ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION

The following discussion includes projections and/or other "forward-looking" information. Grace is subject to risks and other uncertainties that could cause its actual results to differ materially from any such projections or that could cause other forward-looking information to prove incorrect. For a discussion of such risks and uncertainties, see "Introduction and Overview - Projections and Other Forward-Looking Information" in Item 1 of Grace's 1998 Annual Report on Form 10-K ("1998 10-K").

OVERVIEW

FIRST QUARTER 1999 AS COMPARED TO FIRST QUARTER 1998

Sales

Grace is primarily engaged in specialty chemicals businesses on a worldwide basis. These businesses consist of catalysts and silica-based products (Grace Davison), specialty construction chemicals and building materials (Grace Construction Products), and container sealants, closure sealants, and coatings (Darex Container Products). Grace Davison contributes approximately 50% of Grace's annual total sales, Grace Construction Products, 34% of total sales, and Darex Container Products, 16% of total sales.

Sales and revenues of Grace's segments increased 1.3% to $345.4 million in the first quarter of 1999. Excluding the effect of currency translation, sales increased 0.8%. Weak refinery demand for fluid cracking catalysts (FCC) in North America and Asia Pacific was offset by particularly strong Grace Construction Products sales, resulting from the continued success of its new and value-added products and strong construction activity.

Earnings

Grace reported income from continuing operations of $20.0 million, or $0.27 diluted earnings per share, up from $11.8 million ($0.15 diluted earnings per share) in 1998.

Pretax income from continuing operations was $31.7 million, up from $19.4 million in 1998. In December 1998, Grace implemented a productivity effectiveness program, designed to increase the Company's overall administrative and operating effectiveness, thereby reducing costs.

In the first quarter of 1999, cost of goods sold and operating expenses as well as selling, general and administrative expenses were reduced as a result of these productivity initiatives. In addition, general and administrative expenses declined $2.8 million due to Grace's divestment of the assets of its Circe Biomedical business in January 1999. In first quarter 1998, selling expenses included a $1.0 million charge for workforce reductions within Grace Construction Products' manufacturing and sales organization in Europe.

Included in the first quarter 1999 results was a pretax gain on the sale of the corporate aircraft of $4.4 million.

Interest expense and related financing costs for continuing operations were $3.8 million, down from $6.8 million in 1998. Including the interest expense and related financing costs allocated to discontinued operations in first quarter 1998, total interest costs amounted to $20.1 million in that period. While the average interest rate improved approximately 80 basis points, most of the decline in interest expense was due to lower average debt levels as a result of using the $1,256.6 million cash transfer related to the Spin-off and Merger to pay down substantially all of Grace's debt (see Note 5 of this Report).

In the first quarter of 1999, Grace recorded a pretax charge of $4.3 million for incremental restructuring costs for severance related to the productivity effectiveness program implemented in December 1998. This charge

included $2.8 million of severance costs in connection with the relocation of Grace's headquarters from Boca Raton, Florida to Columbia, Maryland, and the consolidation of certain administrative functions in Columbia. The remainder of such charge related to Grace's three operating segments as discussed below.

Grace's effective tax rate was 37.0%, down from 39.0% in 1998. The decrease in the tax rate was due to a reorganization of certain Grace foreign operations resulting in lower foreign taxes.

Included in the 1998 first quarter net loss of $26.0 million, were a loss from discontinued operations of $2.6 million and a loss from extinguishment of debt of $35.2 million (see Note 5 of this Report).

GRACE DAVISON

FIRST QUARTER 1999 AS COMPARED TO FIRST QUARTER 1998

Sales

Grace Davison is a leading global supplier of catalysts and silica products. Refining catalysts, representing approximately 58% of Davison's annual total sales, include fluid cracking catalysts (FCC) used by petroleum refiners to convert distilled crude oil into transportation fuels and other petroleum-based products, and hydroprocessing catalysts, which upgrade heavy oils and remove certain impurities. Silica products and adsorbents (28% of Davison sales) are used in a wide variety of industrial and consumer applications. Polyolefin catalysts (11% of Davison sales) are essential components in the manufacture of polyethylene resins used in products such as plastic film, high performance plastic pipe and plastic household containers.

Grace Davison's sales and revenues were $171.9 million, a 2.5% decline from 1998. Excluding the impact of currency translation, sales declined 4.2% reflecting unfavorable price/mix of 2.6%, coupled with volume declines of 1.6%.

The following discussion of Grace Davison sales excludes the effect of currency translation.

