SHW

Business Context and Reporting Period

Company: The Sherwin-Williams Company
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: June 30, 2005
Business Overview: Sherwin-Williams is a leading manufacturer, marketer, and distributor of paints, coatings, and related products. The company operates through four reportable segments: Paint Stores, Consumer, Automotive Finishes, and International Coatings.

Key Financial Metrics

Amounts in thousands, except per share data.

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 21.5% in Q2 and 19.3% YTD compared to 2004. Growth was driven by strong same-store sales (14.5% increase in Q2), acquisitions (Duron, Inc. and Paint Sundry Brands Corp.), and improvements in Automotive and International segments.
• Profitability: Net income rose 21.2% in Q2 and 32.9% YTD. Diluted EPS increased 24.1% in Q2 and 36.1% YTD.
• Margins: Gross margin declined to 42.6% in Q2 from 44.6% in 2004 due to significant raw material cost increases, partially offset by price increases and better factory utilization. SG&A expenses as a percent of sales improved to 30.2% in Q2 from 31.8% in 2004.
• Liquidity: Cash and cash equivalents decreased by $33.4 million YTD, primarily due to $165.3 million in treasury stock purchases, $57.2 million in dividends, and $69.5 million in capital expenditures. This was partially offset by a $164.4 million increase in short-term borrowings.
• Acquisitions: Acquisitions completed since 2004 contributed $144.1 million (8.9%) to Q2 sales and $265.0 million (9.0%) to YTD sales.

Guidance, Outlook, Risks, and Unusual Items

• Environmental Liabilities: The company recorded a $12.3 million provision for environmental matters in Q2 2005. Total accrued environmental liabilities were $151.4 million at June 30, 2005. Management notes that the unaccrued maximum of the estimated range of possible outcomes is $132.1 million higher than the accrued amount, primarily related to four specific manufacturing sites.
• Lead Paint Litigation: The company is a defendant in numerous legal proceedings regarding lead pigments and lead-based paints. No amounts have been accrued for this litigation as management believes it is without merit, though a trial in Rhode Island is scheduled for September 2005. Potential liability cannot be reasonably estimated.
• Tax Rate: The effective tax rate decreased to 29.9% in Q2 and 27.4% YTD 2005 from 35.0% in 2004, due to favorable tax rulings and foreign operation benefits.
• Capital Allocation: The company continues its share repurchase program, purchasing 1,000,100 shares in Q2. As of June 30, 2005, $6.7 million in shares remained authorized for purchase.
• Forward-Looking Risks: Risks include raw material price volatility, integration of acquisitions, foreign currency fluctuations, and the outcome of pending litigation and environmental remediation.

Investor Verification Checklist

• Raw Material Costs: Verify the sustainability of gross margin compression given the cited raw material cost increases.
• Environmental Exposure: Review the specific status of the four manufacturing sites accounting for the majority of the $132.1 million unaccrued environmental exposure.
• Lead Paint Litigation: Monitor the outcome of the Rhode Island trial scheduled for September 2005 and any new filings.
• Acquisition Integration: Assess the performance of Duron, Inc. and Paint Sundry Brands Corporation to ensure they meet projected sales and profit contributions.
• Liquidity Management: Confirm the company's ability to service increased short-term borrowings ($403 million) while maintaining dividend payments and share buybacks.