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 October 31, 2006, the registrant had 74,014,691 common shares outstanding.

 

 

 

TABLE OF CONTENTS

 

 

Novelis Inc.

 

 

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 AND COMBINED STATEMENTS OF CASH FLOWS (unaudited)
(Continued) (in millions)

 

The accompanying notes to the condensed consolidated and combined financial statements

are an integral part of these condensed statements.

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 September 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, as amended on October 20, 2006. Unless otherwise specifically identified as our “original Form 10-K”, any references to our Form 10-K made throughout this document shall refer to our Annual Report on Form 10-K for the year ended December 31, 2005 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 September 30, 2006 and December 31, 2005; the results of our operations for the three months and nine months ended September 30, 2006 and 2005; our cash flows for the nine months ended September 30, 2006 and 2005; and changes in our shareholders’ equity for the nine months ended September 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. 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 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, if any, 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.

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

All restructuring provisions and recoveries are included in Restructuring charges — net in the accompanying condensed consolidated and combined statements of operations unless otherwise stated below. The following table summarizes the changes in our restructuring liabilities during the nine months ended September 30, 2006 (in millions).

 

 

In August 2006, we announced a restructuring of our European central management and administration activities in Zurich, Switzerland, to reduce overhead costs and streamline support functions. In addition, we are exiting our Neuhausen research and development center in Switzerland. These programs have begun and through September 30, 2006, we have incurred costs of approximately $3 million. We expect to incur total costs of approximately $6 million related to these programs.

 

In July 2006, we announced additional restructuring actions at our Goettingen facility in Germany to reduce overhead administrative costs and streamline functions. We incurred approximately $3 million related to severance costs during the three months ended September 30, 2006.

 

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 $3 million during the nine months ended September 30, 2006, and expect to incur additional costs of $3 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 $2 million through September 30, 2006 and expect all activities (including environmental remediation) to be complete by 2009.

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

In March 2006, we disposed of our aluminum rolling mill in Annecy, France (Annecy) for consideration in the amount of one Euro. We recorded a pre-tax charge of $15 million in connection with the sale, which is included in Other (income) expenses — net in the accompanying condensed consolidated statement of operations for the nine months ended September 30, 2006. The charge was 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).

 

 

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).

 

 

In August 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. We received an

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

advance cash payment of approximately $15 million upon signing of the preliminary agreement, however no gain was recognized at that time because the transfer was subject to regulatory approval by the National Electric Energy Agency, which we received in November 2006. Accordingly, we will recognize a pre-tax gain of approximately $12 million during the fourth quarter of 2006.

 

 

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 using 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 the accompanying 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 nine months ended September 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 in the accompanying condensed consolidated balance sheets (in millions). We have no other material related party balances.

 

 

 

 

We entered into an agreement to sell the common and preferred shares of our 25% interest in Petrocoque S.A. Industria e Comercio (Petrocoque) to an existing shareholder of Petrocoque for approximately $20 million. In November 2006, the sale was consummated, and we will recognize a pre-tax gain of approximately $14 million in the fourth quarter.

 

 

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 the accompanying condensed and consolidated balance sheets, and were $22 million as of September 30, 2006.

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

Through September 30, 2006, we satisfied the 1% per annum principal amortization requirement through fiscal year 2010, as well as $511 million of the principal amortization requirement for 2011. No further minimum principal payments are due until 2011. 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. 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 a prior waiver and consent agreement in May 2006. 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.

 

The amended maximum total leverage, minimum interest coverage and minimum fixed charge coverage ratios for the period ended September 30, 2006 are 6.5 to 1; 2 to 1; and 0.8 to 1, respectively. We were in compliance with these financial covenants as of the period ended September 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 the accompanying condensed consolidated balance sheets and were $25 million as of September 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 September 30, 2006.

 

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 90-day period until the exchange offer closes, with the maximum amount of additional special interest being

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

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. 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. In October 2006, the balance of this loan was refinanced into two short-term floating rate loans: (1) a KRW 10 billion ($11 million) loan, which was repaid in October 2006 and (2) a KRW 20 billion ($21 million) loan due within six months. We were in compliance with all debt covenants related to our Novelis Korea bank loans as of September 30, 2006.

 

Interest Rate Swaps

 

As of September 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, as amended, in addition to these interest rates. As of September 30, 2006, 78% of our debt was fixed rate and 22% 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 period 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 and amended on October 20, 2006), our Quarterly Report on Form 10-Q for the period ended March 31, 2006 (filed on September 15, 2006) and our Quarterly Report on Form 10-Q for the period ended June 30, 2006 (filed on October 20, 2006).