Refining catalyst sales decreased 8.9% as a result of volume declines in North America and Asia Pacific. The impacts of reduced refinery usage and heavy refinery turnaround activity in North America, and the loss of a customer in Asia Pacific were partially offset by volume gains in Europe.

Polyolefin catalyst sales increased 4.6% due to strong volume growth of 14.2%. Double-digit volume growth in North America and Europe was partially offset by unfavorable product mix and pricing pressures.

Silicas and adsorbent sales were essentially flat due to volume gains of 6.0% offset by unfavorable price/mix of 5.8%. In North America and Europe, pricing pressures for insulated glass molecular sieves were offset by volume growth in coatings, dentrifrice, and food and beverage products.

Earnings

Grace Davison's pretax operating income of $21.7 million decreased 10.9% from 1998. Gross margin decreased $2.9 million, reflecting the decline in sales (primarily FCC) coupled with unfavorable product mix. Cost reductions, resulting from productivity initiatives, were realized in direct manufacturing costs as well as operating expenses. First quarter 1999 results included additional restructuring costs of $0.9 million resulting from the implementation of the productivity effectiveness program at the end of 1998. This program will reduce expenses for the remainder of 1999 and beyond.

GRACE CONSTRUCTION PRODUCTS

FIRST QUARTER 1999 AS COMPARED TO FIRST QUARTER 1998

Sales

Grace Construction Products is a leading supplier of specialty chemicals and building materials to the nonresidential (commercial and government) construction industry, and to a lesser extent, the residential construction industry. Specialty construction chemicals, which contribute approximately 58% of Grace Construction Products annual total sales, add strength, control corrosion, and enhance the handling and application of concrete. Specialty building materials prevent water damage to structures and protect structural steel against collapse due to fire.

Grace Construction Products sales and revenues were $114.4 million, a 10.7% increase over 1998. Excluding the effect of currency translation, sales increased 10.9%. Worldwide volumes increased 10.3%.

The following discussion of Grace Construction Products sales excludes the effect of currency translation.

Specialty construction chemicals sales increased 11.1%, driven by volume increases across all regions. In North America and Europe, volumes benefited from continued penetration of value-added concrete products as well as share gains and healthy construction activity. Asia Pacific volumes increased 12.6% due to the consolidation of the results of a concrete products subsidiary in Japan, as Grace increased its ownership in a joint venture to 81% in January 1999.

Specialty building materials sales increased 10.5% on higher volumes in North America, Europe, and Asia Pacific. Volumes benefited from favorable weather conditions in North America, steady construction activity in both North America and Europe, and increased penetration of value-added waterproofing products in Asia Pacific.

Earnings

Grace Construction Products pretax operating income of $10.2 million increased 113.8% over 1998. Gross margin increased $6.4 million compared to 1998, primarily driven by sales increases as well as margin improvements from value-added product penetration. The first quarter of 1998 included a $1.0 million charge for workforce reductions in the European waterproofing manufacturing and sales organization. First quarter 1999 results included additional restructuring costs of $0.3 million resulting from the implementation of the productivity effectiveness program at the end of 1998. This program will reduce expenses for the remainder of 1999 and beyond.

DAREX CONTAINER PRODUCTS

FIRST QUARTER 1999 AS COMPARED TO FIRST QUARTER 1998

Sales

Darex Container Products is a leading global producer of can sealants, closure sealants, coatings for metal packaging, and other related products. Can sealants, which represent approximately 52% of Darex annual total sales, hermetically seal beverage, food, and other cans; closure sealants (13% of sales) seal glass and plastic bottles and jars used in beverage and food applications; and coatings (19% of sales) protect metal packaging from corrosion and its contents from the influences of the metal.

Darex Container Products sales and revenues were $59.1 million, a 3.6% decrease from 1998. Contributing to the sales decline were the divestment of a can forming lubricants business in North America (May 1998) and the impact of currency translation. Excluding the impact of these items, sales were essentially flat.

The following discussion of Darex Container Products sales excludes the effect of currency translation.

Can sealant sales declined 4.9% due primarily to reduced demand in North America caused by customer consolidations, and the continued economic challenges in Asia Pacific. Closure sealants sales increased 5.8%, driven by volume increases in all regions except North America. Coatings sales increased 7.9%, mainly due to increased volumes on competitive gains in Latin America.

