The Sherwin-Williams Management Discusses Q2 2012 Results - Earnings Call Transcript

| About: The Sherwin-Williams (SHW)

The Sherwin-Williams (NYSE:SHW)

Q2 2012 Earnings Call

July 19, 2012 11:00 am ET

Executives

Robert J. Wells - Senior Vice President of Corporate Communications and Public Affairs

Christopher M. Connor - Chairman and Chief Executive Officer

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

Analysts

John P. McNulty - Crédit Suisse AG, Research Division

Ivan M. Marcuse - KeyBanc Capital Markets Inc., Research Division

Dennis McGill - Zelman & Associates, Research Division

P.J. Juvekar - Citigroup Inc, Research Division

Jeffrey J. Zekauskas - JP Morgan Chase & Co, Research Division

Jamie Dunford

Duffy Fischer - Barclays Capital, Research Division

Ghansham Panjabi - Robert W. Baird & Co. Incorporated, Research Division

John E. Roberts - The Buckingham Research Group Incorporated

Donald Carson - Susquehanna Financial Group, LLLP, Research Division

Dmitry Silversteyn - Longbow Research LLC

Eric Bosshard - Cleveland Research Company

Matthew McGinley - ISI Group Inc., Research Division

Robert Koort - Goldman Sachs Group Inc., Research Division

Christopher Perrella

Aram Rubinson - Nomura Securities Co. Ltd., Research Division

Nils-Bertil Wallin - CLSA Asia-Pacific Markets, Research Division

Operator

Good morning. Thank you for joining The Sherwin-Williams Company's review of the second quarter 2012 financial results and expectations for the third quarter and full year. With us on today's call are Chris Connor, Chairman and CEO; Sean Hennessy, Senior Vice President, Finance and CFO; Al Mistysyn, Vice President, Corporate Controller; and Bob Wells, Senior Vice President, Corporate Communications and Public Affairs.

This conference call is being webcast simultaneously in listen-only mode by Vcall via the Internet at www.sherwin.com. An archived replay of this webcast will be available at www.sherwin.com beginning approximately 2 hours after this conference call concludes and will be available until Wednesday, August 8, 2012, at 5 p.m. Eastern Time.

This conference call will include certain forward-looking statements as defined under U.S. federal securities laws with respect to sales, earnings and other matters. Any forward-looking statement speaks only as of the date on which such statement is made, and the company undertakes no obligation to update or revise any forward-looking statement, whether as a result of new information, future events or otherwise. A full declaration regarding forward-looking statements is provided in the company's earnings release transmitted earlier this morning.

[Operator Instructions] I will now turn the call over to Bob Wells.

Robert J. Wells

Thanks, Claudia. Summarizing overall key performance for the second quarter 2012 versus second quarter 2011, consolidated net sales increased $218.3 million or 9.3% to $2.57 billion due primarily to higher paint sales volume in our Paint Stores Group and selling price increase across all segments.

Unfavorable currency translation rate changes decreased consolidated net sales 2.5%, and acquisitions added 1% to net sales in the quarter. Consolidated gross profit dollars increased $127.8 million for the quarter to $1.15 billion. Gross margin increased 130 basis points year-over-year to 44.7% of sales from 43.4% in the second quarter last year.

Selling, general and administrative expenses for the quarter increased 7.2% to $810.2 million. As a percent of sales, SG&A decreased to 31.5% in the second quarter this year from 32.1% last year. Interest expense for the quarter was $10.2 million, a decrease of $1.5 million compared to second quarter last year. Other general expense net increased $3.8 million year-over-year due primarily to higher environmental expense. Consolidated profit before taxes in the quarter increased $70.8 million or 27.5% to $327.8 million.

Our effective tax rate in the second quarter this year was 30.5% compared to 30.3% in the second quarter of 2011. For the full year 2012, we expect our effective tax rate to be in the low 30% range compared to last year's rate of 40.4%.

Consolidated net income increased $48.7 million or 27.2% to $227.8 million. Net income as a percent of sales was 8.9% compared to 7.6% in the second quarter last year. Diluted net income per common share for the quarter increased 30.7% to $2.17 per share from $1.66 per share in 2011.

Looking at our results by operating segment. Paint Stores Group sales in the second quarter increased 14.6% to $1.49 billion. Comparable store sales, or sales by stores open more than 12 calendar months, increased 13.9%.

Regionally, in the second quarter, our Midwestern division led all divisions followed by Southwestern division, Southeastern division and Eastern division. Sales by all 4 Paint Stores divisions rose double digits in the second quarter compared to last year. Paint Stores Group segment profit for the quarter increased $60.4 million or 29.2% to $267 million, and segment margin in the quarter increased to 17.9% from 15.9% last year.

Turning to our Consumer Group. Sales in the second quarter increased 5.9% to $397.7 million. Acquisitions increased consumer segment sales 1.5% in the quarter. Segment profit for the Consumer Group increased $19.4 million or 31.6% to $80.8 million in the quarter. Segment profit as a percent of external sales increased to 20.3% from 16.3% in the same period last year.

For our Global Finishes Group, second quarter sales in U.S. dollars increased 3.3% to $498.7 million. Acquisitions increased net sales in U.S. dollars by approximately 3.8%, while unfavorable currency translation decreased sales by 5.4%.

Segment profit in U.S. dollars increased 58.8% in the quarter to $48 million. Acquisitions increased segment profit approximately $600,000 in the quarter, and unfavorable currency translation rate changes decreased segment profit $4.4 million. As a percent to net external sales, Global Finishes Group segment profit was 9.6% in the quarter compared to 6.3% last year.

