EX-13 6 shw-12312013xex13.htm EXHIBIT 13 SHW-12.31.2013-EX13

Exhibit 13 2





































































































































FINANCIAL PERFORMANCE

 
FINANCIAL TABLE OF CONTENTS
 
Financial Summary
 
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
 
Reports of Management and the Independent Registered Public Accounting Firm
 
 
Consolidated Financial Statements and Notes
 
 
Cautionary Statement Regarding Forward-Looking Information
 
 
Shareholder Information
 
 
Corporate Officers and Operating Management

17


FINANCIAL SUMMARY
(millions of dollars except as noted and per share data)


 
2013
 
2012
 
2011
 
2010
 
2009
Operations
 
 
 
 
 
 
 
 
 
Net sales
$
10,186

 
$
9,534

 
$
8,766

 
$
7,776

 
$
7,094

Cost of goods sold
5,569

 
5,328

 
5,021

 
4,295

 
3,831

Selling, general and administrative expenses
3,468

 
3,260

 
2,961

 
2,728

 
2,535

Impairments and dissolution
 
 
4

 
5

 
4

 
36

Interest expense
63

 
43

 
42

 
71

 
40

Income before income taxes
1,086

 
907

 
742

 
678

 
623

Net income
753

 
631

 
442

 
462

 
436

Financial Position
 
 
 
 
 
 
 
 
 
Accounts receivable - net
$
1,098

 
$
1,033

 
$
990

 
$
917

 
$
696

Inventories
971

 
920

 
927

 
918

 
738

Working capital - net
630

 
1,273

 
99

 
150

 
376

Property, plant and equipment - net
1,021

 
966

 
957

 
952

 
819

Total assets
6,383

 
6,235

 
5,229

 
5,169

 
4,324

Long-term debt
1,122

 
1,632

 
639

 
648

 
783

Total debt
1,722

 
1,705

 
993

 
1,045

 
818

Shareholders’ equity
1,775

 
1,792

 
1,517

 
1,609

 
1,491

Per Common Share Information
 
 
 
 
 
 
 
 
 
Average shares outstanding (thousands)
100,898

 
101,715

 
103,471

 
107,022

 
113,514

Book value
$
17.72

 
$
17.35

 
$
14.61

 
$
15.04

 
$
13.62

Net income - diluted (1) 
7.26

 
6.02

 
4.14

 
4.21

 
3.78

Net income - basic (1) 
7.41

 
6.15

 
4.22

 
4.28

 
3.80

Cash dividends
2.00

 
1.56

 
1.46

 
1.44

 
1.42

Financial Ratios
 
 
 
 
 
 
 
 
 
Return on sales
7.4
%
 
6.6
%
 
5.0
%
 
5.9
%
 
6.1
%
Asset turnover
1.6
x
 
1.5
x
 
1.7
x
 
1.5
x
 
1.6
x
Return on assets
11.8
%
 
10.1
%
 
8.4
%
 
8.9
%
 
10.1
%
Return on equity (2) 
42.0
%
 
41.6
%
 
27.5
%
 
31.0
%
 
27.1
%
Dividend payout ratio (3)
33.2
%
 
37.7
%
 
34.7
%
 
38.1
%
 
35.5
%
Total debt to capitalization
49.2
%
 
48.8
%
 
39.6
%
 
39.4
%
 
35.4
%
Current ratio
1.2

 
1.7

 
1.0

 
1.1

 
1.3

Interest coverage (4) 
18.3
x
 
22.2
x
 
18.4
x
 
10.6
x
 
16.6
x
Net working capital to sales
6.2
%
 
13.3
%
 
1.1
%
 
1.9
%
 
5.3
%
Effective income tax rate (5)
30.7
%
 
30.4
%
 
40.4
%
 
31.8
%
 
30.0
%
General
 
 
 
 
 
 
 
 
 
Capital expenditures
$
167

 
$
157

 
$
154

 
$
125

 
$
91

Total technical expenditures (6) 
144

 
140

 
130

 
103

 
102

Advertising expenditures
263

 
247

 
227

 
218

 
218

Repairs and maintenance
87

 
83

 
78

 
76

 
69

Depreciation
159

 
152

 
151

 
140

 
145

Amortization of intangible assets
29

 
27

 
30

 
35

 
26

Shareholders of record (total count)
7,555

 
7,954

 
8,360

 
8,706

 
9,151

Number of employees (total count)
37,633

 
34,154

 
32,988

 
32,228

 
29,220

Sales per employee (thousands of dollars)
$
271

 
$
279

 
$
266

 
$
241

 
$
243

Sales per dollar of assets
1.60

 
1.53

 
1.68

 
1.50

 
1.64

(1)
All earnings per share amounts are presented using the two-class method. See Note 15.
(2)
Based on net income and shareholders’ equity at beginning of year.
(3)
Based on cash dividends per common share and prior year’s diluted net income per common share.
(4)
Ratio of income before income taxes and interest expense to interest expense.
(5)
Based on income before income taxes.
(6)
See Note 1, page 50 of this report, for a description of technical expenditures.

18 

 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

SUMMARY
The Sherwin-Williams Company, founded in 1866, and its consolidated wholly owned subsidiaries (collectively, the “Company”) are engaged in the development, manufacture, distribution and sale of paint, coatings and related products to professional, industrial, commercial and retail customers primarily in North and South America with additional operations in the Caribbean region, Europe and Asia. The Company is structured into four reportable segments – Paint Stores Group, Consumer Group, Global Finishes Group and Latin America Coatings Group (collectively, the “Reportable Segments”) – and an Administrative Segment in the same way it is internally organized for assessing performance and making decisions regarding allocation of resources. See pages 6 through 15 of this report and Note 18, on pages 73 through 76 of this report, for more information concerning the Reportable Segments.
The Company’s financial condition and liquidity remained strong in 2013 and net operating cash improved primarily due to improved operating results in our Paint Stores, Consumer, and Global Finishes Groups. Net working capital decreased $642.6 million at December 31, 2013 compared to 2012 due primarily to a significant increase in current liabilities while current assets increased only slightly. Current portion of long-term debt increased $499.3 million resulting primarily from the 3.125% Senior Notes becoming due in 2014. The Company has been able to arrange sufficient short-term borrowing capacity at reasonable rates, and the Company has sufficient total available borrowing capacity to fund its current operating needs. Net operating cash increased $195.9 million to $1.08 billion in 2013, which included a first quarter payment of $80.0 million to the Company's employee stock ownership plan (ESOP) relating to a settlement reached with the U.S. Department of Labor that was recorded in 2012 (the "DOL Settlement"), from $887.9 million in 2012, which included a first quarter payment of $59.1 million relating to a settlement reached in the fourth quarter of 2011 with the Internal Revenue Service. Strong net operating cash provided the funds necessary to invest in new stores, manufacturing and distribution facilities, acquire businesses, pay down debt, maintain financial stability and return cash to shareholders through dividends and treasury stock purchases.
Results of operations for the Company were strong and improved in many areas in 2013, primarily due to an improving domestic architectural paint market. Consolidated net sales increased 6.8 percent in 2013 to $10.19 billion from $9.53 billion in 2012 due primarily to higher paint sales volume in the Paint Stores Group and acquisitions. Acquisitions increased consolidated net sales 1.8 percent in 2013. Gross profit as a percent of consolidated net sales increased to 45.3 percent in 2013 from 44.1 percent in 2012 due primarily to increased paint sales volume, improved operating efficiency and selling price increases partially offset by dilution from acquisitions and charges relating to the Brazil government tax assessments. Selling, general and administrative expenses (SG&A) increased $208.0 million in 2013 compared to 2012 due primarily to new stores, increased service expenses to support higher sales levels and maintain customer service, and acquisitions partially offset by the DOL Settlement and foreign currency translation rate fluctuations. See "DOL leveraged ESOP settlement" on page 34
 
and Note 9 on page 66. SG&A decreased as a percent of consolidated net sales to 34.0 percent in 2013 as compared to 34.2 percent in 2012 due primarily higher sales levels and the DOL Settlement partially offset by acquisitions. There were no trademark impairment charges in 2013. Impairments of trademarks were $4.1 million in 2012. Higher debt levels throughout 2013 and a one-time interest expense charge of $3.2 million from early retirement of debt during the fourth quarter resulted in increased interest expense of $19.9 million in 2013. The effective income tax rate was 30.7 percent for 2013 and 30.4 percent for 2012. Diluted net income per common share increased 20.6 percent to $7.26 per share for 2013, which included charges relating to the Brazil government tax assessments ($.21 per share), from $6.02 per share a year ago, which included charges relating to the DOL Settlement ($.47 per share).
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation and fair presentation of the consolidated financial statements, accompanying notes and related financial information included in this report are the responsibility of management. The consolidated financial statements, accompanying notes and related financial information included in this report have been prepared in accordance with U.S. generally accepted accounting principles. The consolidated financial statements contain certain amounts that were based upon management’s best estimates, judgments and assumptions. Management utilized certain outside economic sources of information when developing the bases for their estimates and assumptions. Management used assumptions based on historical results, considering the current economic trends, and other assumptions to form the basis for determining appropriate carrying values of assets and liabilities that were not readily available from other sources. Actual results could differ from those estimates. Also, materially different amounts may result under materially different conditions, materially different economic trends or from using materially different assumptions. However, management believes that any materially different amounts resulting from materially different conditions or material changes in facts or circumstances are unlikely to significantly impact the current valuation of assets and liabilities that were not readily available from other sources.


19

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 

All of the significant accounting policies that were followed in the preparation of the consolidated financial statements are disclosed in Note 1, on pages 48 through 51, of this report. The following procedures and assumptions utilized by management directly impacted many of the reported amounts in the consolidated financial statements.
Non-Traded Investments
The Company has invested in the U. S. affordable housing and historic renovation real estate markets. These investments have been identified as variable interest entities. However, the Company is not the primary beneficiary and did not consolidate the operations of the investments. The carrying amounts of these non-traded investments, which approximate market value, were determined based on cost less related income tax credits determined by the effective yield method. The Company’s risk of loss from these non-traded investments is limited to the amount of its contributed capital. The Company has no ongoing capital commitments, loan requirements or guarantees with the general partners that would require any future cash contributions other than the contractually committed capital contributions that are disclosed in the contractual obligations table on page 29 of this report. See Note 1, on page 48 of this report, for more information on non-traded investments.
Accounts Receivable
Accounts receivable were recorded at the time of credit sales net of provisions for sales returns and allowances. All provisions for allowances for doubtful collection of accounts are included in Selling, general and administrative expenses and were based on management’s best judgment and assessment, including an analysis of historical bad debts, a review of the aging of Accounts receivable and a review of the current creditworthiness of customers. Management recorded allowances for such accounts which were believed to be uncollectible, including amounts for the resolution of potential credit and other collection issues such as disputed invoices, customer satisfaction claims and pricing discrepancies. However, depending on how such potential issues are resolved, or if the financial condition of any of the Company’s customers were to deteriorate and their ability to make required payments became impaired, increases in these allowances may be required. At December 31, 2013, no individual customer constituted more than 5 percent of Accounts receivable.
Inventories
Inventories were stated at the lower of cost or market with cost determined principally on the last-in, first-out (LIFO) method based on inventory quantities and costs determined during the fourth quarter. Inventory quantities were adjusted during the fourth quarter as a result of annual physical inventory counts taken at all locations. If inventories accounted for on the LIFO method are reduced on a year-over-year basis, liquidation of certain quantities carried at costs prevailing in prior years occurs. Management recorded the best estimate of net realizable value for obsolete and discontinued inventories based on historical experience and current trends through reductions to inventory cost by recording a provision included in Cost of goods sold. Where management estimated that the reasonable
 
market value was below cost or determined that future demand was lower than current inventory levels, based on historical experience, current and projected market demand, current and projected volume trends and other relevant current and projected factors associated with the current economic conditions, a reduction in inventory cost to estimated net realizable value was made. See Note 3, on page 52 of this report, for more information regarding the impact of the LIFO inventory valuation.
Purchase Accounting, Goodwill and Intangible Assets
In accordance with the Business Combinations Topic of the ASC, the Company used the purchase method of accounting to allocate costs of acquired businesses to the assets acquired and liabilities assumed based on their estimated fair values at the dates of acquisition. The excess costs of acquired businesses over the fair values of the assets acquired and liabilities assumed were recognized as Goodwill. The valuations of the acquired assets and liabilities will impact the determination of future operating results. In addition to using management estimates and negotiated amounts, the Company used a variety of information sources to determine the estimated fair values of acquired assets and liabilities including: third-party appraisals for the estimated value and lives of identifiable intangible assets and property, plant and equipment; third-party actuaries for the estimated obligations of defined benefit pension plans and similar benefit obligations; and legal counsel or other experts to assess the obligations associated with legal, environmental and other contingent liabilities. The business and technical judgment of management was used in determining which intangible assets have indefinite lives and in determining the useful lives of finite-lived intangible assets in accordance with the Goodwill and Other Intangibles Topic of the ASC.
As required by the Goodwill and Other Intangibles Topic of the ASC, management performs impairment tests of goodwill and indefinite-lived intangible assets on an annual basis, as well as whenever an event occurs or circumstances change that indicate impairment has more likely than not occurred. The optional qualitative assessment, which allows companies to skip the annual two-step quantitative test if it is not more likely