Earnings

Darex Container Products pretax operating income of $6.6 million decreased 1.9% from 1998. Excluding the effect of currency translation, pretax operating income was up 1.6%. Continued cost containment efforts resulted in reduced operating expenses and flat gross margin, despite a decrease in sales. First quarter 1999 results included additional restructuring costs of $0.3 million resulting from the implementation of the productivity effectiveness program at the end of 1998. This program will reduce expenses for the remainder of 1999 and beyond.

DISCONTINUED OPERATIONS

PACKAGING BUSINESS

As discussed in Notes 1 and 3 to the interim Consolidated Financial Statements in this Report, the Spin-off and Merger were completed on March 31, 1998. Results from discontinued operations for the three months ended March 31, 1998 included $32.6 million ($28.3 million after-tax) of costs related to the Packaging Business transaction and $8.4 million ($5.5 million after-tax) for a related pension plan curtailment loss.

FINANCIAL CONDITION

LIQUIDITY AND CAPITAL RESOURCES

Grace's continuing operating activities provided net pretax cash of $17.5 million in the first quarter of 1999, compared to using $295.5 million in the first quarter of 1998. After giving effect to the net pretax cash provided by operating activities of discontinued operations and payments of income taxes, the net cash used by operating activities was $13.5 million in the first three months of 1999 compared to $258.8 million for the same period in 1998. The decrease from the first quarter of 1998 was primarily due to the first quarter 1999 expenditure of $12.5 million for the defense and disposition of asbestos-related litigation, net of amounts received from settlements with certain insurance carriers in connection with such litigation, as compared to the net expenditure of $154.0 million for asbestos-related litigation in the first quarter of 1998. In addition, environmental remediation payments totaled $9.7 million for the first quarter of 1999 compared to $24.4 million in the first quarter of 1998. There was also a decrease in long-term incentive compensation program disbursements of approximately $95.0 million in 1999 compared to 1998. The long-term incentive compensation program has been discontinued going forward. Future disbursements on the runoff of existing plans will total less than $5.0 million over the next two years.

The decrease in other current assets during the first quarter of 1999 of $40.7 million was due to the special purpose subsidiary (SPS) retaining a smaller interest in the pool of accounts receivable sold. The remaining balance of the retained interest held by the SPS at March 31, 1999 totaled $24.4 million. Grace has an agreement

to sell, on an ongoing basis, a pool of its trade accounts receivable to a multi-seller receivables company (the "conduit") through the wholly-owned bankruptcy-remote SPS. Cash proceeds, net of remittances to the conduit for collections, received during the first quarter of 1999 were $34.6 million.

Cash flows provided by investing activities in the first quarter of 1999 were $2.9 million, compared to cash used of $30.5 million in the first quarter of 1998. The 1999 cash inflows were primarily due to $20.4 million of proceeds received from the sale of the corporate aircraft, partially offset by $17.0 million of capital expenditures. Cash used for investing activities in the first quarter of 1998 represented capital expenditures primarily related to the Grace Davison business and the discontinued Packaging Business. Grace anticipates that total 1999 capital expenditures will not exceed $100.0 million, most of which will be directed towards its operating business segments, with the remainder to be used for capital improvement costs incurred in the 1999 move of the corporate headquarters to Columbia, Maryland.

Net cash provided by financing activities in the first quarter of 1999 was minimal, as short-term borrowings of $22.3 million were used to help purchase $26.0 million of the Company's shares as part of the 1998 share repurchase program. Net cash provided by financing activities in the first quarter of 1998 was $966.7 million, primarily reflecting the cash transfer of $1,256.6 million received in connection with the Packaging Business transaction and proceeds from the exercise of employee stock options, partially offset by net repayments of borrowings.

In connection with the Packaging Business transaction, Grace received $1,256.6 million in cash, which was used to repay substantially all of its debt. On March 31, 1998, Grace used $600.0 million of the cash transfer to repay bank borrowings. On April 1, 1998, Grace repaid $611.3 million principal amount of Notes pursuant to a tender offer that expired on March 27, 1998. On April 1, 1998, Grace also repaid $3.5 million principal amount of MTNs and $6.0 million of sundry indebtedness. As a result of this extinguishment of debt, Grace incurred an after-tax charge of $35.2 million for premiums paid in excess of the Notes' principal amounts and other costs related to the purchase of the Notes and MTNs (including the costs of settling related interest rate swap agreements). These costs are presented as an extraordinary item in the Consolidated Statement of Operations in this Report.