For our Latin America Coatings Group, second quarter net sales in U.S. dollars decreased 4.5% to $187.3 million. Unfavorable currency translation rate changes decreased net sales by 14.5% in the quarter. Stated in U.S. dollars, segment profit decreased $9.3 million in the quarter from $15.8 million last year. Unfavorable currency translation rate changes decreased segment profit $2.6 million. As a percent of net sales, segment operating profit was 5% in the quarter compared to 8.1% in second quarter 2011.

I'll conclude my remarks on the quarter with a brief update on the status of our Lead Pigment Litigation. The Santa Clara case, involving claims in public nuisance brought by 10 cities and counties in California against 5 to 10 companies, continues to move forward. At a pretrial hearing held in May, the judge presiding over the case moved the trial date from September of this year to March 11, 2013, to allow the parties more time to complete the discovery process and file dispositive pretrial motions.

That concludes our review of the results for the second quarter 2012, so I'll turn the call over to Chris Connor, who will make some general comments and highlight our expectations for the third quarter and full year. Chris?

Christopher M. Connor

Thank you, Bob. Good morning, everybody. Thanks for joining us today. With a very solid first half of 2012 now on the books, we feel very good about our prospects for the full year. Although we face some tougher comparisons in the second half and particularly in the fourth quarter, we're confident that we can continue to outpace the market in both revenue and volume growth and maintain the strong operating momentum we've established in the first half.

Whether you look at our results for the quarter or for 6 months, the operating leverage and incremental sales volume is pretty easy to spot. In the quarter, we grew net income 27% and earnings per share 31% on a 9% sales gain. Flow-through on the incremental sales of our 4 reportable segments combined passed 41% in the second quarter and 32% in the first half. We controlled our SG&A spending and managed working capital well and generated strong 6-month net operating cash.

The strength in our second quarter results is primarily from the North American market. We often have refer to the specific end market segments that we serve in our Paint Stores Group. In the second quarter, sales to the new residential painting contractor, the residential repaint contractor, property management, commercial contractors, DIY customers, protected and marine contractors and product finishes all grew double digits led by both the new residential and residential repaint segments which were up double digits and down volume as well.

Our Consumer Group delivered solid growth across all major brands and product categories. And our automotive finishes, product finishes and protected and marine coatings businesses in North America were strong across the board. Even as the domestic economy showed signs of slowing the second quarter, demand for our products held up well and our pricing remains firm.

Over the past few months, we've seen the price of high-grade chloride titanium dioxide stabilize due to weak industry demand, and we believe this trend is likely to continue over the balance of 2012.

This factor, combined with a fairly sharp drop in the price of propylene, a key feedstock for monomers, latex, solvents and containers, should help to curb the rate of raw material inflation going forward.

Based on these developments, we now expect average year-over-year raw material cost inflation for the paints and coatings industry to be in the mid- to high-single-digit range in 2012, down from our previous guidance of high single to low double-digits.

The significant jump in our consolidated gross margin in the quarter was the result of 2 factors. First, the increase in production volume; and second, an adjustment in our second quarter LIFO accrual, consistent with our long-standing LIFO accounting practices to reflect our revised outlook for raw material inflation. Because these factors can cause distortions in our gross margin from quarter-to-quarter, comparing our year-to-date gross margin of 43.8% to last year's 43.2%, an improvement of 60 basis points, is a better representation of the progress that we have made in offsetting persistent raw material inflation.

In the first 6 months of 2012, we generated $202 million in net operating cash, an increase of $94 million over the first half of 2011. Cash from operations actually increased $153 million to $261 million before payment of $59 million to the IRS in the first quarter to complete our 2011 tax settlement.

Our working capital, which we describe as receivables plus inventories minus payables, decreased as a percent of sales to 12.6% from 14.9% in the second quarter last year. The change in working capital increased net operating cash by approximately $71 million. We continue to use the company's cash to purchase shares of our stock for treasury, increase our cash dividend and expand our controlled distribution platform.

During the quarter, we acquired 1.5 million shares of the company stock for treasury, bringing our total year-to-date purchase activity to 3.3 million shares at an average cost of $109.89 per share, for a total investment of $363 million. On June 30, we had remaining authorization to acquire 17.75 million shares. Yesterday, our Board of Directors approved a quarterly dividend of $0.39 per share, up from $0.365 per share last year.

Our store growth over the past 4 years, combined with innovative new products, marketing programs and sales initiatives, have resulted in steady market share gains in most contractor segments and double-digit growth in DIY sales 6 of the past 8 quarters. So far this year, our Paint Stores Group has added 20 net new stores, 15 of which were opened in the second quarter. This brings our total store count in the U.S., Canada and the Caribbean to 3,470 locations compared to 3,408 a year ago. As we commented in April, we are ramping up our new store opening activity, and our Paint Store Group plans to add approximately 60 to 65 net new store locations during the year.

Looking ahead, the outlook for global economic growth has become increasingly gloomy, and risks to the U.S. economy have increased accordingly. Thus far, paints and coatings demand in our domestic businesses has remained resilient. We are optimistic that domestic architectural paint market volumes, primarily in the residential segments, will remain positive over the balance of the painting season and demand for most industrial coatings will continue to expand. The greatest challenges in the second half are likely to be the worsening market conditions in Latin America and Europe and the increasingly difficult comparisons from the second half of 2011.

Our outlook for the third quarter 2012 is for consolidated net sales to increase in the mid-single digits compared to last year's third quarter. With sales at this level, we expect diluted net income per common share for the quarter to be in the range of $2.05 to $2.20 per share compared to $1.71 per share in 2011. For the full year 2011, we expect consolidated net sales to increase in the high single digits to low teens over last year. With annual sales at that level, we've raised our expectation for diluted net income per common share for 2012 to be in the range of $6.20 to $6.40 per share compared to $4.14 per share earned in 2011.

Again, let me thank all of you for joining us this morning. And now, we'd be happy to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is coming from the line of John McNulty with Crédit Suisse.

