Amend: Fitch Affirms Sherwin-Williams’ IDR at A; Outlook Remains Stable
This is an amendment to a press release issued on September 14, 2007. It adds the Short-term IDR to the ratings list.
Fitch Ratings has affirmed The Sherwin-Williams Company (NYSE:SHW) as follows:
–Issuer Default Rating (IDR) ‘A’;
–Senior unsecured debt rating ‘A’;
–Revolving bank credit facility ‘A’;
–Commercial Paper ‘F1′;
–Short-term IDR ‘F1′.
The Rating Outlook is Stable.
The ratings and Outlook for SHW are based on the company’s leading market position in the architectural coatings industry, the company’s unique distribution platform, the breadth and depth of its product offerings, the company’s focus on painting contractors and property maintenance managers, solid free cash flow generation and strong management team. Risk factors include lead pigment and lead-based paint litigation cases against SHW, the effects of the sluggish housing market on the company’s architectural paint segment, and the company’s relatively aggressive growth strategy.
In March 2006, Fitch revised its Outlook for SHW from Positive to Stable following the verdict against the company in the Rhode Island (R.I.) lead pigment case. SHW has appealed the verdict to the R.I. Supreme Court. The Stable Outlook, for now, takes into account the uncertainty of the financial impact of the R.I. verdict as well as other pending cases on the company’s credit profile and that these cases, particularly the R.I. case, are unlikely to be resolved in the near-term. Subsequent rating actions will depend on rulings on various remaining issues of the R.I. case, including potential cleanup costs, possible bonding requirements and allocation of damages.
SHW and other paint companies have received favorable rulings in other court cases in recent months. In June 2007, the New Jersey Supreme Court reversed an earlier decision by the Appellate Division and reinstated the dismissal of the public nuisance claims brought by counties and cities of New Jersey. This decision concludes the case in favor of SHW and the other defendants. During the same month, the Missouri Supreme Court affirmed summary judgment for the defendants, which concludes the case in favor of SHW and the other defendants. Finally, a Milwaukee jury in June concluded that although the presence of lead paint in Milwaukee is a public nuisance, the defendant, NL Industries, was not at fault for the public nuisance. (Note: Mautz Paint, which was previously acquired by SHW, was also a defendant in the Milwaukee case but the trial court entered an order severing and staying the claims against Mautz Paint.)
The company’s underlying business continues to perform well, despite the slowdown in the U.S. housing market. Overall sales grew 3.2% during the second quarter of 2007 and the company continues to make progress in restoring margins previously pressured by rising raw material costs through price increases and effective cost control. Consolidated gross profit margins increased 90 bps year-over-year to 44.9% of sales during the second quarter of 2007. The company is now close to re-achieving historical peak gross margins (in the 45+% range experienced during the 2003-2004 period) before the escalation in raw materials costs put pressure on margins in recent years.
The company has been more active in acquisitions in recent months, spending $149 million during the first half of the year. In March 2007, SHW announced the acquisition of M.A. Bruder & Sons Incorporated (MAB), a leading manufacturer and distributor of paints and coatings with 132 company-owned stores in the eastern and southern portions of the U.S. This was followed by the company’s entry into the Indian paint market with its purchase of the business of Nitco Paints, a privately owned manufacturer and distributor of exterior specialty paints and coatings. Most recently, SHW announced that it has entered into a definitive merger agreement with Columbia Paint & Coatings Co., a leading manufacturer and distributor of paints and coatings with 41 company-owned stores servicing the western and pacific northwestern portions of the U.S. These acquisitions are consistent with the company’s strategy of acquiring companies that add to its controlled distribution platform and expanding its presence outside of North America.
SHW has a network of 3,226 company-operated paint stores and 469 company-operated branches. The company is unique in that most of its competitors distribute their products through ‘Big Box’ retailers, hardware stores and mass merchandisers. The networks for competitor paint companies that distribute through company-owned stores are not as extensive as that of SHW. Fitch views this as an advantage, as the company can directly control marketing, merchandising, service, and price decisions. Additionally, SHW also distributes through ‘Big Box’ Home Centers and mass merchandisers, primarily reaching the do-it-yourself customer segment. It is estimated that about 75% of SHW’s sales are through its controlled distribution platform, with the remaining 25% through independent retailers.
SHW seeks to expand its distribution platform by opening new stores and pursuing acquisition opportunities in the highly fragmented industry. Management plans to increase the store base at an average of 3% per year or 100+ net new stores. SHW opened 30 net new stores during the first half of the year and management indicated that they are on track to open around 100 net new stores in 2007. SHW has also increased its distribution platform through acquisitions. The Duron acquisition in 2004 added 231 stores to SHW’s controlled distribution network. The MAB acquisition during the second quarter of 2007 added about 132 stores and the pending acquisition of Columbia Paint & Coatings will increase the company’s network by 41 stores. Despite already meaningful market penetration, Fitch is comfortable with this strategy as Fitch believes that the company has considerable room to further expand its store base domestically. Individual stores do not require significant capital and the expansion program can and will be moderated as the situation requires.
SHW’s strong brand and captive distribution network should give the company a competitive advantage in the growing professional contractor market. Within the industry’s architectural coatings segment, it is estimated that sales to professional contractors accounted for approximately 63% of the unit volume in 2006, compared to 51% in 1996 and 45% in 1986. Fitch expects the professional contractor channel to grow at a faster rate than do-it-yourselfers given the anticipated increase in ‘do-it-for-me’ work as the U.S. population ages. Also, in recent years the company has been successfully growing its stores’ sales to do-it-yourselfers.
