How exposed is Sherwin-Williams to the lead pigment litigation, and has it been reserved for?

The company has not accrued any amount for the lead pigment and lead-based paint litigation, and management says it cannot reasonably estimate the potential liability. After the February 2006 Rhode Island jury verdict and the February 26, 2007 judgment of abatement, the company plans to appeal. Management notes that a significant liability could have a material effect on net income in the period it is recorded, and on results, liquidity, and financial condition more broadly. The company also faces other public nuisance suits (California, Missouri, Wisconsin, New Jersey, Ohio), personal injury claims, including 35 new Wisconsin proceedings after the 2005 risk-contribution ruling, and a coverage lawsuit against its insurers. Investors should treat this as an unquantified contingent liability that could be large.

Why did debt rise, and does the credit downgrade matter for funding?

Total debt rose to $874.5M from $621.2M, mostly because the company borrowed short-term (commercial paper rose $246M to $338.8M) to keep cash on hand while litigation outcomes were uncertain. Cash and short-term investments rose to $490M, which more than covered short-term borrowings. Moody's downgraded the company to A3 and S&P to A- in 2006 because of litigation risk. The company says it has $910M in commercial paper capacity backed by a revolver, plus other credit facilities, and does not expect long-term external financing needs for capex. The downgrade raises borrowing costs and may limit flexibility if a large litigation payment arrives.

Is the 2006 growth sustainable given the housing slowdown and weak DIY demand?

Management said the outlook remained positive but acknowledged slower new residential construction and softer DIY sales. Growth in 2006 came largely from pricing and volume gains in professional and contractor channels, plus the expansion of company-operated stores, which added 117 net new paint stores and about 41 Global Group branches. The company plans to keep opening 100-plus net new stores in 2007 and expects gains in OEM finishes, industrial maintenance, and automotive refinish. Because a large share of sales comes from contractor and store-driven channels, the company is less exposed to the DIY slowdown than mass-market paint makers, but a further slump in housing starts would still hit the Paint Stores Group, which generated about 62% of sales.

How much cash is the company returning to shareholders, and is the dividend policy sustainable?

In 2006 the company paid $135.4M in cash dividends and repurchased 5.6M shares for $311.1M, returning about $446M in total. The board raised the 2007 quarterly dividend to $0.315, implying $1.26 annually, a 26% increase. The stated policy is to pay about 30% of prior-year diluted EPS. Free cash flow as management defines it (net operating cash less capex and dividends) was $470.5M in 2006, which covered the dividend comfortably. Buybacks were funded partly with borrowed money, though, and 2006 buybacks ($311M) exceeded free cash flow after dividends, so repurchase levels depend on continued strong cash generation and on how the litigation is resolved.

What are the main environmental liabilities beyond litigation?

At December 31, 2006, the company had accrued $173.1M for environmental investigation and remediation, up from $158.8M in 2005, and it estimates up to $149.6M of additional unaccrued exposure at the high end of its range. Four current or former manufacturing sites account for about 64% of the accrual. The largest unaccrued exposures are at a former New Jersey site and sites in Illinois and California, where clean-up goals are not yet set. Management says these matters will be resolved over an extended period and does not expect them to have a material adverse effect on financial condition, liquidity, or cash flow, but it cannot provide a reliable timeline or final cost estimate.

SHW 10-K FY2006 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed February 28, 2007. Cited figures are marked; the original filing is the authoritative source.

The Sherwin-Williams Company (SHW) reported a record 2006 for the fiscal year covered by this 10-K filed February 28, 2007.

Consolidated net sales rose 8.6% to $7.81 billion^a, net income increased 24% to $576.1 million, and diluted EPS grew 27.7% to $4.19. Net operating cash flow reached a record $815.8 million, and free cash flow (as management defines it, after capex and dividends) was $470.5 million. Growth was led by the Paint Stores Group, whose sales rose 11.3% to $4.84 billion and whose segment profit rose 26.5% to $719.9 million, plus strong Global Group results.

The Consumer Group was the weak spot, with external sales down 1.9%^b on sluggish DIY demand, although its segment profit still rose 25.2%. Management flagged softer new residential construction and DIY demand heading into 2007, and expects to keep opening stores at a 100-plus net-new pace. The key investor risk is the lead pigment and lead-based paint litigation.

In February 2006 a Rhode Island jury found the company, with two other defendants, caused a public nuisance; on February 26, 2007 the court entered a judgment of abatement and appointed a special master to oversee remedies. The company intends to appeal and has accrued nothing for this litigation, saying it cannot estimate the potential liability. Management also says the outcome could materially affect net income in the period a liability is recorded.

Separately, environmental accruals were $173.1 million at year-end, with up to $149.6 million^c of additional reasonably possible exposure. Financial flexibility was tested in 2006: total debt rose to $874.5 million (30.5% of capitalization), partly because the company borrowed short-term to keep liquidity ahead of litigation uncertainty, and Moody's and S&P both downgraded the company's ratings. On capital allocation, the company repurchased 5.6 million shares for $311.1 million and paid $135.4 million in dividends.