20 

 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

than not that impairment has occurred, is performed when deemed appropriate.
In accordance with the Goodwill and Other Intangibles Topic of the ASC, management tests goodwill for impairment at the reporting unit level. A reporting unit is an operating segment per the Segment Reporting Topic of the ASC or one level below the operating segment (component level) as determined by the availability of discrete financial information that is regularly reviewed by operating segment management or an aggregate of component levels of an operating segment having similar economic characteristics. At the time of goodwill impairment testing (if performing a quantitative assessment), management determines fair value through the use of a discounted cash flow valuation model incorporating discount rates commensurate with the risks involved for each reporting unit. If the calculated fair value is less than the current carrying value, impairment of the reporting unit may exist. The use of a discounted cash flow valuation model to determine estimated fair value is common practice in impairment testing. The key assumptions used in the discounted cash flow valuation model for impairment testing include discount rates, growth rates, cash flow projections and terminal value rates. Discount rates are set by using the Weighted Average Cost of Capital (“WACC”) methodology. The WACC methodology considers market and industry data as well as Company-specific risk factors for each reporting unit in determining the appropriate discount rates to be used. The discount rate utilized for each reporting unit is indicative of the return an investor would expect to receive for investing in such a business. Operational management, considering industry and Company-specific historical and projected data, develops growth rates, sales projections and cash flow projections for each reporting unit. Terminal value rate determination follows common methodology of capturing the present value of perpetual cash flow estimates beyond the last projected period assuming a constant WACC and low long-term growth rates. As an indicator that each reporting unit has been valued appropriately through the use of the discounted cash flow valuation model, the aggregate of all reporting units fair value is reconciled to the total market capitalization of the Company.
The Company performed the optional qualitative assessment for its 2013 and 2012 goodwill impairment test for each of its reporting units. The 2011 goodwill impairment test, in which the fair values of each of the reporting units exceeded their respective carrying values by more than ten percent, served as the starting point. Management identified future projected net income, return on average net assets employed and discount rate as the most relevant drivers affecting the fair value calculations. A budget-to-actual analysis was performed in which each reporting unit's key metrics were compared against budgeted amounts in order to assess the validity of future projected net income used in prior year analyses. Management evaluated whether there were any capital investment or working capital deviations from budget that would significantly affect return on average net assets employed. Management considered how the discount rates used in the fair value calculation would have changed since the 2011 goodwill impairment test and performed a sensitivity analysis, noting that it would require a discount rate significantly higher than what would be expected in order for any reporting unit to have a fair value not more than 10% in
 
excess of its carrying value. Management also analyzed macroeconomic conditions, industry and market considerations, cost factors, overall financial performance of the Company, entity-specific events and reporting unit-specific events. Based on the results of the qualitative assessment, management determined that it was not more likely than not that any of the reporting units were impaired and did not need to perform a quantitative test for any of the reporting units.
In accordance with the Goodwill and Other Intangibles Topic of the ASC, management tests indefinite-lived intangible assets for impairment at the asset level, as determined by appropriate asset valuations at acquisition. Management utilizes the royalty savings method and valuation model to determine the estimated fair value for each indefinite-lived intangible asset or trademark. In this method, management estimates the royalty savings arising from the ownership of the intangible asset. The key assumptions used in estimating the royalty savings for impairment testing include discount rates, royalty rates, growth rates, sales projections and terminal value rates. Discount rates used are similar to the rates developed by the WACC methodology considering any differences in Company-specific risk factors between reporting units and trademarks. Royalty rates are established by management and valuation experts and periodically substantiated by valuation experts. Operational management, considering industry and Company-specific historical and projected data, develops growth rates and sales projections for each significant trademark. Terminal value rate determination follows common methodology of capturing the present value of perpetual sales estimates beyond the last projected period assuming a constant WACC and low long-term growth rates. The royalty savings valuation methodology and calculations used in 2013 impairment testing are consistent with prior years.
The discounted cash flow and royalty savings valuation methodologies require management to make certain assumptions based upon information available at the time the valuations are performed. Actual results could differ from these assumptions. Management believes the assumptions used are reflective of what a market participant would have used in calculating fair value considering the current economic conditions. See Notes 2 and 4, on pages 51 through 53 of this report, for a discussion of businesses acquired, the estimated fair


21

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 

values of goodwill and identifiable intangible assets recorded at acquisition date and reductions in carrying value of goodwill and indefinite-lived intangible assets recorded as a result of impairment tests in accordance with the Goodwill and Other Intangibles Topic of the ASC.
Property, Plant and Equipment and Impairment of Long-Lived Assets
Property, plant and equipment was stated on the basis of cost and depreciated principally on a straight-line basis using industry standards and historical experience to estimate useful lives. In accordance with the Property, Plant and Equipment Topic of the ASC, if events or changes in circumstances indicated that the carrying value of long-lived assets may not be recoverable or the useful life had changed, impairment tests were performed or the useful life was adjusted. Undiscounted future cash flows were used to calculate the recoverable value of long-lived assets to determine if such assets were impaired. Where impairment was identified, management determined fair values for assets using a discounted cash flow valuation model, incorporating discount rates commensurate with the risks involved for each group of assets. Growth models were developed using both industry and company historical results and forecasts. If the usefulness of an asset was determined to be impaired, management estimated a new useful life based on the period of time for projected uses of the asset. Such models and changes in useful life required management to make certain assumptions based upon information available at the time the valuation or determination was performed. Actual results could differ from these assumptions. Management believes the assumptions used are reflective of what a market participant would have used in calculating fair value or useful life considering the current economic conditions. All tested long-lived assets or groups of long-lived assets had undiscounted cash flows that were substantially in excess of their carrying value, except as noted in Note 4. See Notes 4 and 5, on pages 52 through 55 of this report, for a discussion of the reductions in carrying value or useful life of long-lived assets in accordance with the Property, Plant and Equipment Topic of the ASC.
Exit or Disposal Activities
Management is continually re-evaluating the Company’s operating facilities against its long-term strategic goals. Liabilities associated with exit or disposal activities are recognized as incurred in accordance with the Exit or Disposal Cost Obligations Topic of the ASC and property, plant and equipment is tested for impairment in accordance with the Property, Plant and Equipment Topic of the ASC. Provisions for qualified exit costs are made at the time a facility is no longer operational, include amounts estimated by management and primarily include post-closure rent expenses or costs to terminate the contract before the end of its term and costs of employee terminations. Adjustments may be made to liabilities accrued for qualified exit costs if information becomes available upon which more accurate amounts can be reasonably estimated. If impairment of property, plant and equipment exists, the carrying value is reduced to fair value estimated by management. Additional impairment may be recorded for subsequent revisions in estimated fair value. See Note 5, on pages 53 through 55 of this report, for information concerning
 
impairment of property, plant and equipment and accrued qualified exit costs.
Other Liabilities
The Company is self-insured for certain liabilities, primarily worker’s compensation claims, employee medical benefits, and automobile, property, general and product liability claims. Estimated amounts were accrued for certain worker’s compensation, employee medical and disability benefits, automobile and property claims filed but unsettled and estimated claims incurred but not reported based upon management’s estimated aggregate liability for claims incurred using historical experience, actuarial assumptions followed in the insurance industry and actuarially-developed models for estimating certain liabilities. Certain estimated general and product liability claims filed but unsettled were accrued based on management’s best estimate of ultimate settlement or actuarial calculations of potential liability using industry experience and actuarial assumptions developed for similar types of claims.
Defined Benefit Pension and Other Postretirement Benefit Plans
To determine the Company’s ultimate obligation under its defined benefit pension plans and postretirement benefit plans other than pensions, management must estimate the future cost of benefits and attribute that cost to the time period during which each covered employee works. To determine the obligations of such benefit plans, management uses actuaries to calculate such amounts using key assumptions such as discount rates, inflation, long-term investment returns, mortality, employee turnover, rate of compensation increases and medical and prescription drug costs. Management reviews all of these assumptions on an ongoing basis to ensure that the most current information available is being considered. An increase or decrease in the assumptions or economic events outside management’s control could have a direct impact on the Company’s results of operations or financial condition.
In accordance with the Retirement Benefits Topic of the ASC, the Company recognizes each plan’s funded status as an asset for overfunded plans and as a liability for unfunded or underfunded plans. Actuarial gains and losses and prior


22 

 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

service costs are recognized and recorded in Cumulative other comprehensive loss, a component of Shareholders’ equity. The amounts recorded in Cumulative other comprehensive loss will continue to be modified as actuarial assumptions and service costs change, and all such amounts will be amortized to expense over a period of years through the net pension and net periodic benefit costs.
Effective July 1, 2009, the domestic salaried defined benefit pension plan was revised. Prior to July 1, 2009, the contribution was based on six percent of compensation for certain covered employees. Under the revised plan, such participants are credited with certain contribution credits that range from two percent to seven percent of compensation based on an age and service formula.
A reduction in the over-funded status of the Company’s defined benefit pension plans at December 31, 2008 due to the decrease in market value of equity securities held by the plans increased the future amortization of actuarial losses recognized in Cumulative comprehensive loss. This amortization increased net pension costs in 2011, 2012, and 2013. An increase in market value of equity securities held by the plans during 2011, 2012 and 2013 will decrease the future amortization of actuarial losses recognized in Cumulative comprehensive loss. The excess in market value of equity securities held by the plans versus the expected returns in 2013 will decrease the future amortization of actuarial losses. The amortization of actuarial losses on plan assets and an increase in discount rates on projected benefit obligations, will decrease net pension costs in 2014. See Note 6, on pages 56 through 61 of this report, for information concerning the Company’s defined benefit pension plans and postretirement benefit plans other than pensions.
Debt
The fair values of the Company’s publicly traded long-term debt were based on quoted market prices. The fair values of the Company’s non-traded long-term debt were estimated using discounted cash flow analyses, based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements. See Note 1, on page 48 of this report, for the carrying amounts and fair values of the Company’s long-term debt, and Note 7, on pages 61 and 62 of this report, for a description of the Company’s long-term debt arrangements.
Environmental Matters
The Company is involved with environmental investigation and remediation activities at some of its currently and formerly owned sites and at a number of third-party sites. The Company accrues for environmental-related activities for which commitments or clean-up plans have been developed and for which costs can be reasonably estimated based on industry standards and professional judgment. All accrued amounts were recorded on an undiscounted basis. Environmental-related expenses included direct costs of investigation and remediation and indirect costs such as compensation and benefits for employees directly involved in the investigation and remediation activities and fees paid to outside engineering, actuarial, consulting and law firms. Due to uncertainties surrounding environmental investigations and remediation activities, the
 
Company’s ultimate liability may result in costs that are significantly higher than currently accrued. See pages 27 through 29 and Note 8, on pages 62 and 63 of this report, for information concerning the accrual for extended environmental-related activities and a discussion concerning unaccrued future loss contingencies.
Litigation and Other Contingent Liabilities
In the course of its business, the Company is subject to a variety of claims and lawsuits, including litigation relating to product liability and warranty, personal injury, environmental, intellectual property, commercial and contractual claims. Management believes that the Company has properly accrued for all known liabilities that existed and those where a loss was deemed probable for which a fair value was available or an amount could be reasonably estimated in accordance with all present U.S. generally accepted accounting principles. However, because litigation is inherently subject to many uncertainties and the ultimate result of any present or future litigation is unpredictable, the Company’s ultimate liability may result in costs that are significantly higher than currently accrued. In the event that the Company’s loss contingency is ultimately determined to be significantly higher than currently accrued, the recording of the liability may result in a material impact on net income for the annual or interim period during which such liability is accrued. Additionally, due to the uncertainties involved, any potential liability determined to be attributable to the Company arising out of such litigation may have a material adverse effect on the Company’s results of operations, liquidity or financial condition. See pages 31 through 34 of this report and Note 9, on pages 63 through 66 of this report, for information concerning litigation.
In addition, the Company may be subject to potential liabilities for which a loss was not deemed probable at this time and an amount could not be reasonably estimated due to uncertainties involved. See page 31 of this report for more information concerning contingent liabilities.
Income Taxes
The Company estimated income taxes in each jurisdiction that it operated. This involved estimating taxable earnings, specific taxable and deductible items, the likelihood of generating sufficient future taxable income to utilize deferred


23

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 

tax assets and possible exposures related to future tax audits. To the extent these estimates change, adjustments to deferred and accrued income taxes will be made in the period in which the changes occur.
In October 2011, the Company reached a settlement of the IRS’ audit of the Company’s employee stock ownership plan (ESOP). The Company has fully resolved all IRS issues for the 2003 through 2009 tax years relating to the matters challenging the ESOP related federal income tax deductions claimed by the Company and proposing substantial excise taxes and penalties. The IRS Settlement (including interest), which resolved all ESOP related tax issues, resulted in an after-tax charge related to federal and state income taxes totaling approximately $75.0 million, or $.70 per diluted common share, and an additional reduction in Shareholders’ equity of approximately $51.2 million in the Company’s fourth quarter of 2011. The Company paid $60.0 million of the IRS Settlement to the IRS during 2011 and made a final payment of approximately $59.1 million in the first quarter of 2012. The Company has fully resolved all IRS issues relating to the matters challenging the ESOP related federal income tax deductions claimed by the Company.
See Note 14, on pages 70 through 71 of this report, for information concerning the Company’s unrecognized tax benefits, interest and penalties and current and deferred tax expense.
Stock-Based Compensation
The cost of the Company’s stock-based compensation is recorded in accordance with the Stock Compensation Topic of the ASC. The Company follows the “modified prospective” method as described in the Topic whereby compensation cost is recognized for all share-based payments granted after December 31, 2005.
The Company estimates the fair value of option rights using a Black-Scholes-Merton option pricing model which requires management to make estimates for certain assumptions. Management and a consultant continuously review the following significant assumptions: risk-free interest rate, expected life of options, expected volatility of stock and expected dividend yield of stock. An increase or decrease in the assumptions or economic events outside management’s control could have a direct impact on the Company’s results of operations. See Note 12, on pages 68 and 69 of this report, for more information on stock-based compensation.
Revenue Recognition
The Company’s revenue was primarily generated from the sale of products. All sales of products were recognized when shipped and title had passed to unaffiliated customers. Collectibility of amounts recorded as revenue is reasonably assured at time of sale. Discounts were recorded as a reduction to sales in the same period as the sale resulting in an appropriate net sales amount for the period. Standard sales terms are final and returns or exchanges are not permitted unless expressly stated. Estimated provisions for returns or exchanges, recorded as a reduction resulting in net sales, were established in cases where the right of return existed. The Company offered a variety
 
of programs, primarily to its retail customers, designed to promote sales of its products. Such programs required periodic payments and allowances based on estimated results of specific programs and were recorded as a reduction resulting in net sales. The Company accrued the estimated total payments and allowances associated with each transaction at the time of sale. Additionally, the Company offered programs directly to consumers to promote the sale of its products. Promotions that reduced the ultimate consumer sale prices were recorded as a reduction resulting in net sales at the time the promotional offer was made, generally using estimated redemption and participation levels. The Company continually assesses the adequacy of accruals for customer and consumer promotional program costs earned but not yet paid. To the extent total program payments differ from estimates, adjustments may be necessary. Historically, these total program payments and adjustments have not been material.
FINANCIAL CONDITION, LIQUIDITY AND CASH FLOW
Overview
The Company’s financial condition and liquidity remained strong in 2013 and net operating cash improved primarily due to improved operating results in our Paint Stores, Consumer, and Global Finishes Groups. Net working capital decreased $642.6 million at December 31, 2013 compared to 2012 due primarily to a significant increase in current liabilities while current assets increased only slightly. Current portion of long-term debt increased $499.3 million resulting from the 3.125% Senior Notes becoming due in 2014. Accounts payable increased $75.5 million, Accrued taxes increased $27.4 million, and Short-term borrowings increased $27.5 million while all other current liabilities, excluding current portion of long-term debt, increased $22.5 million. Accounts receivable were up $65.2 million and Inventories were up $50.5 million while Cash and cash equivalents decreased $117.7 million. Deferred tax net assets were down $22.2 million while the remaining current assets increased $33.7 million. The Company’s current ratio decreased to 1.25 at December 31, 2013 from 1.68 at December 31, 2012. Total debt at December 31, 2013 increased $17.0 million to $1.72 billion from $1.70 billion at December 31, 2012. Total debt increased as a percentage of total capitalization to 49.2 percent from 48.8 percent at the end of 2012. At December 31, 2013, the Company had remaining borrowing ability of $2.28 billion.


