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| MAS > SEC Filings for MAS > Form 10-K on 17-Feb-2009 | All Recent SEC Filings |
17-Feb-2009
Annual Report
The financial and business analysis below provides information which the Company believes is relevant to an assessment and understanding of its consolidated financial position, results of operations and cash flows. This financial and business analysis should be read in conjunction with the consolidated financial statements and related notes.
The following discussion and certain other sections of this Report contain statements reflecting the Company's views about its future performance and constitute "forward-looking statements" under the Private Securities Litigation Reform Act of 1995. These views involve risks and uncertainties that are difficult to predict and, accordingly, the Company's actual results may differ materially from the results discussed in such forward-looking statements. Readers should consider that various factors, including those discussed in Item 1A "Risk Factors" of this Report, the "Executive Level Overview," "Critical Accounting Policies and Estimates" and "Outlook for the Company" sections, may affect the Company's performance. The Company undertakes no obligation to update publicly any forward-looking statements as a result of new information, future events or otherwise.
Executive Level Overview
The Company manufactures, distributes and installs home improvement and building products. These products are sold to the home improvement and new home construction markets through mass merchandisers, hardware stores, home centers, home builders, distributors and other outlets for consumers and contractors.
During 2008, the Company experienced a significant decline in its markets, including a decline in new home construction of over 30 percent from 2007, as well as a continued decline in consumer spending for home improvement products. The Company's net sales decreased 17 percent in 2008 from 2007 and the Company's operating profit (as adjusted to exclude impairment charges for goodwill and other intangible assets, general corporate expense, net, gains on sale of fixed assets, net and 2008 charge for litigation settlement) declined to 7.2 percent of sales in 2008 from 11.7 percent of sales in 2007.
Factors that affect the Company's results of operations include the levels of home improvement activity and new home construction principally in North America and Europe, the importance of and the Company's relationships with key customers (including The Home Depot, which represented approximately 21 percent of the Company's net sales in 2008), the Company's ability to maintain its leadership positions in its U.S. and global markets in the face of increasing competition and the Company's ability to effectively manage its overall cost structure, including the cost and availability of labor and materials. If the current market conditions, including the rate of consumer spending for home improvement products and new home construction, continue or deteriorate further, the Company's results of operations would continue to be negatively impacted. The Company cannot provide any assurances that current market conditions affecting the home improvement and new home construction markets will not deteriorate further and the Company cannot predict the timing or strength of a recovery in these markets. The Company's International businesses face political, monetary, economic and other risks that vary from country to country, as well as fluctuations in currency exchange rates. Further, the Company has financial commitments and investments in financial assets that are not readily marketable and that involve financial risk, particularly in the current uncertain economic and credit market conditions. In addition, product liability claims and other litigation could be costly. These and other factors are discussed in more detail in Item 1A "Risk Factors" of this Report.
Critical Accounting Policies and Estimates
The Company's discussion and analysis of its financial condition and results of operations are based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make certain estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of any contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses during the reporting periods. The Company regularly reviews its estimates and assumptions, which are based upon historical experience, as well as current economic conditions and various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of certain assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates and assumptions.
The Company believes that the following critical accounting policies are affected by significant judgments and estimates used in the preparation of its consolidated financial statements.
The Company recognizes revenue as title to products and risk of loss is transferred to customers or when services are rendered. The Company records revenue for unbilled services performed based upon estimates of labor incurred in the Installation and Other Services segment; such amounts are recorded in Receivables. The Company records estimated reductions to revenue for customer programs and incentive offerings, including special pricing and co-operative advertising arrangements, promotions and other volume-based incentives. Allowances for doubtful accounts receivable are maintained for estimated losses resulting from the inability of customers to make required payments. In addition, the Company monitors its customer receivable balances and the credit worthiness of its customers on an on-going basis. During downturns in our markets, declines in the financial condition and creditworthiness of customers impact the credit risk of the receivables involved and the Company has incurred additional bad debt expense related to customer defaults. The Company's bad debt expense was $41 million, $29 million and $16 million at December 31, 2008, 2007 and 2006, respectively.
In North America, the Company manufactures products (principally windows, doors and cabinets) and provides installation of insulation and other services to homebuilders. The Company's bad debt expense related to homebuilders was $28 million, $23 million and $8 million for the years ended December 31, 2008, 2007 and 2006, respectively.
Inventories are recorded at the lower of cost or net realizable value, with expense estimates made for obsolescence or unsaleable inventory equal to the difference between the recorded cost of inventories and their estimated market value based upon assumptions about future demand and market conditions. On an on-going basis, the Company monitors these estimates and records adjustments for differences between estimates and actual experience. Historically, actual results have not significantly deviated from those determined using these estimates.
On January 1, 2008, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 157, "Fair Value Measurements," ("SFAS No. 157") for its financial assets and liabilities. SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS No. 157 defines fair value as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." SFAS No. 157 further defines a fair value hierarchy for measurement and disclosure of the fair value of financial instruments, as follows: Level 1 inputs as quoted prices in active markets for identical assets or liabilities; Level 2 inputs as observable inputs other than Level 1 prices, such as quoted market prices for similar assets or liabilities or other inputs that are observable or can be corroborated by market data; and Level 3 inputs as unobservable inputs that are supported by little or no market activity and that are financial instruments whose value is determined using pricing models or instruments for which the determination of fair value requires significant management judgment or estimation.
