Why did reported net income drop so sharply in 2002 even though operating results improved?

Net income fell to $127.6 million from $263.2 million in 2001 because of a one-time $183.1 million after-tax charge recorded as a cumulative effect of adopting SFAS No. 142, which required testing goodwill and indefinite-lived intangibles for impairment. Income before that accounting change rose 18.1% to $310.7 million. The charge reflected lower fair values of acquired trademarks and international businesses, mainly the Thompson Minwax trademarks and South American operations, and was non-cash in nature.

How is the company's balance sheet and capital allocation position?

Financial condition improved in 2002. Cash rose to $164.0 million, total debt fell to $521.7 million from $615.4 million, and the current ratio increased to 1.39. The company spent $126.5 million on capital expenditures, $190.3 million on share repurchases, and $91.0 million on dividends, and it retains authorization to buy back 10.3 million additional shares. Shareholders' equity declined to $1.34 billion from $1.49 billion, mainly due to buybacks and currency translation losses of $48.3 million.

What is the outlook for 2003?

Management expects modest growth in the paint and coatings industry in 2003 and says it anticipates continued improvement in sales and earnings regardless of market conditions, though it explicitly does not guarantee growth. It expects to spend roughly the same on capital expenditures as in 2002. It also warned that rising raw material costs that began in late 2002 and continued international pressures mean the gross margin gains seen in 2002 are not expected to continue. The pension credit is projected to shift to a roughly $1.0 million expense in 2003.

What is the risk from the lead pigment litigation?

The company and other former lead pigment manufacturers face numerous lawsuits, including class actions and suits by the State of Rhode Island and various local governments, seeking damages for lead paint abatement, medical monitoring and public education. In the first Rhode Island trial, the jury split 4-2 in the defendants' favor, leading to a mistrial in October 2002. Additional trials have been scheduled for 2003. Management says it cannot estimate potential liability and has accrued nothing for it, but believes the outcome will not have a material adverse effect on results, liquidity or financial condition based on litigation to date.

How much of the company's business is in company-owned stores versus other channels?

The Paint Stores Segment, the largest segment at about 64% of 2002 net external sales, operates 2,643 company-owned specialty paint stores in the United States, Canada, Puerto Rico, the Virgin Islands and Mexico. This is the exclusive North American channel for Sherwin-Williams-branded architectural and industrial paint. The company added 70 net new stores in 2002 (46 opened and 24 acquired) and aims to grow its store base about 3% per year. The Consumer Segment, about 23% of sales, sells mainly through third-party retailers such as home centers and mass merchants, with about 46% of its sales going through its own Paint Stores Segment.

SHW 10-K FY2002 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed March 13, 2003. Cited figures are marked; the original filing is the authoritative source.

The Sherwin-Williams Company (SHW) reported solid 2002 results despite a difficult economy.

Net sales rose 2.3% to $5.18 billion^a, and income before the cumulative effect of an accounting change grew 18.1% to $310.7 million, or $2.04 per diluted share, a record for the company. Reported net income fell to $127.6 million ($0.84 per diluted share) because of a $183.1 million after-tax goodwill and intangible impairment charge recorded as a cumulative effect of adopting SFAS No. 142. Gross margin improved to 45.1% from 43.8%, driven by the Paint Stores Segment, which contributed about 64% of sales and grew sales 3.7% with 70 net new stores.

The Consumer Segment's operating profit rose 73.8% to $192.5 million^b, while the International Coatings Segment swung to an operating loss, reflecting South American currency weakness and asset impairments. Cash generation and balance sheet strength were key positives. Net operating cash flow was $558.9 million, and free cash flow (as management defines it, after capex and dividends) was $341.4 million.

Management retired $101.9 million^c of debt, reducing total debt to capitalization to 28.0% from 29.3%, and repurchased 6.7 million shares for $190.3 million. The Board raised the quarterly dividend to $0.155 per share, the 24th consecutive annual increase. Shareholders' equity fell to $1.34 billion, however, largely because of buybacks and currency translation losses.