24 

 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Net operating cash increased $195.9 million to $1.08 billion in 2013 from $887.9 million in 2012 due primarily to an increase in net income of $121.5 million and an overall net reduction in working capital accounts. Net operating cash increased as a percent to sales to 10.6 percent in 2013 compared to 9.3 percent in 2012. Strong Net operating cash provided the funds necessary to invest in new stores, manufacturing and distribution facilities, acquire businesses, and return cash to shareholders through dividends and treasury stock purchases. In 2013, the Company used Net operating cash to invest $166.7 million in capital additions and improvements, purchase $769.3 million in treasury stock, pay $205.0 million in cash dividends to its shareholders of common stock, and invest $79.9 million in acquisitions.
Net Working Capital
Total current assets less Total current liabilities (net working capital) decreased $642.6 million to a surplus of $630.2 million at December 31, 2013 from a surplus of $1.27 billion at December 31, 2012. The net working capital decrease is due primarily to a large increase in current liabilities while current assets increased only slightly. Current portion of long-term debt increased $499.3 million resulting from the 3.125% Senior Notes becoming due in 2014. Accounts payable increased $75.5 million, Accrued taxes increased $27.4 million, and Short-term borrowings increased $27.5 million while all other current liabilities, excluding current portion of long-term debt, increased $22.5 million. Accounts receivable were up $65.2 million and Inventories were up $50.5 million while Cash and cash equivalents decreased $117.7 million. Deferred tax net assets were down $22.2 million while the remaining current assets increased $33.7 million. The Company has sufficient total available borrowing capacity to fund its current operating needs. The increase in Total current liabilities caused the Company’s current ratio to decrease to 1.25 at December 31, 2013 from 1.68 at December 31, 2012. Accounts receivable as a percent of Net sales was flat at 10.8 percent in 2013 and 2012. Accounts receivable days outstanding decreased to 54 days in 2013 from 55 days 2012. In 2013, provisions for allowance for doubtful collection of accounts increased $6.8 million, or 14.2 percent. Inventories decreased as a percent of Net sales to 9.5 percent in 2013 from 9.7 percent in 2012 due primarily to tighter inventory management. Inventory days outstanding decreased to 86 days in 2013 from 90 days in 2012. Accounts payable increased in 2013 to $998.5 million compared to $923.0 million last year due primarily to increased purchases to service higher sales levels and timing of payments.
Goodwill and Intangible Assets
Goodwill, which represents the excess of cost over the fair value of net assets acquired in purchase business combinations, increased $22.7 million in 2013 due primarily to $19.8 million additional goodwill resulting from acquisitions.
 
Intangible assets decreased $34.3 million in 2013. Decreases from amortization of finite-lived intangible assets of $29.0 million and adjustments to acquired finite-lived and indefinite-lived intangible assets within the last twelve months of $12.5 million were partially offset by $10.2 million of capitalized software costs. Acquired finite-lived intangible assets included assets such as covenants not to compete, customer lists and product formulations. Costs related to designing, developing, obtaining and implementing internal use software are capitalized and amortized in accordance with the Goodwill and Other Intangibles Topic of the ASC. See Notes 2 and 4, on pages 51 through 53 of this report, for a description of acquired goodwill, identifiable intangible assets and asset impairments recorded in accordance with the Goodwill and Other Intangibles Topic of the ASC and summaries of the remaining carrying values of goodwill and intangible assets.
Deferred Pension and Other Assets
Deferred pension assets of $302.4 million at December 31, 2013 represent the excess of the fair value of assets over the actuarially determined projected benefit obligations, primarily of the domestic salaried defined benefit pension plan. The increase in Deferred pension assets during 2013 of $52.5 million, from $249.9 million last year, was due primarily to an increase in the fair value of equity securities held by the salaried defined benefit pension plan and decreased projected benefit obligations resulting from changes in actuarial assumptions partially offset by net pension liabilities merged into the plan from acquisition of businesses and other insignificant items. In accordance with the accounting prescribed by the Retirement Benefits Topic of the ASC, the increase in the value of the Deferred pension assets is offset in Cumulative other comprehensive loss and is amortized as a component of Net pension costs over a defined period of pension service. See Note 6, on pages 56 through 61 of this report, for more information concerning the excess fair value of assets over projected benefit obligations of the salaried defined benefit pension plan and the amortization of actuarial gains or losses relating to changes in the excess assets and other actuarial assumptions.
Other assets increased $41.8 million to $408.0 million at December 31, 2013 due primarily to increases in other investments. 
Property, Plant and Equipment
Net property, plant and equipment increased $55.5 million to $1.02 billion at December 31, 2013 due primarily to capital expenditures of $166.7 million and acquired assets of $53.4 million partially offset by depreciation expense of $158.8 million,


25

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 

sale or disposition of assets with remaining net book value of $4.5 million and currency translation adjustments of $1.4 million. Capital expenditures during 2013 in the Paint Stores Group were primarily attributable to the opening of new paint stores and improvements in existing stores. In the Consumer Group, capital expenditures during 2013 were primarily related to efficiency improvements and maintenance items in existing production and distribution facilities. Capital expenditures in the Global Finishes Group were primarily attributable to improvements in existing manufacturing and distribution facilities. Capital expenditures in the Latin America Coatings Group were primarily attributable to the opening of new specialty stores and improvements in existing manufacturing and distribution facilities. The Administrative segment incurred capital expenditures primarily for headquarters building and information systems hardware. In 2014, the Company expects to spend more than 2013 for capital expenditures. The predominant share of the capital expenditures in 2014 is expected to be for various productivity improvement and maintenance projects at existing manufacturing and distribution facilities, new store openings and new or upgraded information systems hardware. The Company does not anticipate the need for any specific long-term external financing to support these capital expenditures.
Debt
There were no borrowings outstanding under the domestic commercial paper program at December 31, 2013 and 2012. Borrowings outstanding under this program at December 31, 2011 were $264.9 million with a weighted-average interest rate of 0.2 percent. Borrowings outstanding under various foreign programs at December 31, 2013 were $96.6 million with a weighted-average interest rate of 7.8 percent. At December 31, 2012 and December 31, 2011, foreign borrowings were $69.0 million and $81.4 million with weighted-average interest rates of 2.8 percent and 4.9 percent, respectively. Long-term debt, including the current portion, decreased $10.5 million during 2013 due primarily to the retirement of $9.7 million of the Company's 30-year 7.375% bonds due 2027. On December 4, 2012, Senior Notes were issued totaling $1.00 billion. These Senior Notes are covered under a shelf registration filed with the Securities and Exchange Commission (SEC) on December 16, 2009. The proceeds from the issuance of the Senior Notes were used for general corporate purposes, including repayment of short-term borrowings and financing acquisitions.
On September 19, 2012, Sherwin-Williams Luxembourg S.à r.l., a wholly-owned subsidiary of the Company, entered into a €95.0 million (Euro) five-year revolving credit facility. This facility replaced the existing €97.0 million (Euro) credit facility. On June 29, 2012, Sherwin-Williams Canada Inc., a wholly-owned subsidiary of the Company, entered into a new CAD 75.0 million five-year credit facility which replaced the existing credit facility. On March 18, 2013, the aggregate amount of this credit facility was increased to CAD 150.0 million. These credit facilities are being used for general corporate purposes, including refinancing indebtedness and for acquisitions.
On January 30, 2012, the Company entered into a five-year credit agreement, subsequently amended on multiple dates, which gives the Company the right to borrow and to obtain the
 
issuance, renewal, extension and increase of a letter of credit of up to an aggregate availability of $500.0 million. On April 23, 2012, the Company entered into a five-year credit agreement, subsequently amended on multiple dates, which gives the Company the right to borrow and to obtain the issuance, renewal, extension and increase of a letter of credit up to an aggregate availability of $250.0 million. On November 14, 2012, the Company entered into a three-year credit agreement, subsequently amended on multiple dates, which gives the Company the right to borrow and to obtain the issuance, renewal, extension and increase of a letter of credit up to an aggregate availability of $250.0 million. The three credit agreements entered into in 2012 replace prior credit facilities that matured in 2012 and 2011. At December 31, 2013, 2012 and 2011, there were no borrowings outstanding under any of these credit agreements.
The Company uses a revolving credit agreement primarily to satisfy its commercial paper program’s dollar for dollar liquidity requirement. On July 8, 2011, the Company entered into a new five-year $1.05 billion revolving credit agreement, which replaced the existing three-year $500.0 million credit agreement. The new credit agreement allows the Company to extend the maturity of the facility with two one-year extension options and to increase the aggregate amount of the facility to $1.30 billion, both of which are subject to the discretion of each lender.
See Note 7, on pages 61 and 62 of this report, for a detailed description of the Company’s debt outstanding and other available financing programs.
Defined Benefit Pension and Other Postretirement Benefit Plans
In accordance with the accounting prescribed by the Retirement Benefits Topic of the ASC, the Company’s total liability for unfunded or underfunded defined benefit pension plans increased $12.1 million to $52.1 million primarily due to the acquisition of three Canadian defined benefit pension plans in connection with the 2013 acquisition of the U.S./Canada business of Comex as well as changes in the actuarial assumptions of the Company's foreign plans. Postretirement benefits other than pensions decreased $51.5 million to $286.7 million at December 31, 2013 due primarily to changes in the actuarial assumptions.


26 

 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Effective July 1, 2009, the domestic salaried defined benefit pension plan was revised. Prior to July 1, 2009, the contribution was based on six percent of compensation for covered employees. Under the revised plan, such participants are credited with certain contribution credits that range from two percent to seven percent of compensation based on an age and service formula. Amounts previously recorded in Cumulative other comprehensive loss in accordance with the provisions of the Retirement Benefits Topic of the ASC were modified in 2009 resulting in a decrease in comprehensive loss due primarily to the change in the domestic salaried defined benefit pension plan and an increase in the excess plan assets over the actuarially calculated projected benefit obligation in the domestic defined benefit pension plans. Partially offsetting this decreased loss were modifications to actuarial assumptions used to calculate projected benefit obligations.
Effective October 1, 2011, the domestic salaried defined benefit pension plan was frozen for new hires, and all newly hired U.S. non-collectively bargained employees are eligible to participate in the Company’s domestic defined contribution plan.
The assumed discount rate used to determine the actuarial present value of projected defined benefit pension and other postretirement benefit obligations for domestic plans was increased from 3.73 percent to 4.65 percent at December 31, 2013 due to increased rates of high-quality, long-term investments and was slightly higher for foreign defined benefit pension plans. The rate of compensation increases used to determine the projected benefit obligations remained at 4.0 percent for domestic pension plans and was slightly higher on most foreign plans. In deciding on the rate of compensation increases, management considered historical Company increases as well as expectations for future increases. The expected long-term rate of return on assets was decreased to 6.0 percent for 2013 for domestic pension plans and was slightly lower for most foreign plans. In establishing the expected long-term rate of return on plan assets for 2013, management considered the historical rates of return, the nature of investments and an expectation for future investment strategies. The assumed health care cost trend rates used to determine the net periodic benefit cost of postretirement benefits other than pensions for 2013 were 8.0 percent for medical and prescription drug cost increases, both decreasing gradually to 5.0 percent in 2022. The assumed health care cost trend rates used to determine the benefit obligation at December 31, 2013 were between 6.5 percent and 7.5 percent for medical and prescription drug cost increases. In developing the assumed health care cost trend rates, management considered industry data, historical Company experience and expectations for future health care costs.
For 2014 Net pension cost and Net periodic benefit cost recognition for domestic plans, the Company will use a discount rate of 4.65 percent, an expected long-term rate of return on assets of 6.0 percent, a rate of compensation increase of 4.0 percent and cost trend rates between 6.5 percent and 7.5 percent for health care and prescription drug cost increases. Slightly higher discount rates and rates of compensation increases and lower expected long-term rates of return on plan assets will be used for most foreign plans. Use of these assumptions and amortization of actuarial gains will result in a domestic Net
 
pension cost in 2014 that is expected to be approximately $13.8 million lower than in 2013 and a Net periodic benefit cost for postretirement benefits other than pensions that is expected to decrease $4.1 million in 2014 compared to 2013. See Note 6, on pages 56 through 61 of this report, for more information on the Company’s obligations and funded status of its defined benefit pension plans and postretirement benefits other than pensions.
Other Long-Term Liabilities
Other long-term liabilities increased $74.1 million during 2013 due primarily to an increase in non-current deferred tax liabilities of $73.5 million, an increase in long-term pension liabilities of $3.0 million and an increase in deferred compensation liabilities of $1.7 million, partially offset by a decrease in accruals for extended environmental-related liabilities of $10.6 million and a decrease in long-term commitments related to the affordable housing and historic renovation real estate properties of $5.4 million. See below and Note 8, on pages 62 and 63 of this report, for further information on environmental-related long-term liabilities.
Environmental-Related Liabilities
The operations of the Company, like those of other companies in the same industry, are subject to various federal, state and local environmental laws and regulations. These laws and regulations not only govern current operations and products, but also impose potential liability on the Company for past operations. Management expects environmental laws and regulations to impose increasingly stringent requirements upon the Company and the industry in the future. Management believes that the Company conducts its operations in compliance with applicable environmental laws and regulations and has implemented various programs designed to protect the environment and promote continued compliance. 
Depreciation of capital expenditures and other expenses related to ongoing environmental compliance measures were included in the normal operating expenses of conducting business. The Company’s capital expenditures, depreciation and other expenses related to ongoing environmental compliance measures were not material to the Company’s financial


27

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 

condition, liquidity, cash flow or results of operations during 2013. Management does not expect that such capital expenditures, depreciation and other expenses will be material to the Company’s financial condition, liquidity, cash flow or results of operations in 2014.
The Company is involved with environmental investigation and remediation activities at some of its currently and formerly owned sites (including sites which were previously owned and/or operated by businesses acquired by the Company). In addition, the Company, together with other parties, has been designated a potentially responsible party under federal and state environmental protection laws for the investigation and remediation of environmental contamination and hazardous waste at a number of third-party sites, primarily Superfund sites. In general, these laws provide that potentially responsible parties may be held jointly and severally liable for investigation and remediation costs regardless of fault. The Company may be similarly designated with respect to additional third-party sites in the future.
The Company accrues for estimated costs of investigation and remediation activities at its currently or formerly owned sites and third-party sites for which commitments or clean-up plans have been developed and when such costs can be reasonably estimated based on industry standards and professional judgment. These estimated costs are determined based on currently available facts regarding each site. The Company accrues a specific estimated amount when such an amount and a time frame in which the costs will be incurred can be reasonably determined. If the best estimate of costs can only be identified as a range and no specific amount within that range can be determined more likely than any other amount within the range, the minimum of the range is accrued by the Company in accordance with applicable accounting rules and interpretations. The Company continuously assesses its potential liability for investigation and remediation activities and adjusts its environmental-related accruals as information becomes available upon which more accurate costs can be reasonably estimated. At December 31, 2013, 2012 and 2011, the Company had total current and long-term accruals for environmental-related activities of $102.0 million, $114.3 million and $132.1 million, respectively.
Due to the uncertainties of the scope and magnitude of contamination and the degree of investigation and remediation activities that may be necessary at certain currently or formerly owned sites and third-party sites, it is reasonably likely that further extensive investigations may be required and that extensive remedial actions may be necessary not only on such sites, but on adjacent properties. Depending on the extent of the additional investigations and remedial actions necessary, the Company’s ultimate liability may result in costs that are significantly higher than currently accrued. If the Company’s future loss contingency is ultimately determined to be at the maximum of the range of possible outcomes for every site for which costs can be reasonably estimated, the Company’s aggregate accruals for environmental-related activities would be $87.1 million higher than the accruals at December 31, 2013.
 