On March 31, 1999, Grace had committed borrowing facilities totaling $850.0 million, consisting of $600.0 million expiring in May 1999 and $250.0 million under a long-term facility expiring May 2003. These facilities support the issuance of commercial paper and bank borrowings, of which $101.2 million was outstanding on March 31, 1999. The aggregate amount of net unused and unreserved borrowings under short-term facilities at March 31, 1999 was $748.8 million. In May 1999, Grace entered into a new $250.0 million credit facility replacing the $600.0 million facility under a 364-day credit agreement expiring May 2000. The existing $250.0 million long-term facility continues in effect.

Grace has targeted a ratio of debt to EBITDA (earnings before interest, taxes, depreciation and amortization) of less than 1.0, although Grace will continue to have the flexibility to exceed this target as business needs dictate. The debt to EBITDA ratio for the three months ended March 31, 1999 was estimated at .52.

In April 1998, the Company's Board of Directors approved a program to repurchase up to 20% of the Company's outstanding shares in the open market (approximately 15,165,000 shares). Through March 31, 1999, the Company had acquired 7,207,200 shares of common stock for $111.0 million under the program (an average price per share of $15.40). Cash payments for settled share repurchases were $108.2 million through March 31, 1999.

Grace believes that cash flows generated from future operations and committed borrowing facilities will be sufficient to meet its cash requirements for the foreseeable future.

ASBESTOS-RELATED MATTERS

Through March 31, 1999, Grace paid $12.5 million for the defense and disposition of asbestos-related property damage and personal injury litigation, net of amounts received under settlements with insurance carriers. Although the total amount to be paid in 1999 with respect to asbestos-related claims (after giving effect to payments to be received from insurance carriers) cannot be precisely estimated, Grace currently expects that it will expend approximately $40.0-$70.0 million (pretax) in 1999 to defend against and dispose of such claims. The amounts, with respect to the probable cost of defending against and disposing of asbestos-related claims and probable recoveries from insurance carriers, represent estimates and are on an undiscounted basis; the outcomes of such claims cannot be predicted with certainty.

See Note 2 to the interim Consolidated Financial Statements in this Report for further information concerning asbestos-related lawsuits and claims.

ENVIRONMENTAL MATTERS

There were no significant developments relating to environmental liabilities in the first quarter of 1999.

For additional information relating to environmental liabilities, see Note 11 to the Consolidated Financial Statements in the 1998 10-K and Part II, Item 1 to this Report.

YEAR 2000 COMPUTER SYSTEMS COMPLIANCE

OVERVIEW

Grace has reviewed its Year 2000 compliance efforts by business segment. Each business segment and Grace Corporate has appointed a project leader to coordinate a comprehensive review of all systems used by Grace to determine to what extent Grace may be affected by the failure of its systems to be Year 2000 compliant. In addition, the project leader for Grace Corporate also functions as Grace's overall Project Director, reporting directly to the Chief Executive Officer.

Grace is reviewing both its information technology ("IT") and non-information technology ("non-IT") systems for Year 2000 compliance. IT systems include hardware, infrastructure, local and wide area networks, software, application systems, electronic data exchange and interfaces. Non-IT systems cover process control and manufacturing support equipment, laboratory systems, instruments and scales, telecommunications, and facility and utility support systems. Non-IT systems include systems containing date dependent software as well as embedded date dependent chip technology. Grace is targeting to achieve Year 2000 compliance or to have an appropriate contingency plan in place for all of its critical IT and non-IT systems by mid-1999.

GRACE'S CURRENT STATE OF YEAR 2000 READINESS

Inventory

Grace has completed an inventory of its IT and non-IT systems that could potentially be affected by the Year 2000 issue for each of its business segments and Grace Corporate. All systems have been prioritized as being either critical or non-critical. A critical system is one where failure to be Year 2000 compliant may have a material adverse effect on health and safety, the environment or on Grace's financial condition or results of operations. A non-critical system is one where failure to be Year 2000 compliant could produce brief business interruptions or system failures that may be remedied promptly and that are not reasonably likely to have any such material adverse effect.

Compliance

As of March 1999, 78% of the critical items are Year 2000 compliant, 21% are non-compliant, and evaluation of the remaining items will be completed in May 1999.

For non-IT systems, Grace's most significant Year 2000 exposure is with the process control systems that control the major Grace Davison plants. Grace has commissioned the vendor that supplies approximately 80% of the primary digital control systems for all Grace Davison plants worldwide, to perform a Year 2000 analysis of such systems. The assessment results for the North American plants indicate that the hardware and the system operating and application software associated with these systems have no significant Year 2000 problems for those areas considered non-compliant. The assessment for the international plants is currently in process and will be completed in May 1999.