John P. McNulty - Crédit Suisse AG, Research Division

Looking at the Paint Store segment, when we look at the growth, the 14.5% looks pretty solid. It's down from the levels that you saw in the first quarter. And I guess I'm wondering what the drivers are. Is it all weather that we've kind of talked about last quarter a lot? Or is it, are there other things going whether it's pricing decelerating or actual core growth decelerating? How should we think about that?

Christopher M. Connor

Yes. I think you should think about it, John, as a heck of a strong quarter for the Paint Stores Group, 14% consolidated sales. When we look at some of the competitive numbers that are coming out, it's terrific. We commented that the first quarter is the smallest quarter for the year. We did have unusually good weather. We said we didn't think we'd pull much demand forward and gave guidance that we'd see the strong double-digit sales gain in the second quarter. And that's exactly what happened.

John P. McNulty - Crédit Suisse AG, Research Division

Okay, fair enough. And then just one follow-up. On the margin side, when we look -- the consumer segment year-over-year had actually a better improvement than the Paint Store side, which I guess to us is a little bit counterintuitive given who your customers are. So can you walk us through the dynamics of what may be driving that improvement versus maybe a slightly smaller improvement on the Paint Store side?

Sean P. Hennessy

That was as Chris said, great quarter. John, this is Sean Hennessy. And when you take a look at the gallons that were going through the manufacturing, the logistics, the warehouse systems over there, it was a nice quarter for the Consumer Group on their own. But they also had some really nice improvement with the efficiencies of those gallons. I will go back and just remind you, when we take a look at our company, the gallons that we can put through that stores chain and go through that consumer chain. That's really when you look at that incremental margin that Chris mentioned in his comments, that's really where we get it. And so this is not uncommon. If you look at the margins 3, 4 years ago, the peak margins of consumers have always been higher than stores. But what we've said is, consumers will be more stable.

Operator

Our next question is coming from the line of Ivan Marcuse with KeyBanc Capital Markets.

Ivan M. Marcuse - KeyBanc Capital Markets Inc., Research Division

In your same-store sales growth of 13.9%, how much of that was price, would you gauge?

Christopher M. Connor

Yes. We basically have given some directional color here. We said that volumes were more significant than price. Price was mid-single-digits.

Ivan M. Marcuse - KeyBanc Capital Markets Inc., Research Division

Got you. And then if you -- you mentioned that the economy is showing some weakness. Did you see any sort of like if you look at the quarter month-to-month-to-month, did you see any sort of sequential slowdown? And then if not, if it remained pretty steady, is there any reason to think that it wouldn't remain steady going into the third quarter, which is probably typically your strongest quarter?

Christopher M. Connor

Yes. I would say throughout the quarter, Ivan, the performance is pretty steady month-to-month-to-month. I think we're listening to some of the comments relative to more of the industrial sector of the U.S. economy slowing down a little bit. But as we've commented in the third quarter, we expect the domestic residential architectural volume to remain strong.

Ivan M. Marcuse - KeyBanc Capital Markets Inc., Research Division

Great. And then my last question, in raw materials for the quarter, where would you gauge them up on a year-over-year basis?

Robert J. Wells

With the range of mid- to high single digits, Ivan, it's likely for the industry that raw -- the raw material basket was up -- towards the upper end of that range for 2Q just because of the annualization of inflation last year.

Operator

Our next question is coming from the line of Dennis McGill with Zelman & Associates.

Dennis McGill - Zelman & Associates, Research Division

Just real quickly, Bob, on continuing that last question, what would the exit rate be for the year based on the guidance for the full year on the raw material inflation?

Robert J. Wells

Probably below the low end of that range in the fourth quarter.

Dennis McGill - Zelman & Associates, Research Division

Still positive though?

Robert J. Wells

Yes, and obviously, Dennis, it depends on where they go from here. But based on the trends that we're seeing now that we based our outlook of mid- to high single-digits on, it's going to be mid-single digits at worst in the fourth quarter probably a bit below that.

Dennis McGill - Zelman & Associates, Research Division

And then, Chris, your comment on incremental margins for the first half of the year being around, I think, 30% for the 3 segments combined -- or 4 segments combined. For the full half, is there still a drag of price versus raw materials embedded in that?

Christopher M. Connor

Yes. I mean, the margin performance is behind last year's performance at that point. So there's absolutely a drag on raw still [ph].

Dennis McGill - Zelman & Associates, Research Division

Okay. And then there would also be a drag embedded in that from currency?

Christopher M. Connor

Definitely, yes. On both sides.

Robert J. Wells

Right.

Dennis McGill - Zelman & Associates, Research Division

Okay. And then just the last question, having to do with price. I think I hit around this quickly, but price decelerated in Paint Stores 1Q to 2Q. Can you just clarify that if that's true, and I have just a follow-up on that.

Sean P. Hennessy

Yes, I think when you take a look at it, let me just answer that from the first Q to the second Q. So this is -- when you take a look at the effect of -- let me just talk about the effectiveness of price increases over the year. We've always said and we were always realizing about 75%. And going into this raw material escalation, we continued -- as we continue to see more and more price increases and so forth, what you -- what we start to see is that effectiveness started going down from 75%. I don't think -- I think it's pretty natural when you hear Chris' comments that comp store is up 13.9% over half of that -- I mean, it was over -- it was volume. That tells you that price and the amount of price we put in, you multiply it out that you would say that anniversarying some of these things we didn't get 75%. We also think we probably have gotten the majority. So when you take a look at it, we did anniversary a price increase in June of last year, which when you sit there and take a look at June, we did see a -- in fact, it did have some effectiveness and we started seeing the price difference, so a little bit lower in June versus the other 2 months just as we annualized that price increase. But that's how I would say it's because of that June anniversary. And I think in total, when you look at the kind of pricing we did get in the second quarter, it will also tell you we didn't get 100% of the 75%.