Two of the Company’s formerly owned sites, described below, account for the majority of the accruals for environmental-related activities and the unaccrued maximum of the estimated range of possible outcomes at December 31, 2013, 2012 and 2011. At December 31, 2013, $56.9 million, or 55.9 percent, of the total accrual for environmental-related activities related directly to these two sites. Of the aggregate unaccrued exposure at December 31, 2013, $59.2 million, or 68.0 percent, related to the two manufacturing sites. While environmental investigations and remedial actions are in different stages at these sites, additional investigations, remedial actions and/or monitoring will likely be required at each site.
Both of the sites are formerly owned manufacturing facilities in New Jersey that are in various stages of the environmental-related process. At the first site, extensive soil remediation was conducted on-site and completed in 2010 under an agency approved work plan. A small portion of soil remediation remains to be conducted on-site as well as some additional determination of possible off-site soil impacts. Investigation of the area groundwater continues to determine the degree and extent of contamination, both on-site and off-site. Although contamination determined to be associated with historical operations of the Company exists at the second site and adjacent areas, the extent and magnitude of the contamination has not yet been fully quantified. A final remedial action plan has not yet been formulated and clean up goals have not been approved by the lead governmental agency. It is reasonably likely that further extensive investigations may be required or that extensive remedial actions may be necessary at this formerly owned site, in adjacent areas or along adjacent waterways. At both sites, depending on the extent of the additional remedial actions necessary, the ultimate liability for these sites may exceed the amounts currently accrued and the maximum of the ranges of reasonably possible outcomes currently estimated by management.
Management cannot presently estimate the ultimate potential loss contingencies related to these two sites or other less significant sites until such time as a substantial portion of the investigative activities at each site is completed and remedial action plans are developed.
In accordance with the Asset Retirement and Environmental Obligations Topic of the ASC, the Company has identified certain conditional asset retirement obligations at various current manufacturing, distribution and store facilities. These obligations relate primarily to asbestos abatement and


28 

 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

closures of hazardous waste containment devices. Using investigative, remediation and disposal methods that are currently available to the Company, the estimated cost of these obligations is not significant.
In the event any future loss contingency significantly exceeds the current amount accrued, the recording of the ultimate liability may result in a material impact on net income for the annual or interim period during which the additional costs are accrued. Management does not believe that any potential liability ultimately attributed to the Company for its environmental-related matters or conditional asset retirement obligations will have a material adverse effect on the Company’s financial condition, liquidity, or cash flow due to the extended period of time during which environmental investigation and remediation takes place. An estimate of the potential impact on the Company’s operations cannot be made due to the aforementioned uncertainties.
 
Management expects these contingent environmental-related liabilities and conditional asset retirement obligations to be resolved over an extended period of time. Management is unable to provide a more specific time frame due to the indefinite amount of time to conduct investigation activities at any site, the indefinite amount of time to obtain governmental agency approval, as necessary, with respect to investigation and remediation activities, and the indefinite amount of time necessary to conduct remediation activities.
Contractual Obligations and Commercial Commitments
The Company has certain obligations and commitments to make future payments under contractual obligations and commercial commitments. The following table summarizes such obligations and commitments as of December 31, 2013:

(thousands of dollars)
 
Payments Due by Period
Contractual Obligations
 
Total
 
Less than
1 Year
 
1–3 Years
 
3–5 Years
 
More than
5 Years
Long-term debt
 
$
1,627,581

 
$
502,991

 
$
572

 
$
700,303

 
$
423,715

Operating leases
 
1,220,132

 
277,599

 
441,829

 
256,632

 
244,072

Short-term borrowings
 
96,551

 
96,551

 
 
 
 
 
 
Interest on Long-term debt
 
543,621

 
46,409

 
62,519

 
53,053

 
381,640

Purchase obligations (a)
 
129,746

 
129,746

 
 
 
 
 
 
Other contractual obligations (b)
 
344,800

 
137,080

 
94,474

 
45,825

 
67,421

Total contractual cash obligations
 
$
3,962,431

 
$
1,190,376

 
$
599,394

 
$
1,055,813

 
$
1,116,848

(a) 
Relate to open purchase orders for raw materials at December 31, 2013.
(b) 
Relate primarily to estimated future capital contributions to investments in the U.S. affordable housing and historic renovation real estate partnerships and various other contractual obligations.
 
 
Amount of Commitment Expiration Per Period
Commercial Commitments
 
Total
 
Less than
1 Year
 
1–3 Years
 
3–5 Years
 
More than
5 Years
Standby letters of credit
 
$
25,896

 
$
25,896

 
 
 
 
 
 
Surety bonds
 
36,819

 
36,819

 
 
 
 
 
 
Other commercial commitments
 
42,258

 
42,258

 
 
 
 
 
 
Total commercial commitments
 
$
104,973

 
$
104,973

 
$

 
$

 
$

Warranties
The Company offers product warranties for certain products. The specific terms and conditions of such warranties vary depending on the product or customer contract requirements. Management estimated the costs of unsettled product warranty claims based on historical results and experience. Management periodically assesses the adequacy of the accrual for product warranty claims and adjusts the accrual as necessary. Changes in the Company’s accrual for product warranty claims during 2013, 2012 and 2011, including customer satisfaction settlements during the year, were as follows:
 
(thousands of dollars)
2013
 
2012
 
2011
Balance at January 1
$
22,710

 
$
22,071

 
$
23,103

Charges to expense
33,265

 
28,590

 
29,957

Settlements
(29,220
)
 
(27,951
)
 
(30,989
)
Balance at December 31
$
26,755

 
$
22,710

 
$
22,071

Shareholders’ Equity
Shareholders’ equity decreased $17.3 million to $1.77 billion at December 31, 2013 from $1.79 billion last year. The decrease in Shareholders’ equity resulted primarily from the purchase of treasury stock for $769.3 million partially offset by an increase in retained earnings of $547.6 million, an increase in


29

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 

Other capital of $174.0 million, due primarily to stock options exercised, and a decrease in Cumulative other comprehensive loss of $49.3 million. The Company purchased 4.30 million shares of its common stock during 2013 for treasury. The Company acquires its common stock for general corporate purposes and, depending on its cash position and market conditions, it may acquire additional shares in the future. The Company had remaining authorization from its Board of Directors at December 31, 2013 to purchase 12.15 million shares of its common stock. The decrease of $49.3 million in Cumulative other comprehensive loss was due primarily to $96.0 million in net actuarial gains and prior service costs of defined benefit pension and other postretirement benefit plans partially offset by unfavorable foreign currency translation effects of $46.7 million attributable to the weakening of most foreign operations’ functional currencies against the U.S. dollar.
The increase in Other capital of $174.0 million was due primarily to the recognition of stock-based compensation expense, stock option exercises and related income tax effect. In 2013, redemptions of Preferred stock and Unearned ESOP compensation of $60.7 million occurred. Retained earnings increased $547.6 million during 2013 due to net income of $752.6 million partially offset by $205.0 million in cash dividends paid. The Company’s cash dividend per common share payout target is 30.0 percent of the prior year’s diluted net income per common share. The 2013 annual cash dividend of $2.00 per common share represented 33.2 percent of 2012 diluted net income per common share. The 2013 annual dividend represented the thirty-fifth consecutive year of dividend payments since the dividend was suspended in 1978. At a meeting held on February 19, 2014, the Board of Directors increased the quarterly cash dividend to $.55 per common share. This quarterly dividend, if approved in each of the remaining quarters of 2014, would result in an annual dividend for 2014 of $2.20 per common share or a 30.3 percent payout of 2013 diluted net income per common share. See the Statements of Consolidated Shareholders’ Equity, on page 47 of this report, and Notes 10, 11 and 12, on pages 66 through 69 of this report, for more information concerning Shareholders’ equity.
Cash Flow
Net operating cash increased $195.9 million to $1.08 billion in 2013 from $887.9 million in 2012 due primarily to an increase in net income of $121.5 million, a reduction in working capital of $44.3 million, year over year changes in deferred income taxes of $38.2 million, and decreased costs incurred for environmental-related matters of $19.2 million. Additionally, a payment to the ESOP for the DOL Settlement of $80.0 million in the first quarter of 2013 and a payment to the IRS for the 2011 ESOP settlement of $59.1 million in the first quarter of 2012 reduced cash flow from operations for each respective year. Net operating cash provided the funds necessary to support the Company’s acquisitions, sustain its remaining manufacturing and distribution capabilities, maintain its financial stability and return a portion of the cash generated to its shareholders through dividends and treasury stock purchases. Net investing cash improved $4.1 million to a usage of $338.3 million in 2013 from a usage of $342.5 million in 2012 due primarily to decreased cash usage to acquire businesses. Net financing cash decreased
 
$1.14 billion to a usage of $853.3 million in 2013 from a source of $286.6 million in 2012 due primarily to decreased proceeds from total net debt activity of $679.7 million, increased treasury stock purchases of $211.5 million, decreased proceeds from stock option exercises and income tax effect of stock-based compensation exercises and vesting totaling $208.7 million, and increased payments of cash dividends of $44.0 million. In 2013, the Company used Net operating cash to invest $79.9 million in acquisitions, spend $166.7 million in capital additions and improvements, purchase $769.3 million in treasury stock, and pay $205.0 million in cash dividends to its shareholders of common stock.
Management considers a measurement of cash flow that is not in accordance with U.S. generally accepted accounting principles to be a useful tool in its determination of appropriate uses of the Company’s Net operating cash. Management reduces Net operating cash, as shown in the Statements of Consolidated Cash Flows, by the amount reinvested in the business for Capital expenditures and the return of investment to its shareholders by the payments of cash dividends. The resulting value is referred to by management as “Free Cash Flow” which may not be comparable to values considered by other entities using the same terminology. The reader is cautioned that the Free Cash Flow measure should not be compared to other entities unknowingly, and it does not consider certain non-discretionary cash flows, such as mandatory debt and interest payments. The amount shown below should not be considered an alternative to Net operating cash or other cash flow amounts provided in accordance with U.S. generally accepted accounting principles disclosed in the Statements of Consolidated Cash Flows, on page 46 of this report. Free Cash Flow as defined and used by management is determined as follows: 
 
Year Ended December 31,
(thousands of dollars)
2013
 
2012
 
2011
Net operating cash
$
1,083,766

 
$
887,886

 
$
735,812

Capital expenditures
(166,680
)
 
(157,112
)
 
(153,801
)
Cash dividends
(204,978
)
 
(160,939
)
 
(153,512
)
Free cash flow
$
712,108

 
$
569,835

 
$
428,499



30 

 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Contingent Liabilities
Life Shield Engineered Systems, LLC (Life Shield) is a wholly owned subsidiary of the Company, which ceased operations in 2012. Life Shield developed and manufactured blast and fragment mitigating systems. The blast and fragment mitigating systems create a potentially higher level of product liability for the Company (as an owner of and supplier to Life Shield) than is normally associated with coatings and related products currently manufactured, distributed and sold by the Company.
Certain of Life Shield’s technology has been designated as Qualified Anti-Terrorism Technology and granted a Designation under the Support Anti-terrorism by Fostering Effective Technologies Act of 2002 (SAFETY Act) and the regulations adopted pursuant to the SAFETY Act. Under the SAFETY Act, the potentially higher level of possible product liability for Life Shield relating to the technology granted the Designation is limited to $6.0 million per occurrence in the event any such liability arises from an Act of Terrorism (as defined in the SAFETY Act). The limitation of liability provided for under the SAFETY Act does not apply to any technology not granted a designation or certification as a Qualified Anti-Terrorism Technology, nor in the event that any such liability arises from an act or event other than an Act of Terrorism. Life Shield maintains insurance for liabilities up to the $6.0 million per occurrence limitation caused by failure of its products in the event of an Act of Terrorism.
Management of the Company has reviewed the potential increased liabilities associated with Life Shield’s systems and determined that potential liabilities arising from an Act of Terrorism that could ultimately affect the Company will be appropriately insured or limited by current regulations. However, due to the uncertainties involved in the future development, usage and application of Life Shield’s systems, the number or nature of possible future claims and legal proceedings, or the effect that any change in legislation and/or administrative regulations may have on the limitations of potential liabilities, management cannot reasonably determine the scope or amount of any potential costs and liabilities for the Company related to Life Shield or to Life Shield’s systems. Any potential liability for the Company that may result from Life Shield or Life Shield’s systems cannot reasonably be estimated. However, based upon, among other things, the limitation of liability under the SAFETY Act in the event of an Act of Terrorism, management does not currently believe that the costs or potential liability ultimately determined to be attributable to the Company through its ownership of Life Shield or as a supplier to Life Shield arising from the use of Life Shield’s systems will have a material adverse effect on the Company’s results of operations, liquidity or financial conditions.
Litigation
In the course of its business, the Company is subject to a variety of claims and lawsuits, including, but not limited to, litigation relating to product liability and warranty, personal injury, environmental, intellectual property, commercial, contractual and antitrust claims that are inherently subject to many uncertainties regarding the possibility of a loss to the
 