The board raised the quarterly dividend to $0.315^d (an annualized $1.26, about a 26% increase), consistent with its policy of paying roughly 30% of prior-year diluted EPS. The company also continued to hold 12.8 million shares of repurchase authorization.

02—Key points

Key Highlights

Record 2006 results: net sales up 8.6% to $7.81B, net income up 24.3% to $576.1M, diluted EPS up 27.7% to $4.19.
Paint Stores Group drove growth: sales up 11.3% to $4.84B, segment profit up 26.5% to $719.9M, segment margin 14.9%, comparable store sales up 9.1%.
Record net operating cash flow of $815.8M (over 10% of sales); working capital improved to 11.7% of sales.
Lead pigment litigation is the dominant risk: a February 2006 Rhode Island jury verdict was followed by a February 2007 abatement judgment; the company has accrued nothing and says it cannot estimate potential liability.
Balance sheet strain: total debt up to $874.5M (30.5% of capitalization from 26.4%); Moody's cut the rating to A3 and S&P to A-, with a further negative outlook.
Shareholder returns: $311.1M in buybacks (5.6M shares) and $135.4M in dividends; 2007 quarterly dividend raised to $0.315 (+26%).
Consumer Group sales fell 1.9% to $1.36B on weak DIY demand, though segment profit rose 25.2% to $214.2M on pricing and cost control.

03—Questions

Frequently Asked Questions

How exposed is Sherwin-Williams to the lead pigment litigation, and has it been reserved for?
The company has not accrued any amount for the lead pigment and lead-based paint litigation, and management says it cannot reasonably estimate the potential liability. After the February 2006 Rhode Island jury verdict and the February 26, 2007 judgment of abatement, the company plans to appeal. Management notes that a significant liability could have a material effect on net income in the period it is recorded, and on results, liquidity, and financial condition more broadly. The company also faces other public nuisance suits (California, Missouri, Wisconsin, New Jersey, Ohio), personal injury claims, including 35 new Wisconsin proceedings after the 2005 risk-contribution ruling, and a coverage lawsuit against its insurers. Investors should treat this as an unquantified contingent liability that could be large.
Why did debt rise, and does the credit downgrade matter for funding?
Total debt rose to $874.5M from $621.2M, mostly because the company borrowed short-term (commercial paper rose $246M to $338.8M) to keep cash on hand while litigation outcomes were uncertain. Cash and short-term investments rose to $490M, which more than covered short-term borrowings. Moody's downgraded the company to A3 and S&P to A- in 2006 because of litigation risk. The company says it has $910M in commercial paper capacity backed by a revolver, plus other credit facilities, and does not expect long-term external financing needs for capex. The downgrade raises borrowing costs and may limit flexibility if a large litigation payment arrives.
Is the 2006 growth sustainable given the housing slowdown and weak DIY demand?
Management said the outlook remained positive but acknowledged slower new residential construction and softer DIY sales. Growth in 2006 came largely from pricing and volume gains in professional and contractor channels, plus the expansion of company-operated stores, which added 117 net new paint stores and about 41 Global Group branches. The company plans to keep opening 100-plus net new stores in 2007 and expects gains in OEM finishes, industrial maintenance, and automotive refinish. Because a large share of sales comes from contractor and store-driven channels, the company is less exposed to the DIY slowdown than mass-market paint makers, but a further slump in housing starts would still hit the Paint Stores Group, which generated about 62% of sales.
How much cash is the company returning to shareholders, and is the dividend policy sustainable?
In 2006 the company paid $135.4M in cash dividends and repurchased 5.6M shares for $311.1M, returning about $446M in total. The board raised the 2007 quarterly dividend to $0.315, implying $1.26 annually, a 26% increase. The stated policy is to pay about 30% of prior-year diluted EPS. Free cash flow as management defines it (net operating cash less capex and dividends) was $470.5M in 2006, which covered the dividend comfortably. Buybacks were funded partly with borrowed money, though, and 2006 buybacks ($311M) exceeded free cash flow after dividends, so repurchase levels depend on continued strong cash generation and on how the litigation is resolved.
What are the main environmental liabilities beyond litigation?
At December 31, 2006, the company had accrued $173.1M for environmental investigation and remediation, up from $158.8M in 2005, and it estimates up to $149.6M of additional unaccrued exposure at the high end of its range. Four current or former manufacturing sites account for about 64% of the accrual. The largest unaccrued exposures are at a former New Jersey site and sites in Illinois and California, where clean-up goals are not yet set. Management says these matters will be resolved over an extended period and does not expect them to have a material adverse effect on financial condition, liquidity, or cash flow, but it cannot provide a reliable timeline or final cost estimate.

04—Continue

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