 

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 five waiver and consent agreements from the lenders under the facility to extend the various filing deadlines. Under the most recent waiver, we extended the filing deadline for this Form 10-Q to the earlier of 30 days after the receipt of an effective notice of default under the Senior Notes and December 29, 2006 (as applicable).

 

To date, fees related to the five waiver and consent agreements total $6 million, including $1 million and $5 million which were incurred during the three months and nine months ended September 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.

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

Unamortized fees related to these waiver and consent agreements are included in Other long-term assets in the accompanying condensed consolidated balance sheets and total $5 million as of September 30, 2006.

 

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 and did expire on October 31, 2006. Accordingly, during the fourth quarter of 2006, we will charge the $4 million in fees to Interest expense and debt issuance costs — net.

 

Lines of Credit /Short Term Borrowings

 

As of September 30, 2006, our short-term borrowings were $113 million, consisting of (1) $70 million in short-term loans in the United States and the United Kingdom under our $500 million revolving credit facility; (2) a $15 million unsecured short-term loan in Korea; and (3) $28 million in bank overdrafts. As of September 30, 2006, $17 million of our $500 million revolving credit facility was utilized for letters of credit. As of September 30, 2006, we had approximately $413 million available under our $500 million revolving credit facility, and the weighted average interest rate on our short-term borrowings was 6.96% (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 September 30, 2006, all of our $25 million unsecured line of credit facility in Brazil was available for use.

 

 

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

 

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

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 the accompanying condensed consolidated and combined statements of operations. 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 operations 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 nine months ended September 30, 2006, there were no tax payments made that were reduced by excess tax benefits.

 

Compensation to be Settled in Stock

 

Novelis 2006 Incentive Plan

 

At our annual shareholders meeting on October 26, 2006, our shareholders approved the Novelis 2006 Incentive Plan (2006 Incentive Plan) to effectively replace the Novelis Conversion Plan of 2005 (the Conversion Plan) and Stock Price Appreciation Unit Plan (both described below). Under the 2006 Incentive Plan, up to an aggregate number of 7,000,000 shares of Novelis common stock are authorized to be issued in the form of stock options, stock appreciation rights (SARs), restricted shares, restricted share units, performance shares and other stock-based incentives. Stock options and SARs expire seven years from their grant date. SARs may be settled in cash, common shares or a combination thereof, at the election of the holder. Any shares that are subject to an award under the 2006 Incentive Plan other than stock options and SARs will be counted against the 7,000,000 share limit as 1.75 shares for every one share subject to the award. The number of annual awards issued to any single employee or non-employee director is limited. The Human Resources Committee of our board of directors has the discretion to determine which employees and non-employee directors receive awards and the type, number and terms and conditions of such awards under

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

COMBINED FINANCIAL STATEMENTS (unaudited) — (Continued)

the 2006 Incentive Plan. Generally, all vested awards expire 90 days after termination of employment, except in the case of death, disability or retirement, when the vested awards expire after one year. All awards vest immediately upon a change in control of the Company.

 

2006 Stock Options

 

On October 26, 2006, our board of directors authorized a grant of an aggregate of 884,080 seven-year non-qualified stock options under the 2006 Incentive Plan at an exercise price of $25.53 to certain of our executive officers and key employees. These options are comprised of two equal portions: premium and non-premium options. Both the premium and non-premium options vest ratably in 25% annual increments over the four year period measured from October 26, 2006, and may be exercised, in whole or in part, once vested. However, while the premium and non-premium options carry the same exercise price of $25.53, in no event may the premium options be exercised unless the fair market value per share, as defined in the 2006 Incentive Plan, on the business day preceding the exercise date equals or exceeds $28.59. If the participant retires before October 26, 2007, the options will be forfeited. If the participant retires on or after October 26, 2007, the options will continue to vest in accordance with the vesting schedule, but must be exercised no later than the third anniversary following the participant’s retirement date. In the event of the participant’s death or disability, all of the options will become immediately vested, but must be exercised no later than the first anniversary following the participant’s termination of employment. All of the options become immediately vested and exercisable, without regard to the per share price restriction on premium options, upon a change in control of the Company.

 

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.

 

The number of shares payable under the Agreements varies by Executive. Currently, there are 145,800 shares subject to award. In accordance with the provisions of FASB Statement No. 123 (Revised), we valued these awards as of the issuance date and will amortize their cost over the requisite service period of the Executives. As of September 30, 2006, there was approximately $1.7 million of unamortized compensation expense related to each of the two vesting dates, which is expected to be recognized over the next 1.25 years and 2.25 years, respectively.