Dennis McGill - Zelman & Associates, Research Division

Okay, that's very helpful. And then on top of that, with the new residential market and construction coming back and likely outgrowing overall volumes and thinking about that over the next couple of years, is there a negative mix on price there because that tends to be more boiler-type product?

Christopher M. Connor

I don't think so. I mean we've commented that sometimes pricing for those larger customers will be a little bit softer. But again, the operating margins are very consistent across all of these customer segments. So that's not a concern for us at all, Dennis.

Sean P. Hennessy

I think there's been a market change a little bit from the 80s when it was more of a "blow and go" I think that you're seeing.

Christopher M. Connor

Higher quality products will be included in that segment.

Dennis McGill - Zelman & Associates, Research Division

So the price per gallon in new construction is not that different than what you might see in other segments?

Christopher M. Connor

Probably less, but not that dramatic.

Sean P. Hennessy

Yes.

Operator

Our next question is coming from the line of P.J. Juvekar with Citigroup.

P.J. Juvekar - Citigroup Inc, Research Division

Yes, so the contractor strength that you saw in the early spring, has that continued here late in the season? And do you expect the contractor market to outperform DIY in the second half?

Christopher M. Connor

Yes. I mean we took you through kind of the litany, P.J., of the specific contractor segments inside that broad category that we monitor and the comment that all -- every one of those segments was up double digits in the quarter. And again, as we commented throughout the year, this will be the strength for the company this year. We continue to have lots of projects on the books, and we're expecting to have a good performance from that group in the third and fourth quarter.

P.J. Juvekar - Citigroup Inc, Research Division

Great. And in Global Finishes, your margins have jumped up nicely despite some negative FX impact. Are these margins sustainable given, Chris, your gloomy outlook that you described?

Sean P. Hennessy

Yes. We think -- this is Sean, by the way, P.J., but we think the margins, it's showing a couple of things. I think in Chris' comments, he talked about domestic sales inside that Global Finishes Group were strong. And we get more flow-through on domestic sales, I mean, to outside the country. So I think that shouldn't change. I think it's consistent with what Chris said. And also, I think the operating margins are starting to be improved as we're starting to see some integration activity start to show some positive results.

P.J. Juvekar - Citigroup Inc, Research Division

And finally, with raw material sort of taming down, what kind of pricing do you expect in the second half?

Christopher M. Connor

Well, I think we've indicated we publicly share with you when we raise prices, February's the last time we've taken prices. We don't comment prospectively on forward price increases. We made the comment that our price has held firm in the second quarter. Time will tell.

Operator

Our next question is coming from the line of Jeff Zekauskas with JPMorgan.

Jeffrey J. Zekauskas - JP Morgan Chase & Co, Research Division

So your consolidated sales grew a little bit more than 9% in the quarter and you expect mid-single digits in the third quarter. Is the difference between the 2 growth rates, the Latin American Coatings Group and the Global Finishes Group essentially, that is slower growth there?

Sean P. Hennessy

Yes. And we expect that what we have seen throughout the year and if you look at how the euro and really the Brazilian reais and you look at the Mexican peso versus last year and what we originally thought to convert that foreign currency is going to be, the headwind is going, yes. And so when you sit there and take a look at it, that's part of the biggest piece of the issue. The other thing, this is in Bob's comments, when you take a look at the -- the third and fourth quarter are a little stronger for us. And this is when we start seeing the strength last year. So we're going up against a little tougher comp, but foreign exchange headwind is definitely the bigger difference between the second and third quarter.

Jeffrey J. Zekauskas - JP Morgan Chase & Co, Research Division

Okay. And for the 6 months, you reported that administrative costs are up about $42 million or $43 million. For the year, are they going to be flat or up $42 million or $43 million? Or do you have some rough estimate?

Sean P. Hennessy

Yes. I think when you take look at -- that growth really came from incentive comps, continuing to do some work on environmental issues and as well as we've done a lot of work on what I'll call IT projects. And I think those things will continue to go through. But I think when you take a look at that $40 million increase year-over-year, I would guess that we would not run at that rate in the second half and it would probably be half of that in the second half.

Jeffrey J. Zekauskas - JP Morgan Chase & Co, Research Division

Right. Okay, and then lastly, Chris was talking about the stability in the TiO2 market. And I always get muddled over that. That is, are TiO2 prices stabilizing in July versus where they were in April? Or did they stabilize in April where they were in December? What's the stability?

Robert J. Wells

Well, what we mean by stability, this is Bob, what we mean by stability is that pricing is no longer -- does not appear to be rising. We do not believe that the price increase announced by the industry effective in July was very successful. So it appears that TiO2 pricing has stabilized. We do not believe that they're tracking down.

Jeffrey J. Zekauskas - JP Morgan Chase & Co, Research Division

And then lastly, the LIFO accrual change in the quarter, how much did that benefit gross margin or operating profits, or whatever measure, just the effective change in the accrual?

Sean P. Hennessy

Right. The change in accrual is probably around 4/10.

Jeffrey J. Zekauskas - JP Morgan Chase & Co, Research Division

4/10?

Sean P. Hennessy

Yes. 40 basis points of our margin. The core margin was approximately 44.3, and then you had some LIFO adjustments from the first quarter that reversed in the second quarter.

Operator

Our next question is coming from the line of Chuck Cerankosky with North Coast Research.

Jamie Dunford

This is Jamie Dunford on for Chuck. What are some of the changes you guys have seen that has given the confidence to increase the guidance for this year?

Christopher M. Connor

Well, I think as we've said all along, Jamie, that as we get into the year and have a little better visibility towards the end when we're able to give you a better look. And as we've commented, it's been a strong gallon performance for the company. And you should read into the guidance for the remainder of the year, we're confident that we're going to continue to see that kind of gallon growth, again driven by North American and residential architectural paint gallons.

