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Fitch Affirms Sherwin-Williams' IDR at 'A'; Outlook Remains Stable

Posted on: Monday, 2 October 2006, 12:00 CDT

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'.

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 paint litigation cases against SHW, increasing raw materials costs and the company's aggressive growth strategy.

In March 2006, Fitch revised the Outlook for SHW from Positive to Stable as a result of the Feb. 22, 2006 verdict against the company in the Rhode Island lead-based paint case. Following the Rhode Island verdict, a California state appeals court reinstated a class-action lawsuit alleging that several paint manufacturers, including SHW, knowingly sold harmful lead-based paint products for decades. The Stable Outlook, for now, takes into account the uncertainty of the financial impact of these cases on the company's credit profile. These cases, particularly the Rhode Island case, are unlikely to be resolved in the near-term. Subsequent rating actions will depend on rulings on various remaining issues of the Rhode Island case, including potential cleanup costs, possible bonding requirements during an appeal process and allocation of damages.

SHW's underlying business continues to perform well, despite persistent increases in raw materials costs. Overall sales grew 8.4% during the 2nd quarter of 2006 and SHW achieved year-over-year gross margin improvement as the non-stores component of the company is starting to realize price increases announced over the past year. In its Paint Stores Group, which accounts for about 61% of total company sales, SHW achieved a 9.6% same-store growth during the second quarter, with the increase split between higher volume and increased pricing. Typically, the company's Paint Stores Group can quickly adjust prices, which the company has done to offset higher raw materials costs. Management indicated that raw material pricing remained challenging during the second quarter, but the company is beginning to see some signs of stability returning to the market. Management expects industry year-over-year raw materials costs to increase in the range of 8% for 2006. (This is down from the 8-10% initially projected by the company during the first quarter.)

SHW has a network of 3,000 company-operated specialty stores in the U.S., Canada, Virgin Islands, and Puerto Rico and 428 company-operated branches worldwide. SHW is unique in that most of its competitors distribute their products through 'Big Box' retailers, hardware stores and mass merchandisers. The networks for paint companies that distribute through company-owned stores are not as extensive as that of SHW. (SHW has more company-owned paint stores than the next 10 competitors combined.) 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 such as Home Depot, Lowe's and Menards and mass merchandisers such as Wal-Mart, Sears, and K-Mart, 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'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 60% of the unit volume in 2005, compared to 51% in 1995 and 45% in 1985. 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 population ages. Also, in recent years the company has been successfully growing its stores' sales to do-it-yourselfers.

SHW seeks to expand its distribution platform by increasing the number of company-owned stores and pursuing acquisition opportunities in the highly fragmented industry. Management plans to expand the store base at an average of 3% per year (100+ net new stores in 2006). 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 be moderated as the situation requires. SHW has been an active consolidator in the coatings industry. In 2004, SHW completed the acquisitions of Duron, Inc. (the 5th largest specialty paint retailer in the U.S. and a major manufacturer of coatings) and Paint Sundry Brands (a leading marketer and manufacturer of high quality paint brushes and rollers). These acquisitions provided the company with a broadened, controlled distribution platform (231 Duron stores) as well as recognized branded products (Purdy brushes and rollers) in the marketplace.

SHW has a strong balance sheet and generates solid free cash flow. SHW's debt to capitalization was 28.6% at June 30, 2006 compared to 39.7% at March 31, 2006 and 26.4% at the conclusion of 2005. 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 for the latest twelve months [LTM] from 6/30/06), which has allowed the company to fund certain acquisitions and stock repurchases. SHW maintains ample liquidity with cash of $248.6 million and $660 million of availability under the commercial paper program that is backed by the company's $910 million revolving credit agreement. In 2006, the company also improved its liquidity with an additional $500 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-Based Paint Case:

On February 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-based paint lawsuit brought by the State of Rhode Island. On February 28, 2006, the judge ruled that the SHW and the other defendants do not have to pay punitive damages. A hearing was held at the end of August to address post trial motions, including the defendants' request for a new trial. Fitch expects that SHW's (and the other defendants) next legal steps will depend on the ruling to be rendered on the post trial motions. The timing of a decision or an opinion on the post trial motions (from the judge presiding over the case) cannot be ascertained at 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. Thus far, no new lead-based paint cases have been filed since the Rhode Island verdict. However, several cities in the state of Ohio are considering litigation against the paint industry. It appears that a number of cities have hired law firms (including Motley Rice who represented Rhode Island) to represent the cities if litigation against paint companies were to be initiated.

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 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. The company has not accrued any amounts for this litigation and has not disclosed the extent of its insurance coverage. Fitch anticipates that SHW will appeal the guilty verdict, irrespective of the abatement costs, to the Rhode Island Supreme Court.

If a judgment is entered against the defendants and the court ruling is appealed to the Rhode Island Supreme Court, SHW may be required to post a bond, or other types of financial instruments, in order to stay collection of the judgment. Over the past few months, the company has enhanced its liquidity by entering into a new $250 million 3-year revolving and letter of credit facility and a new $250 million 5-year revolving and letter of credit facility. The company now has these two facilities available to it in addition to its $910 million syndicated unsecured revolving credit facility (maturing July 2009) with a $500 million letter of credit sub-facility and a $500 million accounts receivable securitization borrowing facility.

California (Santa Clara) Lead-Based Paint 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.

City of Milwaukee Lead-Based Paint Case:

These proceedings were initiated in April 2001 against Mautz Paint Co. and NL Industries, Inc. SHW acquired certain assets of Mautz in November 2001 and agreed to defend and indemnify Mautz for its liability for this case. The City's complaint includes claims for continuing public nuisance, conspiracy, and restitution. The claims were originally dismissed in August 2003, but were subsequently reversed by the Wisconsin Court of Appeals. Discovery is currently proceeding and a trial date was originally scheduled for January 8, 2007. However, the discovery proceeding is taking longer than anticipated and the trial has been postponed to April 2007.

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 (61.2% of 2Q06 YTD sales), Consumer Group (18.8%), and Global Group (20%). 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.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.

Source: Business Wire

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