 

Novelis Conversion Plan of 2005

 

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 have been granted through September 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 (1) the immediate vesting of all options upon the death or retirement of the optionee and (2) in the case of an unsolicited change of control of Novelis, all options will vest immediately. The amendment of the Conversion Plan will be accounted for as a modification under FASB Statement No. 123 (Revised) and as such, we will recognize additional compensation cost for the excess, if any, of the fair value of the modified

 

Novelis Inc.

 

NOTES TO THE CONDENSED CONSOLIDATED AND

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options over the fair value of the original options immediately before the terms were modified. We are currently in the process of evaluating the impact, if any, of this modification on our consolidated financial position, results of operations and cash flows.

 

As of September 30, 2006, there were 2,644,665 options outstanding at a weighted average exercise price of $21.62, and 871,246 of these options were exercisable at a weighted average exercise price of $21.28.

 

The table below shows our stock option activity for the nine months ended September 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 weighted average assumptions shown below. No new options have been issued since the adoption of the Conversion Plan. Through September 30, 2006, we have not changed the assumptions we use to measure the fair value of the options.

 

 

Total compensation cost recognized for stock options issued to employees was $1 million for both of the three months ended September 30, 2006 and 2005, and $2 million for both of the nine months ended September 30, 2006 and 2005. 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 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

 

Novelis Inc.

 

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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 Appreciation Rights

 

On October 26, 2006, our board of directors authorized a grant of 381,090 Stock Appreciation Rights under the 2006 Incentive Plan at an exercise price of $25.53 to certain of our executive officers and key employees (as discussed above). The terms of the SARs are identical in all material respects to those of the 2006 Stock Options, except that the incremental increase in the value of the SARs is settled in cash rather than shares of Novelis’ common stock at the time of exercise. The SARs are comprised of two equal portions: premium and non-premium SARs. Both the premium and non-premium SARs vest ratably in 25% annual increments over the four year period measured from October 26, 2006, and may be exercised, in whole or in part, once vested. However, while the premium and non-premium SARs carry the same exercise price of $25.53, in no event may the premium award shares be exercised unless the fair market value per share, as defined in the 2006 Incentive Plan, on the business day preceding the exercise date equals or exceeds $28.59. If the participant retires before October 26, 2007, the SARs will be forfeited. If the participant retires on or after October 26, 2007, SARs will continue to vest in accordance with the vesting schedule, but must be exercised no later than the third anniversary following the participant’s retirement date. In the event of the participant’s death or disability, all of the SARs will become immediately vested, but must be exercised no later than the first anniversary following the participant’s termination of employment. All of the SARs will become immediately vested and exercisable, without regard to the per share price restriction on premium award shares, upon a change in control of the Company.

 

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 September 30, 2006, 115,419 SPAUs were exercisable at a weighted average exercise price of $21.53. As of September 30, 2006, there was $2 million of unamortized compensation cost related to non-vested SPAUs, which is expected to be recognized over a remaining vesting period of 2.25 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 SPAUs granted to employees.

 

Novelis Inc.

 

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

 

 

The fair value of each SPAU was estimated as of September 30, 2006 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. In October 2005, an aggregate of $7 million was paid to employees who held RSUs that had vested on September 30, 2005. On September 30, 2006, there were 120,949 RSUs and related dividends outstanding, and these were paid to employees in October 2006 in the aggregate amount of $2.8 million. During the three months ended September 30, 2006, $0.6 million of compensation cost was expensed, of which $0.4 million was previously unamortized.

 

Novelis Inc.

 

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The table below shows our RSU activity for the nine months ended September 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 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 nine months ended September 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 common 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

 

Novelis Inc.

 

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later of six months from the date the specific common 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 common share 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 PSUs 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 market value of each award. Key assumptions used to determine the fair value of PSUs as of September 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 represents 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 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 April 2006 in the aggregate amount of $3 million. As of September 30, 2006, there was approximately $0.6 million of unamortized compensation expense related to the second tranche, which is expected to be recognized over the next three quarters, and approximately $0.8 million of unamortized compensation expense related to the third tranche, which is expected to be recognized over the next 1.5 years.

 

Compensation Cost

 

For the three months and nine months ended September 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 $3 million and $7 million, respectively, and was included in Selling, general and administrative expenses. Stock-based compensation expense for arrangements that are settled in cash for the three months and nine months ended September 30, 2005 was $1 million and $3 million, respectively.

 

Novelis Inc.

 

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