SHW has a strong balance sheet and typically generates solid free cash flow. SHW’s debt to capitalization was 27.3% at June 30, 2007 compared to 35.1% at March 31, 2007 and 30.5% at the conclusion of 2006. SHW is targeting gross debt to capitalization in the 35% range. The company generates significant free cash flow (over $300 million for each of the last five years and $504 for the latest twelve months [LTM] from 6/30/07), which has allowed the company to fund certain acquisitions and stock repurchases. SHW maintains ample liquidity with cash of $57.5 million and $530.5 million of availability under the commercial paper program that is backed by the company’s $910 million revolving credit agreement. The company also improved its liquidity with an additional $800 million in revolving and letter of credit facilities and a $500 million accounts receivable securitization borrowing facility.
Fitch’s rating takes into account the cyclicality of SHW’s end markets. Residential, commercial and industrial construction are each cyclical and can be influenced by economic trends. SHW showed during the recent recession that it is capable of managing working capital and lowering expenses to generate strong cash flow. Fitch expects the company will be inclined to follow the same practices and build up cash during future periods of economic pressure.
Rhode Island Lead Pigment Case:
On Feb. 22, 2006, a Rhode Island jury found that SHW and two other companies (NL Industries and Millennium Holdings) were liable for creating a public nuisance in a lead pigment lawsuit brought by the State of Rhode Island. On Feb. 28, 2006, the judge ruled that the SHW and the other defendants do not have to pay punitive damages. On Feb. 26, 2007, the court issued a decision on post-trial motions and other matters pending before the court. Specifically, the court: denied the defendant’s post-trial motion for a new trial; decided to enter a judgment of abatement against the defendants, and; decided to appoint a special master for the purpose of assisting the court in its consideration of a proper abatement plan.
On March 16, 2007, final judgment was entered against the defendants. On the same day, SHW filed its notice of appeal to the Rhode Island Supreme Court. The defendants had asked the Superior Court judge to put the entire abatement process on hold until the Rhode Island Supreme Court rules on their appeal but the judge denied the request. As such, the appeal process with the Rhode Island Supreme Court will run concurrently with the determination of an abatement remedy (the process to clean up the lead-based paints on Rhode Island houses). The Superior Court judge had asked both the State and the defendants to recommend experts for a court appointed special master to oversee the process of determining the abatement remedy. Both sides have submitted candidates but the judge has not announced the appointment of a special master as of this time.
The downside risks associated with the ruling against SHW include the company’s potential liability for the Rhode Island cleanup costs and the increased possibility that the decision could have broader ramifications by encouraging similar legal actions from other states and/or municipalities. Since the fall of last year, the State of Ohio and eleven cities in Ohio individually initiated proceedings in state court against Sherwin-Williams and other companies asserting claims for public nuisance. Two municipalities, the City of Cincinnati and East Cleveland, have since withdrawn the public nuisance lawsuits against the defendants. Motley Rice (the firm that tried the Rhode Island case) will be representing the nine Ohio cities in the case against Sherwin-Williams and other defendants.
The financial impact on SHW cannot be determined at this time as the absolute size and extent of the cleanup activity has not been established. The cleanup costs could vary, depending on what the court asks the companies to do. The remedies could range from the funding of educational programs about the dangers of lead-based paint to painting over of exposed lead-based paint to removing and replacing surfaces covered by lead-based paint (walls, millwork). Moreover, the allocation of damages among the defendants is yet to be determined. While a judgment has been entered against the defendants, SHW has not been required (so far) to post a bond (or other types of financial instruments) as the cost for the abatement remedy is yet to be determined. SHW has not accrued any amounts for this litigation and has not disclosed the extent of its insurance coverage.
California (Santa Clara) Lead Pigment Case:
On March 3, 2006, a California state appeals court reinstated a lawsuit by California cities and counties that seeks to force eight paint manufacturers to clean up lead-based paint used in low-income housing and government buildings. The Sixth District Court of Appeal reversed a Santa Clara County Superior Court judge’s decision in 2003 to dismiss the lawsuit. The defendants include SHW, Lead Industries Association, Atlantic Richfield Co., American Cyanamid Co., Conagra Grocer Products Co., E.I. duPont De Nemours and Co., and O’Brien Corp. The California lawsuit, filed in 2000 in Santa Clara County, makes similar claims as the Rhode Island case. SHW appealed this ruling and the California Supreme Court refused to review the ruling and the trial will proceed on this case. No trial date has been set.
Founded in 1866, Sherwin-Williams is one of the world’s leading companies engaged in the manufacture, distribution, and sale of coatings and related products to professional, industrial, commercial, and retail customers. The company is structured in three business segments: Paint Stores Group (61.1% of 2Q07 YTD sales), Consumer Group (17.7%), and Global Group (21.2%). The Paint Stores Group is the exclusive North American distributor of Sherwin-Williams branded paints and related products. The Consumer Group sells paints and coatings and related products under various branded products (Dutch Boy, Pratt & Lambert, Martin-Senour, Thompson, Minwax, etc.), licensed products (Martha Stewart), and private labels (Wal-Mart, Sears). The Global Group develops, manufactures, distributes and sells a variety of paint and coatings products worldwide.
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