shares payable under the Agreements varies by Executive. Currently, there are 145,800 shares subject to awards. In accordance with the provisions of FASB Statement No. 123 (Revised), we will value these awards as of the issuance date and amortize their cost over the requisite service period of the Executives.

 

Compensation Cost

 

For the three months and six months ended June 30, 2006, stock-based compensation expense for arrangements that are settled in cash, including amounts related to the cumulative effect of an accounting change, net of tax, from adopting FASB Statement No. 123 (Revised), was $1 million and $4 million, respectively, and was included in Selling, general and administrative expenses. Stock-based compensation expense for both the three months and six months ended June 30, 2005 was $2 million.

 

 

Components of net periodic benefit cost for all of our significant plans are shown in the table below (in millions).