Operator

Our next question is coming from Duffy Fischer with Barclays Capital.

Duffy Fischer - Barclays Capital, Research Division

Can you talk about the gap between pricing in stores and the big box? And how has that changed over the last one year?

Christopher M. Connor

Yes, Duffy, we pay attention to that. I think you've seen price, some price increases across the board, both at big box channel, as well as the hardware channel, specialty store, et cetera. We've long commented about the irrational industry that we operate in, as titanium dioxide, raw material cost pressures impact all manufacturers and suppliers and then as a result pricing eventually winds its way to the marketplace. We're comfortable with the gap. There's a reason that certain consumers choose to shop in a specialty store environment. And to remind you, many contractors buy at a significant discount off of that shelf price so the gap diminishes quite substantially, if any gap at all exists, when you get to that customer segment.

Duffy Fischer - Barclays Capital, Research Division

Fair enough. And then just to clarify, with your assumptions for pricing, your assumptions for cost, what should we think about for that incremental volume going forward from volumes so that, that incremental dollar sales is from a volume basis? What's the incremental margin that you guys will realize?

Sean P. Hennessy

A lot of times we get -- we really point to, if you look back at the incremental margins that we're realizing in 2002 to 2007 time frame, we felt that the incremental gallons this time would be stronger than they were in that time frame. So the numbers that Chris said, we're feeling pretty good about. I think that our -- as long as we continue to get those kinds of gallons, I think you're going to see flow-through.

Operator

Our next question is coming from the line of Ghansham Panjabi with Robert W. Baird.

Ghansham Panjabi - Robert W. Baird & Co. Incorporated, Research Division

Chris, on the inter-quarter trends that you articulated, were those trends pretty consistent month-to-month for the Global Finishes and Latin American businesses also?

Christopher M. Connor

Yes, it was a steady quarter across the board. All 3 months, we were looking pretty much the same difference. We had some day-count changes from -- month-to-month which impacts the retailer like that but for the most part, very steady.

Ghansham Panjabi - Robert W. Baird & Co. Incorporated, Research Division

So you caution that is more a function of what you read about in the news, et cetera, over what you're necessarily seeing, right?

Christopher M. Connor

Correct.

Ghansham Panjabi - Robert W. Baird & Co. Incorporated, Research Division

Okay. And then within Global Finishes, given the strength in the margins, I'm sorry if I missed this but can kind of parse that to volume by the various constituents in there: auto, refinish, protective, et cetera?

Christopher M. Connor

Yes. Ghansham, we don't really break out volumes like that. We give you that information on our storage business directionally but not for the other segments. I think suffice it to say that the kind of pricing activity that the company has taken have been fairly consistent across these boards. So we're definitely providing volume gains in each of those areas.

Ghansham Panjabi - Robert W. Baird & Co. Incorporated, Research Division

Okay. And then just finally on working capital. Obviously, a terrific job there and inventories are below year-over-year and then with the surge in sales you've had. Is this sort of the new run rate in terms of working capital? Or do you think there's more to go here?

Sean P. Hennessy

Yes, I think when we take a look at our working capital, last year, we finished right around just below 11% as a percent of sales. We think we're in pretty good shape. One of the things I just want to remind you is last year we did take a little more inventory into the third quarter from the second quarter because possible shortages and a lot of raw material discussions. If you remember the -- last year, consumer group actually we started to see that inventory drop in the third quarter last year, and we actually have some positive inventory drop. That's when you start to see some flow through. So consumer had good flow through in the third quarter and we said this year was going be more of a normalized nature. And so when you take a look at it, I think that our working capital's in pretty good shape, and I think 11% or just short of 11% for the full year, I think it's a pretty good number.

Operator

Our next question is coming from the line of John Roberts with Buckingham Research.

John E. Roberts - The Buckingham Research Group Incorporated

The drought that we've had across much of the U.S., not good for the crops but probably pretty good for exterior painting. Did you see much higher growth in exterior versus interior?

Christopher M. Connor

No. I mean, this is the time of year that we should be seeing our exterior gallons perform. They are. They're in line. There's nothing unusual there. Dry weather is good for painting, but 100-degree days, not so much. So we lose the mid-part of the day, painters are starting a lot earlier. Guys are waiting at the front door when we get them open at 6 a.m. in the morning.

John E. Roberts - The Buckingham Research Group Incorporated

Okay. And then secondly, have you seen the lower propylene prices actually flow through in resin and polypropylene containers and so forth? Or is that still just your anticipation of that?

Christopher M. Connor

I think the propylene-based commodities, John, in the second quarter were probably down slightly. I think there may be more benefit to go.

Operator

Our next question is coming from Don Carson with Susquehanna Financial.

Donald Carson - Susquehanna Financial Group, LLLP, Research Division

Chris, I just want to get your actual view on the overall markets. So what's your assumption for how much U.S. architectural volumes will grow overall this year? And again, what percentage would be contractor versus the big box? And then within contractors, it seems that you're growing share. I know some of your competitors like Penmoore [ph] and Access [ph] have well-publicized problems. Just wondering how that's benefiting you.

Christopher M. Connor

Yes. I think, Don, we've talked about the industry data points. And a lot of smart people like you and your colleagues on the phone have talked about the architectural gallon market in United States growing perhaps at a 3%, 4% rate, which would be more than double its normalized run rate. So that kind of gives you a sense. That feels about right. We've shared with you directionally the kind of gallon performance that we're having on top of that. So we think we're gaining share. We have commented that the contractor is rebounding and reverting back to about 60%. Our expectation of the total purchases of architectural coatings in America -- we're probably a year or 2 away from them getting back to that level. So they're going a little bit faster and the market's going a little faster and we're just in the sweet spot and catching it.