Grace Construction Products' facilities primarily utilize a batch process approach for manufacturing and have limited automated process controls that may be directly impacted by Year 2000 issues. Darex Container Products has more than 20 manufacturing facilities worldwide and certain facilities have automated process controls. All critical process control systems for both Grace Construction Products and Darex Container Products have been reviewed, and substantially all are Year 2000 compliant; remediation plans are in place for the noncompliant systems.

Grace has contacted its key customers and vendors (including telecommunications and utility providers, banks and governmental agencies) in an effort to ascertain their compliance status. Through March 31, 1999, 67% of key vendors and 36% of key customers had returned information on their compliance status to Grace. Grace is currently analyzing these responses and following up with those key vendors and customers who have not responded or whose responses are not adequate.

REMEDIATION AND TESTING

Grace has documented remediation (including, in certain cases, validation testing) plans in place for all non-compliant critical IT and non-IT systems and expects to have completed the remediation of all such systems by mid-1999. Remediation for non-critical systems will take place throughout 1999 and into 2000. Grace will have contingency plans in place for those non-critical systems that have not been remediated by the end of 1999.

Grace primarily uses internal resources to validate the remediation procedures as they relate to critical IT and non-IT systems. The Grace Year 2000 Project Director reviews the Grace Year 2000 effort on an on-going basis, reporting regularly to the Audit Committee of the Board of Directors of Grace.

A major component of Grace's IT remediation activity is in place as a result of the conversion of its financial and certain operational support systems to programs using software of SAP America, Inc. (SAP), which has represented that its systems used by Grace are Year 2000 compliant. Unrelated to its Year 2000 efforts, Grace commenced this project in 1995. Grace Construction Products and Darex Container Products have completed the implementation of the SAP software in North America and many countries throughout the rest of the world, and expect to complete the implementation in the remaining countries by mid-1999.

Grace Davison is implementing SAP in conjunction with Grace Construction Products and Darex Container Products in Asia Pacific and Latin America, respectively. In North America and Europe, Grace Davison will not convert to SAP until after December 31, 1999. Until Grace Davison converts to SAP, it plans to install new software releases to upgrade existing systems and is contracting with outside programming services to resolve its Year 2000 issue in North America, with completion expected by June 30, 1999. In Europe, Grace Davison uses a largely internally developed software program that is now supported and maintained by a third party, to provide its business and financial systems support. Grace has contracted with such third party to provide Grace Davison with a version of system software that is Year 2000 compliant, which should be certified by June 30, 1999.

COSTS

Grace estimates as of March 31, 1999 that the total cost of its Year 2000 efforts is not expected to exceed $4.6 million, of which approximately $1.8 million has been spent to date.

This amount excludes the cost of the SAP implementation since, despite being a critical component of the Grace Year 2000 remediation effort, this was a project that was already planned and was not accelerated due to Year 2000 issues. This amount also excludes internal costs, principally the payroll costs, of IT personnel not solely devoted to the Year 2000 remediation effort. No material IT or non-IT projects were delayed due to the Grace Year 2000 remediation effort.

CONTINGENCY PLANS

Grace is developing contingency plans to cover situations where systems are not remediated on a timely basis and should have such contingency plans covering all non-compliant critical IT and non-IT systems in place by June 30, 1999. Contingency plans will also be developed for some non-critical systems that will not be tested or remediated; such contingency plans will provide for the remediation of these systems in the event that they are affected by Year 2000 issues. Contingency plans will also address key customer and vendor non-compliance for Year 2000.

RISK

If Grace fails to take appropriate remedial action, Year 2000 non-compliance could have a material adverse effect on the financial condition or results of operations of Grace. In particular, the failure of process control equipment, infrastructure such as utilities, or non-compliance by third parties could affect the ability of Grace to manufacture products and meet the demands of its customers. Also, the failure of Grace's wide area communications network could disrupt its SAP systems and financial reporting processes. However, Grace believes that the efforts being taken to ensure Year 2000 compliance outlined above, together with contingency planning, will be effective to minimize interruptions or loss of business, or environmental, health and safety risks.

The foregoing Year 2000 discussion is based on management's current evaluation using available information. Factors that might cause material changes include, but are not limited to, the readiness of third parties and Grace's ability to respond to unforeseen Year 2000 complications.