Company. These uncertainties will ultimately be resolved when one or more future events occur or fail to occur confirming the incurrence of a liability or the reduction of a liability. In accordance with the Contingencies Topic of the ASC, the Company accrues for these contingencies by a charge to income when it is both probable that one or more future events will occur confirming the fact of a loss and the amount of the loss can be reasonably estimated. In the event that the Company’s loss contingency is ultimately determined to be significantly higher than currently accrued, the recording of the additional liability may result in a material impact on the Company’s results of operations, liquidity or financial condition for the annual or interim period during which such additional liability is accrued. In those cases where no accrual is recorded because it is not probable that a liability has been incurred and the amount of any such loss cannot be reasonably estimated, any potential liability ultimately determined to be attributable to the Company may result in a material impact on the Company’s results of operations, liquidity or financial condition for the annual or interim period during which such liability is accrued. In those cases where no accrual is recorded or exposure to loss exists in excess of the amount accrued, the Contingencies Topic of the ASC requires disclosure of the contingency when there is a reasonable possibility that a loss or additional loss may have been incurred.
Lead pigment and lead-based paint litigation. The Company’s past operations included the manufacture and sale of lead pigments and lead-based paints. The Company, along with other companies, is and has been a defendant in a number of legal proceedings, including individual personal injury actions, purported class actions, and actions brought by various counties, cities, school districts and other government-related entities, arising from the manufacture and sale of lead pigments and lead-based paints. The plaintiffs’ claims have been based upon various legal theories, including negligence, strict liability, breach of warranty, negligent misrepresentations and omissions, fraudulent misrepresentations and omissions, concert of action, civil conspiracy, violations of unfair trade practice and consumer protection laws, enterprise liability, market share liability, public nuisance, unjust enrichment and other theories. The plaintiffs seek various damages and relief, including personal injury and property damage, costs relating to the detection and abatement of lead-based paint from buildings, costs associated with a public education campaign, medical monitoring costs and others. The Company is also a defendant in legal proceedings arising from the manufacture and sale of non-lead-based paints that seek recovery based upon various legal theories, including the failure to adequately warn of potential exposure to lead during surface preparation when using non-lead-based paint on surfaces previously painted with lead-based paint. The Company believes that the litigation brought to date is without merit or subject to meritorious defenses and is vigorously defending such litigation. The Company has not settled any lead pigment or lead-based paint litigation. The Company expects that additional lead pigment and lead-based paint litigation may be filed against the Company in the future asserting similar or different legal theories and seeking similar or different types of damages and relief.


31

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 

Notwithstanding the Company’s views on the merits, litigation is inherently subject to many uncertainties, and the Company ultimately may not prevail. Adverse court rulings or determinations of liability, among other factors, could affect the lead pigment and lead-based paint litigation against the Company and encourage an increase in the number and nature of future claims and proceedings. In addition, from time to time, various legislation and administrative regulations have been enacted, promulgated or proposed to impose obligations on present and former manufacturers of lead pigments and lead-based paints respecting asserted health concerns associated with such products or to overturn the effect of court decisions in which the Company and other manufacturers have been successful.
Due to the uncertainties involved, management is unable to predict the outcome of the lead pigment and lead-based paint litigation, the number or nature of possible future claims and proceedings, or the effect that any legislation and/or administrative regulations may have on the litigation or against the Company. In addition, management cannot reasonably determine the scope or amount of the potential costs and liabilities related to such litigation, or resulting from any such legislation and regulations. The Company has not accrued any amounts for such litigation. With respect to such litigation, including the public nuisance litigation, the Company does not believe that it is probable that a loss has occurred, and it is not possible to estimate the range of potential losses as there is no prior history of a loss of this nature and there is no substantive information upon which an estimate could be based. In addition, any potential liability that may result from any changes to legislation and regulations cannot reasonably be estimated. In the event any significant liability is determined to be attributable to the Company relating to such litigation, the recording of the liability may result in a material impact on net income for the annual or interim period during which such liability is accrued. Additionally, due to the uncertainties associated with the amount of any such liability and/or the nature of any other remedy which may be imposed in such litigation, any potential liability determined to be attributable to the Company arising out of such litigation may have a material adverse effect on the Company’s results of operations, liquidity or financial condition. An estimate of the potential impact on the Company’s results of operations, liquidity or financial condition cannot be made due to the aforementioned uncertainties.
Public nuisance claim litigation. The Company and other companies are or were defendants in legal proceedings seeking recovery based on public nuisance liability theories, among other theories, brought by the State of Rhode Island, the City of St. Louis, Missouri, various cities and counties in the State of New Jersey, various cities in the State of Ohio and the State of Ohio, the City of Chicago, Illinois, the City of Milwaukee, Wisconsin and the County of Santa Clara, California and other public entities in the State of California. Except for the Santa Clara County, California proceeding, all of these legal proceedings have been concluded in favor of the Company and other defendants at various stages in the proceedings.
The proceedings initiated by the State of Rhode Island included two jury trials. At the conclusion of the second trial, the
 
jury returned a verdict finding that (i) the cumulative presence of lead pigment in paints and coatings on buildings in the State of Rhode Island constitutes a public nuisance, (ii) the Company, along with two other defendants, caused or substantially contributed to the creation of the public nuisance, and (iii) the Company and two other defendants should be ordered to abate the public nuisance. The Company and two other defendants appealed and, on July 1, 2008, the Rhode Island Supreme Court, among other determinations, reversed the judgment of abatement with respect to the Company and two other defendants. The Rhode Island Supreme Court’s decision reversed the public nuisance liability judgment against the Company on the basis that the complaint failed to state a public nuisance claim as a matter of law.
The Santa Clara County, California proceeding was initiated in March 2000 in the Superior Court of the State of California, County of Santa Clara. In the original complaint, the plaintiffs asserted various claims including fraud and concealment, strict product liability/failure to warn, strict product liability/design defect, negligence, negligent breach of a special duty, public nuisance, private nuisance, and violations of California’s Business and Professions Code. A number of the asserted claims were resolved in favor of the defendants through pre-trial proceedings. The named plaintiffs in the Fourth Amended Complaint, filed on March 16, 2011, are the Counties of Santa Clara, Alameda, Los Angeles, Monterey, San Mateo, Solano and Ventura, and the Cities of Oakland and San Diego and the City and County of San Francisco. The Fourth Amended Complaint asserted a sole claim for public nuisance, alleging that the presence of lead pigments for use in paint and coatings in, on and around residences in the plaintiffs’ jurisdictions constitutes a public nuisance. The plaintiffs sought the abatement of the alleged public nuisance that exists within the plaintiffs’ jurisdictions. A trial commenced on July 15, 2013 and ended on August 22, 2013. The court entered final judgment on January 27, 2014, finding in favor of the plaintiffs and against the Company and two other defendants (ConAgra Grocery Products Company and NL Industries, Inc.). The final judgment held the Company jointly and severally liable with the other two defendants to pay $1.15 billion into a fund to abate the public nuisance. The Company strongly disagrees with the judgment. The Company has filed a motion for new trial and a motion to vacate the judgment, and will file a notice of appeal at the appropriate time. The Company believes that the judgment conflicts with established principles of law and is unsupported by the evidence. The Company has had a favorable history with respect to lead pigment and lead-based paint litigation, particularly other public nuisance litigation, and accordingly, the Company believes that it is not probable that a loss has occurred and it is not possible to estimate the range of potential loss with respect to the case.


32 

 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Litigation seeking damages from alleged personal injury. The Company and other companies are defendants in a number of legal proceedings seeking monetary damages and other relief from alleged personal injuries. These proceedings include claims by children allegedly injured from ingestion of lead pigment or lead-containing paint, claims for damages allegedly incurred by the children’s parents or guardians, and claims for damages allegedly incurred by professional painting contractors. These proceedings generally seek compensatory and punitive damages, and seek other relief including medical monitoring costs. These proceedings include purported claims by individuals, groups of individuals and class actions.
The plaintiff in Thomas v. Lead Industries Association, et al., initiated an action in state court against the Company, other alleged former lead pigment manufacturers and the Lead Industries Association in September 1999. The claims against the Company and the other defendants included strict liability, negligence, negligent misrepresentation and omissions, fraudulent misrepresentation and omissions, concert of action, civil conspiracy and enterprise liability. Implicit within these claims is the theory of “risk contribution” liability (Wisconsin’s theory which is similar to market share liability) due to the plaintiff’s inability to identify the manufacturer of any product that allegedly injured the plaintiff. The case ultimately proceeded to trial and, on November 5, 2007, the jury returned a defense verdict, finding that the plaintiff had ingested white lead carbonate, but was not brain damaged or injured as a result. The plaintiff appealed and, on December 16, 2010, the Wisconsin Court of Appeals affirmed the final judgment in favor of the Company and other defendants.
Wisconsin is the only jurisdiction to date to apply a theory of liability with respect to alleged personal injury (i.e., risk contribution/market share liability) that does not require the plaintiff to identify the manufacturer of the product that allegedly injured the plaintiff in the lead pigment and lead-based paint litigation. Although the risk contribution liability theory was applied during the Thomas trial, the constitutionality of this theory as applied to the lead pigment cases has not been judicially determined by the Wisconsin state courts. However, in an unrelated action filed in the United States District Court for the Eastern District of Wisconsin, Gibson v. American Cyanamid, et al., on November 15, 2010, the District Court held that Wisconsin’s risk contribution theory as applied in that case violated the defendants’ right to substantive due process and is unconstitutionally retroactive. The District Court's decision in Gibson v. American Cyanamid, et al., has been appealed by the plaintiff.
Insurance coverage litigation. The Company and its liability insurers, including certain underwriters at Lloyd’s of London, initiated legal proceedings against each other to primarily determine, among other things, whether the costs and liabilities associated with the abatement of lead pigment are covered under certain insurance policies issued to the Company. The Company’s action, filed on March 3, 2006 in the Common Pleas Court, Cuyahoga County, Ohio, is currently stayed and inactive. The liability insurers’ action, which was filed on February 23, 2006 in the Supreme Court of the State of New York, County of New York, has been dismissed. An ultimate loss
 
in the insurance coverage litigation would mean that insurance proceeds could be unavailable under the policies at issue to mitigate any ultimate abatement related costs and liabilities. The Company has not recorded any assets related to these insurance policies or otherwise assumed that proceeds from these insurance policies would be received in estimating any contingent liability accrual. Therefore, an ultimate loss in the insurance coverage litigation without a determination of liability against the Company in the lead pigment or lead-based paint litigation will have no impact on the Company’s results of operation, liquidity or financial condition. As previously stated, however, the Company has not accrued any amounts for the lead pigment or lead-based paint litigation and any significant liability ultimately determined to be attributable to the Company relating to such litigation may result in a material impact on the Company’s results of operations, liquidity or financial condition for the annual or interim period during which such liability is accrued.


33

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 

DOL leveraged ESOP settlement. As previously disclosed in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2012, on February 20, 2013, the Company reached a settlement with the DOL of the DOL's investigation of transactions related to the Company's ESOP that were implemented on August 1, 2006 and August 27, 2003. The DOL had notified the Company, among others, of potential enforcement claims asserting breaches of fiduciary obligations and sought compensatory and equitable remedies. The Company resolved all ESOP related claims with the DOL by agreeing, in part, to make a one-time payment of $80.0 million to the ESOP, resulting in a $49.2 million after tax charge to earnings in the fourth quarter of 2012. The Company made this required $80.0 million payment to the ESOP during the first quarter of 2013.
Government tax assessment settlements related to Brazilian operations (the "Brazil government tax assessments"). Charges of $28.7 million and $2.9 million were recorded to Cost of goods sold and SG&A, respectively, during 2013. The charges were primarily related to import duty taxes paid to the Brazilian government related to the handling of import duties on products brought into the country for the years 2006 through 2012. The Company elected to pay the taxes through an existing voluntary amnesty program offered by the government to resolve these issues rather than contest them in court. The after-tax charges were $21.9 million for the year. The Company's import duty process in Brazil was changed to reach a final resolution of this matter with the Brazilian government.
Market Risk
The Company is exposed to market risk associated with interest rate, foreign currency and commodity fluctuations. The Company occasionally utilizes derivative instruments as part of its overall financial risk management policy, but does not use derivative instruments for speculative or trading purposes. The Company entered into foreign currency option and forward currency exchange contracts with maturity dates of less than twelve months in 2013, 2012 and 2011, primarily to hedge against value changes in foreign currency. There were no derivative contracts outstanding at December 31, 2013, 2012 and 2011. The Company believes it may be exposed to continuing market risk from foreign currency exchange rate and commodity price fluctuations. However, the Company does not expect that foreign currency exchange rate and commodity price fluctuations or hedging contract losses will have a material adverse effect on the Company’s financial condition, results of operations or cash flows. See Notes 1 and 13 on pages 48 and 70 of this report.
Financial Covenant
Certain borrowings contain a consolidated leverage covenant. The covenant states the Company’s leverage ratio is not to exceed 3.00 to 1.00. In connection with the new credit facility entered into on July 8, 2011, the leverage ratio was increased to 3.25 to 1.00. The leverage ratio is defined as the ratio of total indebtedness (the sum of Short-term borrowings, Current portion of long-term debt, and Long-term debt) at the reporting date to consolidated “Earnings Before Interest, Taxes, Depreciation, and Amortization” (EBITDA) for the 12-month
 
period ended on the same date. Refer to the “Results of Operations” caption below for a reconciliation of EBITDA to Net income. At December 31, 2013, the Company was in compliance with the covenant. The Company’s Notes, Debentures and revolving credit agreement contain various default and cross-default provisions. In the event of default under any one of these arrangements, acceleration of the maturity of any one or more of these borrowings may result. See Note 7 on pages 61 and 62 of this report.
Employee Stock Ownership Plan (ESOP)
Participants in the Company’s ESOP are allowed to contribute up to the lesser of twenty percent of their annual compensation or the maximum dollar amount allowed under the Internal Revenue Code. Prior to July 1, 2009, the Company matched one hundred percent of all contributions up to six percent of eligible employee contributions. Effective July 1, 2009, the ESOP was amended to change the Company match to one hundred percent on the first three percent of eligible employee contributions and fifty percent on the next two percent of eligible contributions. Effective July 1, 2011, the ESOP was amended to reinstate the Company match to six percent of eligible employee contributions. The Company’s matching contributions to the ESOP charged to operations were $67.4 million in 2013 compared to $142.8 million in 2012, including the $80.0 million DOL Settlement. The Company can fund the ESOP by redeeming a portion of the Preferred stock held by the ESOP or with cash. At December 31, 2013, there were 13,609,442 shares of the Company’s common stock being held by the ESOP, representing 13.6 percent of the total number of voting shares outstanding. See Note 11, on pages 67 and 68 of this report, for more information concerning the Company’s ESOP and preferred stock.