Donald Carson - Susquehanna Financial Group, LLLP, Research Division

And on the gross margin, the comps get a lot easier in the second half and, of course, now raws aren't going up as much. So are you looking now for much bigger improvement in second half gross margins than you were say back at June -- your May 23 meeting?

Sean P. Hennessy

Well, we always look at that 41.80% in the third quarter and thought that we were going be able to beat that. That was for sure. We expect that the second half margins when you look at versus last second half margins, we feel a little more bullish than we did back on the 23rd, you're right.

Donald Carson - Susquehanna Financial Group, LLLP, Research Division

And have you changed any of your production plans accordingly given that the raw is coming down in some cases in the second half, did that mean you came into the third quarter with less inventory than you might have otherwise?

Sean P. Hennessy

Yes. I think when you take a look at that -- the question that was asked there earlier, and you see the raw materials had the production down, I think we definitely have less inventory than we did a year ago. Last year, we're were in a position we thought that the raws will continue to rise. And this year, we thought it was little more prudent not to have as much inventory.

Operator

Our next question is coming from Dmitry Silversteyn with Longbow Research.

Dmitry Silversteyn - Longbow Research LLC

Just want to understand a couple of dynamics that you're seeing here. The expansion in margins on the global side of business, you talked about some integration cost sitting there, assuming it's from European acquisitions that you got a couple of years ago. Sort of what's going on in that market? And am I right in assuming that was the major driver behind the margin improvements that you're seeing in global? Or is there some other benefit that's going on there?

Robert J. Wells

I think the number one was the domestic sales in the Global Finishes Group. We do still have quite a bit of sales inside the United States and Canada. And when you look at the domestic sales, that's by far was the #1 reason for the margin improvement. But on top of that, there was some improvement on the European operations. And you're right, it's the acquisitions we did a few years ago.

Dmitry Silversteyn - Longbow Research LLC

Would it be fair to say then that the margin impact was driven more by mix as -- after growing higher margin North American business versus perhaps flattish margin or flattish volumes in Europe which is a lower margin business?

Christopher M. Connor

Yes.

Dmitry Silversteyn - Longbow Research LLC

That's fine. Secondly, your administrative costs continue to be up year-over-year and that's sequential. So I'm assuming that's the sort of the new run rate that we should looking at in terms of operating profitability?

Sean P. Hennessy

Yes. And as I said, I don't think it will be up $40 million like we were in the first half of the year. But I think when you take a look at that, last year, our admin was around $243 million give-and-take. I think if you -- the run rate will be in that $290 million to $310 million.

Dmitry Silversteyn - Longbow Research LLC

Got it. That's helpful. And then finally, just curious about your comments on TiO2 [indiscernible] outlook. I guess you talked about pricing being flattish on weak demand. Paint is the #1 source of TiO2 demand. And paint market, at least in North America, seems to be doing well. So is it the weakness in international markets that's leading to declining demand for TiO2?

Sean P. Hennessy

That's correct, and primarily Asia Pacific.

Operator

Our next question is coming from the line of Eric Bosshard with Cleveland Research Company.

Eric Bosshard - Cleveland Research Company

A couple of things. The gross margin I understand looking at the first half in total the full out [ph] of the LIFO benefit. Should the second half gross margin expansion be materially greater than the first half?

Sean P. Hennessy

We'll wait and see. I don't want to put some guidance out there that we're going to have to live with, Eric. I mean, we're pretty careful. Usually, we like to give you a pretty good guidance for the second quarter, but we'll wait to see what happens with the raws in the next couple of months, and I think we'll see. But there's a lot of different moving parts right now with the volatility in the raw materials, quite honestly. I don't want to put an add to it [ph] like you did.

Eric Bosshard - Cleveland Research Company

I understand. Secondly, in terms of price, the change from 2Q to 1Q, I guess, I mean, if you could just clarify a little further, it sounded like price in 1Q contributed maybe as much as 9 or 10 points and 2Q closer to 5. Is that right? And should the second half be sustained in this 5, or how should we think about that? And if you could give us any more color on what's going on within that?

Sean P. Hennessy

Yes. I think when you take a look at the way prices moved up last year, I think the numbers you have are, in the ballpark, pretty good. I think that we'll see what happens with price, but we don't see price growing from that second quarter number, that's for sure.

Eric Bosshard - Cleveland Research Company

And is that, just I guess accordingly, is that just cycling off or is there -- are you taking a little more aggressive position on price that's accelerating your share progress?

Sean P. Hennessy

It's cycling off. I think we're going to -- just I like I mentioned, it's cycling off of the June 6 price increase from 2011. We've got a couple of -- I think in October we're going to see another cycling off. So we don't see the price metrics changing in the architectural paint market. But it's just that annualization.

Christopher M. Connor

I think the comment we made in the opening part of the call, Eric, about prices holding firm. That's our expectation. So it's always as, Sean commented, we're just coming up against these robust and consistent price increases we had in the past years.

Eric Bosshard - Cleveland Research Company

Okay. And then the last question in terms of volume, which sounds like it was a very good number this quarter again. Is that the rate at which volume should grow? I'm just trying to understand the sales guides for the second half of the year, and full year. Is the second quarter volume growth that you saw, is that what you expect to be sustained in the back half?

Sean P. Hennessy

I think when you take a look at it and because of the strength of the volumes, we starting to go against harder comps. I think if we see volume slightly below where we were in the second quarter but not materially lower.

Christopher M. Connor

I mean, negative volumes first half, positive volumes second half last year. The kind of run rate to run right now feels consistent to us, we just have that tougher comparison.

Eric Bosshard - Cleveland Research Company

And I just -- last one if I might. The second quarter sales guidance I think was 10 to 15 and you reported roughly 10 or 9.5. Was the difference there currency or international growth, can you just sort of talk about the severity or the differences between those 2?