Investors should monitor the ongoing lead pigment and lead-based paint litigation, which the company says it has never lost or settled, but which has no accrual recorded and faces a trial calendar in 2003. Management also cautioned that raw material costs began rising in late 2002 and that gross margin gains are not expected to continue in 2003, while guiding only to modest industry growth and continued sales and earnings improvement.

02—Key points

Key Highlights

Net sales up 2.3% to $5.18 billion; Paint Stores Segment sales up 3.7% to $3.3 billion, with comparable-store sales up 1.9%.
Income before cumulative accounting effect rose 18.1% to $310.7 million ($2.04 diluted EPS, a company record), but reported net income fell to $127.6 million ($0.84 diluted EPS) after a $183.1 million after-tax goodwill and intangible impairment under SFAS No. 142.
Gross margin expanded to 45.1% from 43.8%, helped by higher-margin Paint Stores mix, moderating raw material costs, and Consumer Segment plant closure savings.
Consumer Segment operating profit jumped 73.8% to $192.5 million; International Coatings swung to a $5.6 million operating loss, including $11.9 million in asset impairments and currency pressure in South America.
Net operating cash flow of $558.9 million; $101.9 million of debt retired, total debt-to-capitalization improved to 28.0%, and $190.3 million spent repurchasing 6.7 million shares.
Quarterly dividend increased to $0.155 per share (annual pace of $0.62), the 24th consecutive annual increase; 2002 dividend was $0.60.
Lead pigment and lead-based paint litigation remains unresolved with no amount accrued; the company reports it has never lost or settled a case in the past fifteen years, but more trials are scheduled for 2003.

03—Questions

Frequently Asked Questions

Why did reported net income drop so sharply in 2002 even though operating results improved?
Net income fell to $127.6 million from $263.2 million in 2001 because of a one-time $183.1 million after-tax charge recorded as a cumulative effect of adopting SFAS No. 142, which required testing goodwill and indefinite-lived intangibles for impairment. Income before that accounting change rose 18.1% to $310.7 million. The charge reflected lower fair values of acquired trademarks and international businesses, mainly the Thompson Minwax trademarks and South American operations, and was non-cash in nature.
How is the company's balance sheet and capital allocation position?
Financial condition improved in 2002. Cash rose to $164.0 million, total debt fell to $521.7 million from $615.4 million, and the current ratio increased to 1.39. The company spent $126.5 million on capital expenditures, $190.3 million on share repurchases, and $91.0 million on dividends, and it retains authorization to buy back 10.3 million additional shares. Shareholders' equity declined to $1.34 billion from $1.49 billion, mainly due to buybacks and currency translation losses of $48.3 million.
What is the outlook for 2003?
Management expects modest growth in the paint and coatings industry in 2003 and says it anticipates continued improvement in sales and earnings regardless of market conditions, though it explicitly does not guarantee growth. It expects to spend roughly the same on capital expenditures as in 2002. It also warned that rising raw material costs that began in late 2002 and continued international pressures mean the gross margin gains seen in 2002 are not expected to continue. The pension credit is projected to shift to a roughly $1.0 million expense in 2003.
What is the risk from the lead pigment litigation?
The company and other former lead pigment manufacturers face numerous lawsuits, including class actions and suits by the State of Rhode Island and various local governments, seeking damages for lead paint abatement, medical monitoring and public education. In the first Rhode Island trial, the jury split 4-2 in the defendants' favor, leading to a mistrial in October 2002. Additional trials have been scheduled for 2003. Management says it cannot estimate potential liability and has accrued nothing for it, but believes the outcome will not have a material adverse effect on results, liquidity or financial condition based on litigation to date.
How much of the company's business is in company-owned stores versus other channels?
The Paint Stores Segment, the largest segment at about 64% of 2002 net external sales, operates 2,643 company-owned specialty paint stores in the United States, Canada, Puerto Rico, the Virgin Islands and Mexico. This is the exclusive North American channel for Sherwin-Williams-branded architectural and industrial paint. The company added 70 net new stores in 2002 (46 opened and 24 acquired) and aims to grow its store base about 3% per year. The Consumer Segment, about 23% of sales, sells mainly through third-party retailers such as home centers and mass merchants, with about 46% of its sales going through its own Paint Stores Segment.

04—Continue

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