34 

 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

RESULTS OF OPERATIONS - 2013 vs. 2012
Shown below are net sales and segment profit and the percentage change for the current period by segment for 2013 and 2012:
 
Year Ended December 31,
(thousands of dollars)
2013
 
2012
 
Change
Net Sales:
 
 
 
 
 
Paint Stores Group
$
6,002,143

 
$
5,409,947

 
10.9
 %
Consumer Group
1,341,689

 
1,321,887

 
1.5
 %
Global Finishes Group
2,004,530

 
1,960,699

 
2.2
 %
Latin America Coatings Group
832,450

 
836,057

 
-0.4
 %
Administrative
4,720

 
5,872

 
-19.6
 %
Net sales
$
10,185,532

 
$
9,534,462

 
6.8
 %
 
 
 
 
 
 
 
Year Ended December 31,
(thousands of dollars)
2013
 
2012
 
Change
Income Before Income Taxes:
 
 
 
 
 
Paint Stores Group
$
990,523

 
$
861,763

 
14.9
 %
Consumer Group
242,061

 
216,422

 
11.8
 %
Global Finishes Group
170,591

 
147,231

 
15.9
 %
Latin America Coatings Group
38,645

 
81,238

 
-52.4
 %
Administrative
(355,862
)
 
(399,345
)
 
10.9
 %
Income before
income taxes
$
1,085,958

 
$
907,309

 
19.7
 %
Consolidated net sales for 2013 increased due primarily to higher paint sales volume in the Paint Stores Group and acquisitions. One acquisition completed in 2013 and two acquisitions completed in 2012 increased consolidated net sales 1.8 percent. Unfavorable currency translation rate changes decreased 2013 consolidated net sales 0.8 percent. Net sales of all consolidated foreign subsidiaries were up 3.9 percent to $2.13 billion for 2013 versus $2.05 billion for 2012 due primarily to acquisitions and selling price increases. Unfavorable foreign currency translation rates reduced net sales for all consolidated foreign subsidiaries during 2013 by 3.4 percent. Net sales of all operations other than consolidated foreign subsidiaries were up 7.6 percent to $8.06 billion for 2013 versus $7.48 billion for 2012.
Net sales in the Paint Stores Group in 2013 increased primarily due to higher architectural paint sales volume across all end market segments and acquisitions. Acquisitions increased net sales 2.2 percent for the year. Net sales from stores open for more than twelve calendar months increased 7.8 percent for the full year. During 2013, the Paint Stores Group acquired 306 stores, opened 86 new stores and closed 4 redundant locations for a net increase of 388 stores, increasing the total number of stores in operation at December 31, 2013 to 3,908 in the United States, Canada and the Caribbean. The Paint Stores Group’s objective is to expand its store base an average of three percent
 
each year, primarily through internal growth. Sales of products other than paint increased approximately 8.7 percent for the year over 2012. A discussion of changes in volume versus pricing for sales of products other than paint is not pertinent due to the wide assortment of general merchandise sold.
Net sales of the Consumer Group increased due primarily to acquisitions partially offset by the previously disclosed elimination of a portion of a paint program with a large retail customer. Acquisitions increased net sales 2.4 percent compared to 2012. Sales of aerosols, brushes, rollers, caulk and other paint related products, excluding acquisitions, were all up low-single digits as compared to 2012. A discussion of changes in volume versus pricing for sales of products other than paint is not pertinent due to the wide assortment of paint-related merchandise sold. The Consumer Group plans to continue its promotions of new and existing products in 2014 and continue expanding its customer base and product assortment at existing customers.
The Global Finishes Group’s net sales in 2013, when stated in U.S. dollars, increased due primarily to selling price increases and acquisitions partially offset by unfavorable currency translation rate changes. Acquisitions increased this Group’s net sales in U.S. dollars by 1.2 percent. Paint sales volume percentage, excluding acquisitions, decreased in the low-single digits. Unfavorable currency translation rate changes in the year decreased net sales by 0.4 percent for 2013. In 2013, the Global Finishes Group opened 2 new branches and closed 4 locations for a net decrease of 2 branches, decreasing the total to 300 branches open in the United States, Canada, Mexico, South America, Europe and Asia at year-end. In 2014, the Global Finishes Group expects to continue expanding its worldwide presence and improving its customer base.
The Latin America Coatings Group’s net sales in 2013, when stated in U.S. dollars, decreased due primarily to unfavorable currency translation rate changes partially offset by selling price increases. Paint sales volume in 2013 was nearly flat when compared to 2012. Unfavorable currency translation rate changes in the year decreased net sales by 7.1 percent for 2013. In 2013, the Latin America Coatings Group opened 14 new stores and closed 8 locations for a net increase of 6 stores, increasing the total to 282 stores open in North and South America at year-end. In 2014, the Latin America Coatings Group expects to continue expanding its regional presence and improving its customer base.
Net sales in the Administrative segment, which primarily consist of external leasing revenue of excess headquarters space and leasing of facilities no longer used by the Company in its primary business, decreased by an insignificant amount in 2013.
Consolidated gross profit increased $410.3 million in 2013 and improved as a percent to net sales to 45.3 percent from 44.1 percent in 2012 due primarily to higher paint sales volume partially offset by dilution from acquisitions and unfavorable


35

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 

currency translation rate changes. The Paint Stores Group’s gross profit for 2013 increased $330.9 million compared to 2012 due primarily to higher paint sales volume and acquisitions and increased as a percent of sales due primarily to higher paint sales volume partially offset by acquisitions. Acquisitions increased Paint Stores Group's gross profits by $18.0 million, or 15.5 percent of acquisition net sales. The Consumer Group’s gross profit increased $47.4 million and increased as a percent of sales for 2013 over 2012 due primarily to increased production volume and improved operating efficiencies. Acquisitions increased Consumer Group's gross profits by $8.0 million, or 24.7 percent of acquisition net sales. The Global Finishes Group’s gross profit for 2013 increased $43.6 million due primarily to selling price increases, improved operating efficiencies and acquisitions partially offset by unfavorable currency translation rate changes. The Global Finishes Group’s gross profit increased as a percent of sales due primarily to selling price increases and improved operating efficiencies partially offset by dilution from acquisitions and unfavorable currency translation rate changes. Acquisitions increased Global Finishes Group’s gross profit by $5.7 million, or 25.2 percent of acquisition net sales, and foreign currency translation rate fluctuations decreased gross profit by $3.9 million for 2013. The Latin America Coatings Group’s gross profit for 2013 decreased $28.8 million and decreased as a percent of sales. Charges of $28.7 million recorded during 2013 reduced gross profit related to the Brazil government tax assessments. Additionally, unfavorable currency translation rate changes were only partially offset by selling price increases. Foreign currency translation rate fluctuations decreased gross profit by $15.4 million for 2013. The Administrative segment’s gross profit increased by $17.1 million due primarily to the DOL Settlement recorded during 2012.
SG&A increased by $208.0 million due primarily to increased expenses to support higher sales levels in nearly all Reportable Segments and acquisitions partially offset by the DOL Settlement recorded during 2012. Acquisitions added $75.6 million of SG&A in 2013, representing 44.1 percent of acquisition net sales. SG&A decreased as a percent of sales to 34.0 percent in 2013 from 34.2 percent in 2012. In the Paint Stores Group, SG&A increased $204.1 million for the year due primarily to increased spending due to the number of new store openings and increased expenses to maintain customer service and acquisitions SG&A, including transaction and integration costs, of $61.6 million, or 52.9 percent of acquisition net sales. The Consumer Group’s SG&A increased by $15.9 million for the year due to increased sales levels and acquisitions SG&A of $8.1 million, or 25.0 percent of acquisition net sales. The Global Finishes Group’s SG&A increased by $13.0 million for the year relating primarily to increased sales levels and acquisitions SG&A of $5.9 million, or 26.2 percent of acquisition net sales, partially offset by foreign currency translation rate fluctuations reducing SG&A by $3.0 million. The Latin America Coatings Group’s SG&A increased by $8.1 million for the year relating primarily to the Brazil government tax assessments and related expenses partially offset by foreign currency translation rate fluctuations of $10.3 million. The Administrative segment’s SG&A decreased $33.1 million primarily due to the DOL Settlement recorded during 2012 partially offset by increased
 
information systems costs to integrate previous years acquisitions and acquisition transaction expenses.
Other general expense - net decreased $2.7 million in 2013 compared to 2012. The decrease was mainly caused by a decrease of $9.1 million of expense in the Administrative segment, primarily due to a year-over-year decrease in provisions for environmental matters of $9.5 million partially offset by increased loss on sale or disposal of assets of $1.8 million. In addition, Other general expense - net in the Consumer Group had lower income adjustments associated with prior exit or disposal activities of $5.0 million as compared to 2012, while insignificant changes occurred in Other general expense - net of the remaining Reportable Segments. See Note 13, on pages 69 and 70 of this report, for more information concerning Other general expense - net.
Impairments of trademarks of $4.1 million were recorded in 2012. As required by the Goodwill and Other Intangibles Topic of the ASC, management performed an annual impairment test of goodwill and indefinite-lived intangible assets as of October 1, 2013. The impairment test in 2013 resulted in no impairment of goodwill and trademarks. The impairment test in 2012 resulted in no impairment of goodwill and an impairment of $4.1 million of several indefinite-lived trademarks primarily in the Paint Stores Group as a result of planned conversion of various acquired brands. The remaining book values of these trademarks are now being amortized over their estimated future lives. The impairment charges are shown as a separate line in the Statements of Consolidated Income in accordance with the Goodwill and Other Intangibles Topic of the ASC. See Note 4, on pages 52 and 53 of this report, for more information concerning the impairment of intangible assets.
Interest expense, included in the Administrative segment, increased $19.9 million in 2013 versus 2012 due primarily to higher average debt levels and a one-time interest expense charge of $3.2 million from early retirement of debt during the fourth quarter.
Other expense (income) - net decreased to $0.9 million expense from $9.9 million income in 2012. This was primarily due to foreign currency related transaction losses of $7.7 million in 2013 versus foreign currency related transaction gains of $3.1 million in 2012, primarily in the Global Finishes and Latin America Coatings Groups. See Note 13, on page 70 of this report, for more information concerning Other expense (income) - net.


36 

 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Consolidated Income before income taxes in 2013 increased $178.6 million due primarily to an increase of $410.3 million in gross profit partially offset by an increase of $208.0 million in SG&A and an increase of $27.7 million in interest expense, interest and net investment income and other expenses. Income before income taxes increased $128.8 million in the Paint Stores Group, $23.4 million in the Global Finishes Group and $25.6 million in the Consumer Group, but declined $42.6 million in the Latin America Coatings Group when compared to 2012. The Administrative segment had a favorable impact on Income before income taxes of $43.5 million when compared to 2012. Segment profit of all consolidated foreign subsidiaries decreased 33.0 percent to $106.2 million for 2013 versus $158.4 million for 2012 due primarily to an increase in SG&A of $38.0 million, including the Brazil government tax assessments and related expenses, and reduced Other income - net of $24.1 million partially offset by an increase in gross profit of $13.4 million, which included charges to Cost of goods sold due to the Brazil government tax assessments. Segment profit of all operations other than consolidated foreign subsidiaries increased 30.8 percent to $979.8 million for 2013 versus $748.9 million for 2012.
Net income increased $121.5 million in 2013 due to the increase in Income before income taxes.
The effective income tax rate for 2013 was 30.7 percent. The effective income tax rate for 2012 was 30.4 percent. Diluted net income per common share increased 20.6 percent to $7.26 per share for 2013, which included charges relating to the Brazil government tax assessments ($.21 per share), from $6.02 per share a year ago, which included charges relating to the DOL Settlement ($.47 per share).
Management considers a measurement that is not in accordance with U.S. generally accepted accounting principles a useful measurement of the operational profitability of the Company. Some investment professionals also utilize such a measurement as an indicator of the value of profits and cash that are generated strictly from operating activities, putting aside working capital and certain other balance sheet changes. For this measurement, management increases Net income for significant non-operating and non-cash expense items to arrive at an amount known as EBITDA. The reader is cautioned that the following value for EBITDA should not be compared to other entities unknowingly. EBITDA should not be considered an alternative to Net income or Net operating cash as an indicator of operating performance or as a measure of liquidity. The reader should refer to the determination of Net income and Net operating cash in accordance with U.S. generally accepted accounting principles disclosed in the Statements of Consolidated Income and Statements of Consolidated Cash Flows, on pages 44 and 46 of this report. EBITDA as used by management is calculated as follows:
 
 
Year Ended December 31,
(thousands of dollars)
2013
 
2012
 
2011
Net income
$
752,561

 
$
631,034

 
$
441,860

Interest expense
62,714

 
42,788

 
42,497

Income taxes
333,397

 
276,275

 
299,688

Depreciation
158,763

 
152,217

 
151,212

Amortization
29,031

 
26,985

 
29,692

EBITDA
$
1,336,466

 
$
1,129,299

 
$
964,949

RESULTS OF OPERATIONS - 2012 vs. 2011
Shown below are net sales and segment profit and the percentage change for the current period by segment for 2012 and 2011
  
Year Ended December 31,
(thousands of dollars)
2012
 
2011
 
Change
Net Sales:
 
 
 
 
 
Paint Stores Group
$
5,409,947

 
$
4,779,826

 
13.2
 %
Consumer Group
1,321,887

 
1,274,281

 
3.7
 %
Global Finishes Group
1,960,699

 
1,878,326

 
4.4
 %
Latin America Coatings Group
836,057

 
828,451

 
0.9
 %
Administrative
5,872

 
4,815

 
22.0
 %
Net sales
$
9,534,462

 
$
8,765,699

 
8.8
 %
 
 
 
 
 
 
  
Year Ended December 31,
(thousands of dollars)
2012
 
2011
 
Change
Income Before Income Taxes:
 
 
 
 
 
Paint Stores Group
$
861,763

 
$
645,743

 
33.5
 %
Consumer Group
216,422

 
173,654

 
24.6
 %
Global Finishes Group
147,231

 
90,271

 
63.1
 %
Latin America Coatings Group
81,238

 
75,494

 
7.6
 %
Administrative
(399,345
)
 
(243,614
)
 
-63.9
 %
Income before
income taxes
$
907,309

 
$
741,548

 
22.4
 %
Consolidated net sales for 2012 increased due primarily to higher paint sales volume in the Paint Stores Group and selling price increases across all Reportable segments. Two acquisitions completed in 2012 and one acquisition completed in 2011 increased consolidated net sales 0.9 percent. Unfavorable currency translation rate changes decreased 2012 consolidated net sales 1.8 percent. Net sales of all consolidated foreign subsidiaries were up 3.4 percent to $2.05 billion for 2012 versus $1.98 billion for 2011 due primarily to acquisitions and selling price increases. Unfavorable foreign currency translation rates reduced net sales for all consolidated foreign subsidiaries during 2012 by 7.9 percent. Net sales of all operations other than consolidated foreign subsidiaries were up 10.3 percent to $7.48 billion for 2012 versus $6.78 billion for 2011.