Sean P. Hennessy

FX is 100%. The Brazilian reais in town, it was just 2.10. That and the Mexican peso, and the euro, all 3 of those I would say -- it's 99% of where the difference between our guidance and the 9.3 that we came in at.

Operator

Our next question is coming from Matt McGinley with ISI Group.

Matthew McGinley - ISI Group Inc., Research Division

I have a follow-up on the LIFO comments that you made. I know in the 10-K you disclosed that LIFO has an impact of about $0.59 during all 2011. I think you said it was 40 basis points of help there that you got from that in the second quarter. So I think you're still a lot less in terms of how you recover that. Is there a particular quarter within the year we had a bigger impact? Or was that relatively spread out over the entire year?

Sean P. Hennessy

In 2011?

Matthew McGinley - ISI Group Inc., Research Division

Correct.

Robert J. Wells

Yes, I think the one -- it was really the third quarter. And last year you saw the third quarter was around 41.8% last year. It was a little heavier than the other 3. And that's because the raw materials continue to rise and the basket continued to rise, and we were trying to catch up. And this year, it looks we're seeing that the basket forecast that we're giving it continues to go down.

Matthew McGinley - ISI Group Inc., Research Division

Okay. So all this equal, you'd expect the third could be the quarter of greatest recovery within the year?

Sean P. Hennessy

Oh, yes. I mean, I think that the year-over-year comparison of gross margin, we're going to see the greatest impact of that in the third quarter.

Matthew McGinley - ISI Group Inc., Research Division

Yes. And then on your third quarter sales guidance, you said that the waning impacts of pricing will not be the benefit that it was in clearly the past handful of quarters. You said that FX would likely be worse. Are you within -- in terms with your guidance, are you saying that the units will be positive? Or would you expect that to be down in the third quarter?

Christopher M. Connor

I think it is to be positive.

Matthew McGinley - ISI Group Inc., Research Division

For the company in total and so not just with the Paint Stores Group?

Christopher M. Connor

Absolutely.

Operator

Our next question is coming from Bob Koort with Goldman Sachs.

Robert Koort - Goldman Sachs Group Inc., Research Division

John, I think you mentioned you guys had drawn down a little bit on your inventories. I think maybe you're referring to raw material inventory. So I'm just curious, what your expectation as you go through the second half. Is there still some room to do that? Or certainly on the TiO2 side, we've seen your supplier base has had some challenges here in the last few months. So have you reached a sort of detente there? Or what's your expectation going into the second half?

Sean P. Hennessy

I think our raw material inventory will be slightly lower, 5% lower at the end of the year than we are right now. I think -- but I do think finished goods will also be down just as they always do in the third and fourth quarter because our production goes down.

Robert Koort - Goldman Sachs Group Inc., Research Division

It's interesting, it sounds like there's a bifurcated market. You mentioned that in the U.S., architectural paint demand has been very good and you commented that it should continue to do so. Yet the TiO2 weakness seems to be more Asian-based. Do you expect that you'll see some changing behavior from your suppliers now that TiO2 market's loosened up? Or is it still going to be the same old fight that you usually confront?

Christopher M. Connor

You're articulating diverging market trends and softness globally but the strength in the U.S. Don't forget that titanium prices have been running on us the past couple of years, it's been also a diverging trend because they were referencing tighter demand and we were seeing collapse in the U.S. architectural market. So it's not for us to articulate what their behavior will be like going forward. We can only report on past trends of buying these raw materials. When global supply slackens, it's a period of time when they like to go to get pricing. And it's what Bob commented on that it's the July price increase that was announced did not go in, and we'll see how the second half unfolds.

Robert J. Wells

And just as a reminder Bob, the North American market consumes less than 25% of global supply of TiO2. So we've got 75%, more than 75% of the global TiO2 market that's struggling for volume even if North America is relatively strong.

Robert Koort - Goldman Sachs Group Inc., Research Division

Yes, that's helpful. And then lastly, if I might, can you give me a sense, if I read in some trade rag that propylene price, contract price changed today, how long would it be before it actually shows up in any meaningful way on a cost of good volumes for Sherwin-Williams?

Robert J. Wells

About -- typically about 50 to 90 days.

Operator

Our next question is coming from Kevin McCarthy with Bank of America.

Christopher Perrella

This is Chris Perrella on for Kevin. Could you elaborate on the softening that you're seeing down in Latin America whether regionally -- a particular region or end markets down there.

Christopher M. Connor

Yes. I think to put that in perspective, we're still seeing volume gains in our Latin American operations. First and foremost, the segment reporting is impacted by the FX that Sean is taking you through now. So that's a lot of the headwind. There's a general softening in the Brazilian economy that you read about and we feel that. Same is true slightly in Mexico. But beyond that, I mean these businesses are performing well, holding their own, gaining share in some cases and generating volume gains.

Christopher Perrella

And pricing gains as well in the region?

Christopher M. Connor

Yes. Again, back to the global rational nature of this industry and the important need to get pricing after raws. And so we have seen pricing throughout the region over the last couple of years, including the beginning half of this year, consistent with the kind of comments we've been making about North America.

Christopher Perrella

Okay. And the Geocel acquisition, does that account for the growth in the -- or the sales contribution on the consumer segment?

Sean P. Hennessy

Yes, it will be reported in the consumer segment. There was one month of -- yes, so it was not the majority of the sales growth by any stretch of imagination.

Operator

Our next question is coming from Aram Rubinson with Nomura Securities.

Aram Rubinson - Nomura Securities Co. Ltd., Research Division

Question about innovation and what it means for price. It sounded at least from the analyst day that innovation is at its highest level in many years. And I would think that usually helps to sustain price. Just wondering why given that circumstance, why we'd be getting less than a 75% kind of realization. And I'm also wondering how that change manifests itself, if its pushback from contractors on price, if it's promotions for retail or something else? And is there something we can be doing to kind of get back to that realization?