37

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 

Net sales in the Paint Stores Group in 2012 increased primarily due to higher paint sales volume and selling price increases. Net sales from stores open for more than twelve calendar months increased 12.5 percent for the full year. During 2012, the Paint Stores Group opened 81 new stores and closed 11 redundant locations for a net increase of 70 stores, increasing the total number of stores in operation at December 31, 2012 to 3,520 in the United States, Canada and the Caribbean. The Paint Stores Group’s objective is to expand its store base an average of three percent each year, primarily through internal growth. Sales of products other than paint increased approximately 10.2 percent for the year over 2011. A discussion of changes in volume versus pricing for sales of products other than paint is not pertinent due to the wide assortment of general merchandise sold.
Net sales of the Consumer Group increased due primarily to selling price increases and acquisitions. Acquisitions increased net sales 3.2 percent compared to 2011. Sales of aerosols, brushes, rollers, caulk and other paint-related products were all up mid-single digits as compared to 2011. A discussion of changes in volume versus pricing for sales of products other than paint is not pertinent due to the wide assortment of paint-related merchandise sold. The Consumer Group plans to continue its promotions of new and existing products in 2013 and continue expanding its customer base and product assortment at existing customers.
The Global Finishes Group’s net sales in 2012, when stated in U.S. dollars, increased due primarily to selling price increases, higher paint sales volume, and acquisitions partially offset by unfavorable currency translation rate changes. Acquisitions increased this Group’s net sales in U.S. dollars by 1.8 percent. Paint sales volume percentage, excluding acquisitions, increased in the low-single digits. Unfavorable currency translation rate changes in the year decreased net sales by 3.5 percent for 2012. In 2012, the Global Finishes Group opened 1 new branch and closed 2 locations for a net decrease of 1 branch, decreasing the total to 302 branches open in the United States, Canada, Mexico, South America, Europe and Asia at year-end. In 2013, the Global Finishes Group expects to continue expanding its worldwide presence and improving its customer base.
The Latin America Coatings Group’s net sales in 2012, when stated in U.S. dollars, increased due primarily to selling price increases and higher paint sales volume partially offset by unfavorable currency translation rate changes. Paint sales volume percentage increased in the low-single digits. Unfavorable currency translation rate changes in the year decreased net sales by 10.2 percent for 2012. In 2012, the Latin America Coatings Group opened 17 new stores and closed 6 locations for a net increase of 11 stores, increasing the total to 276 stores open in North and South America at year-end. In 2013, the Latin America Coatings Group expects to continue expanding its regional presence and improving its customer base.
Net sales in the Administrative segment, which primarily consist of external leasing revenue of excess headquarters space
 
and leasing of facilities no longer used by the Company in its primary business, increased by an insignificant amount in 2012.
Consolidated gross profit increased $461.7 million in 2012 and improved as a percent to net sales to 44.1 percent from 42.7 percent in 2011 due primarily to higher paint sales volume and selling price increases partially offset by increases in raw material costs and unfavorable currency translation rate changes. The Paint Stores Group’s gross profit for 2012 increased $370.2 million compared to 2011 and increased as a percent of sales due primarily to higher paint sales volume and selling price increases partially offset by increases in raw material costs. The Consumer Group’s gross profit increased $62.5 million and increased as a percent of sales for 2012 over 2011 due primarily to selling price increases and improved operating efficiencies partially offset by increases in raw material costs. Acquisitions increased Consumer Group's gross profits by $8.7 million, or 21.5 percent of acquisition net sales. The Global Finishes Group’s gross profit for 2012 increased $52.3 million and increased as a percent of sales due primarily to selling price increases and higher paint sales volume partially offset by increases in raw material costs and unfavorable currency translation rate changes. Acquisitions increased Global Finishes Group’s gross profit by $8.2 million, or 23.7 percent of acquisition net sales, and foreign currency translation rate fluctuations decreased gross profit by $19.1 million for 2012. The Latin America Coatings Group’s gross profit for 2012 decreased $2.3 million and decreased slightly as a percent of sales. Selling price increases and improved sales volumes were not enough to offset higher raw material costs and unfavorable currency translation rate changes which reduced gross profit dollars. Foreign currency translation rate fluctuations decreased gross profit by $26.6 million for 2012. The Administrative segment’s gross profit decreased by $21.0 million due primarily to the DOL Settlement.
SG&A increased by $298.8 million due primarily to increased expenses to support higher sales levels in all Reportable Segments, the DOL Settlement and acquisitions. Acquisitions added $16.3 million of SG&A in 2012, representing 21.6 percent of acquisition net sales. SG&A increased as a percent of sales to 34.2 percent in 2012 from 33.8 percent in 2011. In the Paint Stores Group, SG&A increased $153.7 million for the year due primarily to increased spending due to the number of new store openings and increased expenses to maintain customer service. The Consumer Group’s SG&A increased by $23.6 million for the year due to increased sales levels and acquisitions SG&A of $7.1 million, or 17.6 percent of acquisition net sales. The Global Finishes Group’s SG&A increased by $2.1 million for the year relating primarily to


38 

 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
 
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

increased sales levels and acquisitions SG&A of $9.2 million, or 26.4 percent of acquisition net sales, partially offset by foreign currency translation rate fluctuations reducing SG&A by $15.9 million. The Latin America Coatings Group’s SG&A decreased by $2.4 million for the year relating primarily to foreign currency translation rate fluctuations of $17.5 million partially offset by increased expenses to support higher sales volume levels. The Administrative segment’s SG&A increased $121.9 million primarily due to an increase in incentive compensation, including stock-based compensation expense, the DOL Settlement and information systems costs to integrate previous years acquisitions. See Note 12, on pages 68 through 69 of this report, for more information concerning stock-based compensation.
Other general expense - net increased $2.5 million in 2012 compared to 2011. The increase was mainly caused by an increase of $6.7 million of expense in the Administrative segment, primarily due to loss on sale or disposal of assets of $3.5 million in 2012 versus a gain on sale of assets of $5.5 million in 2011. Partially offsetting this unfavorable comparison was a decrease in provisions for environmental matters of $2.4 million in the Administrative segment. In addition, Other general expense - net in the Consumer Group had higher income adjustments associated with prior exit or disposal activities of $3.1 million as compared to 2011, while insignificant changes occurred in Other general expense - net of the remaining Reportable Segments. See Note 13, on pages 69 and 70 of this report, for more information concerning Other general expense - net.
Impairments of trademarks decreased $1.4 million in 2012 compared to 2011. As required by the Goodwill and Other Intangibles Topic of the ASC, management performed an annual impairment test of goodwill and indefinite-lived intangible assets as of October 1, 2012. The impairment test in 2012 and 2011 resulted in no impairment of goodwill and an impairment of $4.1 million and $5.5 million, respectively, of several indefinite-lived trademarks primarily in the Paint Stores Group for both years as a result of planned conversion of various acquired brands. The remaining book values of these trademarks are now being amortized over their estimated future lives. The impairment charges are shown as a separate line in the Statements of Consolidated Income in accordance with the Goodwill and Other Intangibles Topic of the ASC. See Note 4, on pages 52 and 53 of this report, for more information concerning the impairment of intangible assets.
Interest expense, included in the Administrative segment, increased $0.3 million in 2012 versus 2011 due primarily to
 
higher average debt levels.
Other income - net increased to $9.9 million income from $4.8 million income in 2011. This was primarily due to foreign currency related transaction gains of $3.1 million in 2012 versus foreign currency related transaction losses of $4.7 million in 2011, primarily in the Global Finishes and Latin America Coatings Groups. See Note 13, on page 70 of this report, for more information concerning Other income - net.
Consolidated Income before income taxes in 2012 increased $165.8 million due primarily to an increase of $461.7 million in gross profit and a reduction of $1.5 million in interest expense, interest and net investment income and other expenses, partially offset by an increase of $298.8 million in SG&A. Income before income taxes increased $216.0 million in the Paint Stores Group, $57.0 million in the Global Finishes Group, $42.8 million in the Consumer Group and $5.7 million in the Latin America Coatings Group when compared to 2011. The Administrative segment had a unfavorable impact on Income before income taxes of $155.7 million when compared to 2011. Segment profit of all consolidated foreign subsidiaries increased 29.4 percent to $158.4 million for 2012 versus $122.4 million for 2011 due primarily to increases in gross profit of $8.0 million and Other income - net of $43.0 million partially offset by an increase in SG&A of $13.3 million. Favorable foreign currency translation rates, partially offset by acquisitions, decreased segment profit of all consolidated foreign subsidiaries by 14.0 percent. Segment profit of all operations other than consolidated foreign subsidiaries increased 21.0 percent to $748.9 million for 2012 versus $619.1 million for 2011.
Net income increased $189.2 million in 2012 due to the increase in Income before income taxes.
The effective income tax rate for 2012 was 30.4 percent. The effective income tax rate for 2011 was 40.4 percent, including income tax expense of $75.0 million relating to the IRS Settlement. Excluding the impact of the IRS Settlement would result in an effective income tax rate for 2011 of 30.3 percent. Diluted net income per common share increased 45.4 percent to $6.02 per share for 2012, which included charges relating to the DOL Settlement ($.47 per share), from $4.14 per share a year ago, which included charges relating to the IRS Settlement ($.70 per share) and dilution from acquisitions ($.04 per share).





39


REPORT OF MANAGEMENT ON INTERNAL CONTROL
OVER FINANCIAL REPORTING

Shareholders
The Sherwin-Williams Company
We are responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. We recognize that internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and is subject to the possibility of human error or the circumvention or the overriding of internal control. Therefore, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, we believe we have designed into the process safeguards to reduce, though not eliminate, this risk. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In order to ensure that the Company’s internal control over financial reporting was effective as of December 31, 2013, we conducted an assessment of its effectiveness under the supervision and with the participation of our management group, including our principal executive officer and principal financial officer. This assessment was based on the 1992 criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
In 2013, the Company completed the acquisition of the U.S./Canada business of Consorcio Comex, S.A. de C.V. As permitted by the Securities and Exchange Commission, management excluded the non-integrated operations of this acquisition from its assessment of internal control over financial reporting as of December 31, 2013. Non-integrated operations of this acquisition constituted approximately four percent of consolidated total assets (excluding goodwill and other intangible assets) as of December 31, 2013, and increased consolidated net sales by one percent and decreased consolidated net income by 2% for the year then ended. Operations of this acquisition will be included in the Company's assessment as of December 31, 2014.
Based on our assessment of internal control over financial reporting under the criteria established in Internal Control – Integrated Framework, we have concluded that, as of December 31, 2013, the Company’s internal control over financial reporting was effective to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Our internal control over financial reporting as of December 31, 2013 has been audited by Ernst & Young LLP, an independent registered public accounting firm, and their report on the effectiveness of our internal control over financial reporting is included on page 41 of this report.

C. M. Connor
Chairman and Chief Executive Officer

S. P. Hennessy
Senior Vice President - Finance and Chief Financial Officer


A. J. Mistysyn
Vice President - Corporate Controller

40 


REPORT OF THE INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Shareholders and the Board of Directors
The Sherwin-Williams Company
We have audited The Sherwin-Williams Company’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework) (the COSO criteria). The Sherwin-Williams Company’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

As indicated in the accompanying Report of Management on Internal Control over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of the U.S./Canada business of Consorcio Comex, S.A. de C.V. (Comex), which is included in the 2013 consolidated financial statements of the Sherwin-Williams Company and constituted approximately four percent of consolidated total assets (excluding goodwill and other intangible assets) as of December 31, 2013 and increased consolidated net sales by one percent and decreased consolidated net income by two percent for the year then ended. Our audit of internal control over financial reporting of The Sherwin-Williams Company as of December 31, 2013 also did not include an evaluation of and conclusion on the effectiveness of the internal controls over financial reporting of the U.S./Canada business of Comex.
In our opinion, The Sherwin-Williams Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of The Sherwin-Williams Company as of December 31, 2013, 2012 and 2011, and the related statements of consolidated income and comprehensive income, cash flows and shareholders’ equity for the years then ended and our report dated February 27, 2014 expressed an unqualified opinion thereon.