Christopher M. Connor

Well, innovation, I think, is an important part of it, but it speaks to the products that are introduced, not the core product line. So as we commented on our investor day, this has been a particularly robust year for us with new products, I think somewhere around 30 new products that hit the market. And to your point, our intent is to bring those products at more of the higher end of the performance spectrum. So they are setting higher selling prices, better margins. But the vast majority of products that we sell as company year-in and year-out despite a strong year like this, come from the core products. The real workhorse products that painters use day in and day out. And that's where I think Sean made the comment about going out for pricing and not really having the full 75% implemented just yet.

Sean P. Hennessy

And I think if you take a look at the history back in the 80s when we used to go out once a year, that 75%, the first time we tried to get a second price increase in the first -- 2 in 1 year, we didn't get all 75%. All of a sudden, we got pretty good unfortunately for 2 in a year, then we went [indiscernible] to 3. And I think we had somewhere in the neighborhood of 7 price increases in about 35 months. So it was so rapid I think that it was hard. We were halfway through it I think that's really what happened to us. Not that I think the market has changed.

Aram Rubinson - Nomura Securities Co. Ltd., Research Division

Two quick things. Can you talk how much FX was in Q3 guidance? And also, last time, you gave us a gross profit dollar change by segment. Would you mind doing that for us again, please?

Sean P. Hennessy

When I did that last time, we got the Q completely written. We're not in that same spot. We're going to release the Q on the 25th of July. So I think we're not going be exact now with you between now and then. But then I think you get the dollar exchanges right then and there from the Q. But no, I think that the FX, if you take a look at how much headwind we had in the second quarter, I think you can -- the guidance has more FX headwind than the second quarter. I'm not -- I really don't want to give you an exact number.

Operator

Our next question is coming from the line of Nils Wallin with CLSA.

Nils-Bertil Wallin - CLSA Asia-Pacific Markets, Research Division

On the Latin American group, it looks like FX hurt your top line close to $30 million and yet on the operating profit level, it was only about $2.6 million hit. So could you explain what you do to mitigate that falling all the way to the bottom line? Was it improved leverage or a fixed cost leverage from higher volumes? Or just add a little bit more color to what you did to mitigate that headwind.

Sean P. Hennessy

Yes. I think one of the things you have to realize is when you do get FX headwinds, it's not dollar for dollar going to the bottom line because it also affects your SG&A and it affects other things. So when you take a look at it, I think Chris has hinted that we did have volume gains down there, and the world market on the raw materials that grows -- pricing was going on in there. So I think volume offset it. I think pricing offset it. And those are really the 2 things.

Nils-Bertil Wallin - CLSA Asia-Pacific Markets, Research Division

Okay. On your guidance for the full year, it suggests some deceleration in the back half in terms of earnings growth. Is there anything behind that? Is it conservatism? Is it seasonality? Or is it just growth happened to be so strong?

Sean P. Hennessy

No. I think the first half, I mean, when you sit there and say that this first half -- and if you get a chance to read the Q, there's a lot of things in there over the last 12 months. So really when you look at the last 4 quarters combined, our net operating cash flow was over 10%, the flow-through was very strong when you put these 4 quarters together. So it's going up against a little tougher comparisons. And when we look at the second half, we're pretty excited about how things are going to come out. We think that we're going to have some nice flow-through.

Nils-Bertil Wallin - CLSA Asia-Pacific Markets, Research Division

Great. And then just finally, it seems in the Paint Stores Group, the remodel part of the portfolio is probably driving a little bit more of the volume than the new residential. I don't know if that's completely accurate, so if you could help me with that. But is this -- as we see home sales improve, existing home sales, whatever's going on there, are we going to -- do you think there'll be a mix shift? Or are we going to see that residential growth -- shouldn't the remodel growth stay where it is? And then on top that, have a nice icing on the cake from new residential.

Christopher M. Connor

Yes, I think that's a good way to think about it, Nils. As a reminder, the demand for architectural paint in North America is predominantly for remodel, redecorating and maintenance, so you can think in terms of 80% plus or minus a few points on that. So as the new construction comes back, it will have a positive impact but a smaller amount. I think most folks are talking about housing starts somewhere in the 700,000 range. We believe that the sustainable number in our country's north of 1 million units, so we have several years of reasonable marginal growth and improvement in that to get back to a normalized run rate. On our way there, our expectations will be that the ongoing maintenance, decorating for the existing infrastructure housing stock will be really driving this number. And to your point about as housing sales are picking back up, as housing volumes are improving, those are all really positive market metrics for sustained growth in this business.

Operator

Our last question is a follow-up from the line of Dmitry Silversteyn with Longbow Research.

Dmitry Silversteyn - Longbow Research LLC

Yes, I just have a quick clarification. You talked about the paint group seeing about mid-single digit of pricing on year-over-year basis. I'm assuming it's somewhat similar in the consumer group, which would imply that volume growth there was pretty close to 0 year-over-year. Can you talk a little bit about sort of what's driving that if my math is correct?

Christopher M. Connor

Well, as we've stated over and over, we don't give that kind of same clarity and break out that we do in our stores business for the other segments. And I will tell you that our consumer group did have volume growth as well.

Operator

Gentlemen, there are no further questions. I'll now turn the floor back over to Bob Wells for closing remarks.

Robert J. Wells

I'd like to thank you all once again for your participation in today's call. I will be available as usual over the balance of the day and week to address any follow-up questions. We appreciate you joining us today, and thanks for your continued interest in Sherwin-Williams.

Operator

This does conclude today's teleconference. You may disconnect your lines at this time, and we thank you for your participation.

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