Cleveland, Ohio
February 27, 2014

41


REPORT OF MANAGEMENT ON THE
CONSOLIDATED FINANCIAL STATEMENTS


Shareholders
The Sherwin-Williams Company
We are responsible for the preparation and fair presentation of the consolidated financial statements, accompanying notes and related financial information included in this report of The Sherwin-Williams Company and its consolidated subsidiaries (collectively, the “Company”) as of December 31, 2013, 2012 and 2011 and for the years then ended in accordance with U.S. generally accepted accounting principles. The consolidated financial information included in this report contains certain amounts that were based upon our best estimates, judgments and assumptions that we believe were reasonable under the circumstances.
We have conducted an assessment of the effectiveness of internal control over financial reporting based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. As discussed in the Report of Management on Internal Control Over Financial Reporting on page 40 of this report, we concluded that the Company’s internal control over financial reporting was effective as of December 31, 2013.
The Board of Directors pursues its responsibility for the oversight of the Company’s accounting policies and procedures, financial statement preparation and internal control over financial reporting through the Audit Committee, comprised exclusively of independent directors. The Audit Committee is responsible for the appointment and compensation of the independent registered public accounting firm. The Audit Committee meets at least quarterly with financial management, internal auditors and the independent registered public accounting firm to review the adequacy of financial controls, the effectiveness of the Company’s internal control over financial reporting and the nature, extent and results of the audit effort. Both the internal auditors and the independent registered public accounting firm have private and confidential access to the Audit Committee at all times.
We believe that the consolidated financial statements, accompanying notes and related financial information included in this report fairly reflect the form and substance of all material financial transactions and fairly present, in all material respects, the consolidated financial position, results of operations and cash flows as of and for the periods presented.

C. M. Connor
Chairman and Chief Executive Officer

S. P. Hennessy
Senior Vice President - Finance and Chief Financial Officer

A. J. Mistysyn
Vice President - Corporate Controller

42 


REPORT OF THE INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
ON THE CONSOLIDATED FINANCIAL STATEMENTS


Shareholders and the Board of Directors
The Sherwin-Williams Company
We have audited the accompanying consolidated balance sheets of The Sherwin-Williams Company as of December 31, 2013, 2012 and 2011, and the related statements of consolidated income and comprehensive income, cash flows and shareholders’ equity for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of The Sherwin-Williams Company at December 31, 2013, 2012 and 2011, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), The Sherwin-Williams Company’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework) and our report dated February 27, 2014 expressed an unqualified opinion thereon.





Cleveland, Ohio
February 27, 2014
 


43

STATEMENTS OF CONSOLIDATED INCOME AND COMPREHENSIVE INCOME
(thousands of dollars except per common share data)

 
Year Ended December 31,
 
2013
 
2012
 
2011
 
 
 
 
 
 
Net sales
$
10,185,532

 
$
9,534,462

 
$
8,765,699

Cost of goods sold
5,568,966

 
5,328,236

 
5,021,137

 
 
 
 
 
 
Gross profit (1)
4,616,566

 
4,206,226

 
3,744,562

Percent to net sales
45.3
%
 
44.1
%
 
42.7
%
 
 
 
 
 
 
Selling, general and administrative expenses (1)
3,467,681

 
3,259,648

 
2,960,814

Percent to net sales
34.0
%
 
34.2
%
 
33.8
%
 
 
 
 
 
 
Other general expense - net
2,519

 
5,248

 
2,731

Impairment of trademarks
 
 
4,086

 
5,492

Interest expense
62,714

 
42,788

 
42,497

Interest and net investment income
(3,242
)
 
(2,913
)
 
(3,711
)
Other expense (income) - net
936

 
(9,940
)
 
(4,809
)
 
 
 
 
 
 
Income before income taxes
1,085,958

 
907,309

 
741,548

Income taxes (1), (2)
333,397

 
276,275

 
299,688

 
 
 
 
 
 
Net income
$
752,561

 
$
631,034

 
$
441,860

 
 
 
 
 
 
Net income per common share:
 
 
 
 
 
Basic
$
7.41

 
$
6.15

 
$
4.22

Diluted
$
7.26

 
$
6.02

 
$
4.14

(1) Includes DOL Settlement of $49,163, net of tax (Cost of goods sold $16,000, Selling, general and administrative expenses $64,000 and tax benefit $30,837), or $.47 per share in the Year ended December 31, 2012.
(2) Includes IRS Settlement of $74,982, or approximately $.70 per share, in the Year ended December 31, 2011. See Note 14 for more information on the IRS Settlement.
 
Year Ended December 31,
 
2013
 
2012
 
2011
 
 
 
 
 
 
Net income
$
752,561

 
$
631,034

 
$
441,860

 
 
 
 
 
 
Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
 
 
 
 
Foreign currency translation adjustments
(46,748
)
 
(7,403
)
 
(65,632
)
 
 
 
 
 
 
Employee benefit plans:
 
 
 
 
 
Net actuarial gains (losses) and prior service costs
 
 
 
 
 
arising during period (3)
85,051

 
(6,192
)
 
(36,415
)
Less: amortization of net actuarial losses and
 
 
 
 
 
prior service costs included in Net pension costs (4)
10,933

 
10,973

 
13,045

 
95,984

 
4,781

 
(23,370
)
 
 
 
 
 
 
Unrealized net gains (losses) on available-for-sale securities:
 
 
 
 
 
Unrealized holding gains (losses)
 
 
 
 
 
arising during period (5)
134

 
123

 
(623
)
Less: reclassification adjustments for (gains) losses
 
 
 
 
 
included in net income (6)
(25
)
 
(12
)
 
68

 
109

 
111

 
(555
)
 
 
 
 
 
 
Other comprehensive income (loss)
49,345

 
(2,511
)
 
(89,557
)
 
 
 
 
 
 
Comprehensive income
$
801,906

 
$
628,523

 
$
352,303

(3) Net of taxes of $(63,342), $2,846 and $25,504, in 2013, 2012 and 2011, respectively.
(4) Net of taxes of $(7,643), $(13,350) and $(8,183), in 2013, 2012 and 2011, respectively.
(5) Net of taxes of $(84), $(77) and $256, in 2013, 2012 and 2011, respectively.
(6) Net of taxes of $17, $7 and $(42) in 2013, 2012 and 2011, respectively.

See notes to consolidated financial statements.

44 

CONSOLIDATED BALANCE SHEETS
(thousands of dollars)

 
December 31,
 
2013
 
2012
 
2011
Assets
 
 
 
 
 
Current assets:
 
 
 
 
 
Cash and cash equivalents
$
744,889

 
$
862,590

 
$
32,696

Accounts receivable, less allowance
1,097,751

 
1,032,508

 
989,873

Inventories:
 
 
 
 
 
Finished goods
779,057

 
732,359

 
730,727

Work in process and raw materials
191,758

 
187,965

 
196,082

 
970,815

 
920,324

 
926,809

Deferred income taxes
104,496

 
126,730

 
149,207

Other current assets
240,766

 
207,086

 
163,008

Total current assets
3,158,717

 
3,149,238

 
2,261,593

 
 
 
 
 
 
Goodwill
1,178,687

 
1,156,005

 
1,108,008

Intangible assets
313,299

 
347,553

 
305,873

Deferred pension assets
302,446

 
249,911

 
228,350

Other assets
407,975

 
366,134

 
368,898

Property, plant and equipment:
 
 
 
 
 
Land
125,131

 
102,336

 
105,010

Buildings
715,096

 
677,944

 
668,802

Machinery and equipment
1,838,590

 
1,750,729

 
1,657,874

Construction in progress
62,563

 
56,582

 
41,264

 
2,741,380

 
2,587,591

 
2,472,950

Less allowances for depreciation
1,719,997

 
1,621,695

 
1,516,420

 
1,021,383

 
965,896

 
956,530

Total Assets
$
6,382,507

 
$
6,234,737

 
$
5,229,252

 
 
 
 
 
 
Liabilities and Shareholders’ Equity
 
 
 
 
 
Current liabilities:
 
 
 
 
 
Short-term borrowings
$
96,551

 
$
69,035

 
$
346,313

Accounts payable
998,484

 
922,999

 
965,149

Compensation and taxes withheld
337,637

 
314,892

 
251,060

Accrued taxes
79,504

 
52,104

 
120,555

Current portion of long-term debt
502,948

 
3,689

 
7,823

Other accruals
513,433

 
513,717

 
471,761

Total current liabilities
2,528,557

 
1,876,436

 
2,162,661

 
 
 
 
 
 
Long-term debt
1,122,373

 
1,632,165

 
639,231

Postretirement benefits other than pensions
268,874

 
320,223

 
297,528

Other long-term liabilities
688,168

 
614,109

 
612,913

 
 
 
 
 
 
Shareholders’ equity:
 
 
 
 
 
Common stock - $1.00 par value:
 
 
 
 
 
    100,129,380, 103,270,067 and 103,854,234 shares outstanding
 
 
 
 
 
at December 31, 2013, 2012 and 2011, respectively
112,902

 
111,623

 
107,454

Preferred stock - convertible, no par value:
 
 
 
 
 
40,406, 101,086 and 160,273 shares outstanding
 
 
 
 
 
at December 31, 2013, 2012 and 2011, respectively
40,406

 
101,086

 
160,273

Unearned ESOP compensation
(40,406
)
 
(101,086
)
 
(160,273
)
Other capital
1,847,801

 
1,673,788

 
1,297,625

Retained earnings
1,774,050

 
1,226,467

 
756,372

Treasury stock, at cost
(1,639,174
)
 
(849,685
)
 
(276,654
)
Cumulative other comprehensive loss
(321,044
)
 
(370,389
)
 
(367,878
)
Total shareholders’ equity
1,774,535

 
1,791,804

 
1,516,919

 
 
 
 
 
 
Total Liabilities and Shareholders’ Equity
$
6,382,507

 
$
6,234,737

 
$
5,229,252

See notes to consolidated financial statements.

45

STATEMENTS OF CONSOLIDATED CASH FLOWS
(thousands of dollars)

 
Year Ended December 31,
Operating Activities
2013
 
2012
 
2011
Net income
$
752,561

 
$
631,034

 
$
441,860

Adjustments to reconcile net income to net operating cash:
 
 
 
 
 
Depreciation
158,763

 
152,217

 
151,212

Amortization of intangible assets
29,031

 
26,985

 
29,692

Impairment of trademarks and goodwill
 
 
4,086

 
5,492

Provisions for environmental-related matters
(2,751
)
 
6,736

 
9,100

Provisions for qualified exit costs
4,682

 
2,734

 
534

Deferred income taxes
27,775

 
(10,422
)
 
16,913

Defined benefit pension plans net cost
20,641

 
20,309

 
12,326

Income tax effect of ESOP on other capital
 
 
 
 
(3,211
)
Stock-based compensation expense
58,004

 
54,348

 
48,176

Net increase in postretirement liability
5,233

 
3,666

 
6,793

Decrease in non-traded investments
57,261

 
72,861

 
62,540

Loss (gain) on disposition of assets
5,207

 
3,454

 
(5,469
)
Other
(27,214
)
 
(18,349
)
 
3,137

Change in working capital accounts:
 
 
 
 
 
(Increase) in accounts receivable
(41,473
)
 
(33,578
)
 
(93,697
)
Decrease (increase) in inventories
25,031

 
19,929

 
(19,222
)
Increase (decrease) in accounts payable
34,685

 
(51,124
)
 
64,053

Increase (decrease) in accrued taxes
11,314

 
(70,264
)
 
5,435

Increase (decrease) in accrued compensation and taxes withheld
24,435

 
63,697

 
(538
)
Increase (decrease) in refundable income taxes
13,244

 
(32,967
)
 
(572
)
DOL settlement accrual
(80,000
)
 
80,000

 
 
Other
43,804

 
11,000

 
36,249

Costs incurred for environmental-related matters
(12,539
)
 
(31,689
)
 
(30,451
)
Costs incurred for qualified exit costs
(7,419
)
 
(4,577
)
 
(6,181
)
Other
(16,509
)
 
(12,200
)
 
1,641

Net operating cash
1,083,766

 
887,886

 
735,812

 
 
 
 
 
 
Investing Activities
 
 
 
 
 
Capital expenditures
(166,680
)
 
(157,112
)
 
(153,801
)
Acquisitions of businesses, net of cash acquired
(79,940
)
 
(99,242
)
 
(44,436
)
Proceeds from sale of assets
3,045

 
9,677

 
12,842

Increase in other investments
(94,739
)
 
(95,778
)
 
(92,374
)
Net investing cash
(338,314
)
 
(342,455
)
 
(277,769
)
 
 
 
 
 
 
Financing Activities
 
 
 
 
 
Net increase (decrease) in short-term borrowings
31,634

 
(284,839
)
 
(43,346
)
Proceeds from long-term debt
473

 
999,697

 
40,777

Payments of long-term debt
(10,932
)
 
(14,000
)
 
(49,881
)
Payments of cash dividends
(204,978
)
 
(160,939
)
 
(153,512
)
Proceeds from stock options exercised
69,761

 
221,126

 
69,536

Income tax effect of stock-based compensation exercises and vesting
47,527

 
104,858

 
12,958

Treasury stock purchased
(769,271
)
 
(557,766
)
 
(367,372
)
Other
(17,522
)
 
(21,559
)
 
15,631

Net financing cash
(853,308
)
 
286,578

 
(475,209
)
Effect of exchange rate changes on cash
(9,845
)
 
(2,115
)
 
(8,723
)
Net (decrease) increase in cash and cash equivalents
(117,701
)
 
829,894

 
(25,889
)
Cash and cash equivalents at beginning of year
862,590

 
32,696

 
58,585

Cash and cash equivalents at end of year
$
744,889

 
$
862,590

 
$
32,696

Taxes paid on income
$
200,748

 
$
223,329

 
$
196,147

Interest paid on debt
61,045

 
41,551

 
42,897


See notes to consolidated financial statements.

46 

STATEMENTS OF CONSOLIDATED SHAREHOLDERS' EQUITY

 
Common
Stock
 
Preferred
Stock
 
Unearned
ESOP
Compen-sation
 
Other
Capital
 
Retained
Earnings
 
Treasury
Stock
 
Cumulative
Other
Comprehensive
Loss
 
Total
Balance at January 1, 2011
$
231,346

 
$
216,753

 
$
(216,753
)
 
$
1,222,909

 
$
4,824,489

 
$
(4,390,983
)
 
$
(278,321
)
 
$
1,609,440

Net income
 
 
 
 
 
 
 
 
441,860

 
 
 
 
 
441,860

Other comprehensive loss
 
 
 
 
 
 
 
 
 
 
 
 
(89,557
)
 
(89,557
)
Treasury stock purchased
 
 
 
 
 
 
 
 
 
 
(367,372
)
 
 
 
(367,372
)
Treasury stock retired
(125,426
)
 
 
 
 
 
 
 
(4,356,465
)
 
4,481,891

 
 
 


Redemption of preferred stock
 
 
(56,480
)
 
56,480

 
 
 
 
 
 
 
 
 


Income tax effect of ESOP*
 
 
 
 
 
 
(54,420
)
 
 
 
 
 
 
 
(54,420
)
Stock options exercised
1,234

 
 
 
 
 
68,302

 
 
 
(190
)