Financial investments that are available to be traded on readily accessible stock exchanges (domestic or foreign) are considered to have active markets and have been valued using Level 1 inputs. Financial
investments that are not available to be traded on a public market or have limited secondary markets, or contain provisions that limit the ability to sell the investment are considered to have inactive markets and have been valued using Level 2 or 3 inputs. The Company incorporated credit risk into the valuations of financial instruments by estimating the likelihood of non-performance by the counterparty to the applicable transactions. The estimate included the length of time relative to the contract, financial condition of the counterparty and current market conditions. The criteria for estimating if a market was active or inactive were based on the individual facts and circumstances.
The Company has maintained investments in available-for-sale securities and a number of private equity funds, which aggregated $101 million and $138 million, respectively, at December 31, 2008. Investments in available-for-sale securities are recorded at fair value, and unrealized gains or losses (that are deemed to be temporary) are recognized, net of tax effect, through shareholders' equity, as a component of other comprehensive income in the Company's consolidated balance sheet. The fair value of the Company's investments in available-for-sale securities is estimated using primarily Level 1 inputs. The fair value of the Company's investment in Asahi Tec preferred stock is estimated using a discounted cash flow model (Level 3 input). If the Company changed the discount rate used in the fair value estimate by 100 basis points, the value of the Asahi Tec preferred stock would change by approximately four percent.
The Company records an impairment charge to earnings when an investment has experienced a decline in fair value that is deemed to be other-than-temporary. During 2008, the Company recognized non-cash, pre-tax impairment charges of $31 million related to its investment in TriMas common stock and $1 million related to its investment in Asahi Tec common stock.
In the past, the Company invested excess cash in auction rate securities. Auction rate securities are investment securities that have interest rates which are reset every 7, 28 or 35 days. At December 31, 2008, the Company's investment in auction rate securities was $22 million; the Company has not increased its investment in auction rate securities since 2007. The fair value of auction rate securities is estimated based on a discounted cash flow model (Level 3 input). If the Company changed the discount rate used in the fair value estimate by 75 basis points, the value of the auction rate securities would change by approximately $1 million.
The Company's investments in private equity funds and other private investments are carried at cost. It is not practicable for the Company to estimate a fair value because the private equity funds have no quoted market price and sufficient information is not readily available for the Company to utilize a valuation model to determine the fair value for each fund. These investments are evaluated quarterly for potential other-than-temporary impairment when impairment indicators are present, or when an event or change in circumstances has occurred, that may have a significant adverse effect on the fair value of the investment. Impairment indicators the Company considers include the following: whether there has been a significant deterioration in earnings performance, asset quality or business prospects; a significant adverse change in the regulatory, economic or technological environment; a significant adverse change in the general market condition or geographic area in which the investment operates; industry and sector performance; current equity and credit market conditions; and any bona fide offers to purchase the investment for less than the carrying value. The Company also considers specific adverse conditions related to the financial health of and business outlook for the fund, including industry and sector performance. The significant assumptions utilized in analyzing a fund for potential other-than-temporary impairment include current economic conditions, market analysis for specific funds and performance indicators in the automotive and transportation, residential and commercial construction, bio-technology, health care and information technology sectors in which the applicable funds' investments operate.
At December 31, 2008, the Company had investments in 17 venture capital funds, with an aggregate carrying value of $33 million. The venture capital funds invest in start-up or smaller, early-stage established businesses, principally in the information technology, bio-technology and health care sectors. At December 31, 2008, the Company also has investments in 29 buyout funds, with an aggregate carrying
value of $105 million. The buyout funds invest in later-stage, established businesses and, other than the Heartland Industrial Partners Fund ("Heartland Fund") which is primarily in the automotive and transportation sector, no buyout fund has a concentration in a particular sector.
Since there is no active trading market for these investments, they are for the most part illiquid. These investments, by their nature, can also have a relatively higher degree of business risk, including financial leverage, than other financial investments. The timing of distributions from the funds, which depends on particular events related to the underlying investments, as well as the funds' schedules for making distributions and their needs for cash, can be difficult to predict. As a result, the amount of income that is recorded from these investments can vary substantially from quarter to quarter. Future changes in market conditions, the future performance of the underlying investments or new information provided by private equity fund managers could affect the recorded values of such investments and the amounts realized upon liquidation.
During 2008, as a result of the Company's review of its private equity investments, the Company determined that the Heartland Fund was negatively impacted by the 2008 decline in North American automotive production and the expected continued decline in automotive production in 2009. In addition, five funds with limited exposure to the residential and commercial construction markets were negatively impacted by the 2008 decline in housing starts and the expected continued decline in 2009, as well as a slow-down in commercial construction; these conditions resulted in the impairment of certain investments within these five funds. During 2008, the Company recognized non-cash, pre-tax impairment charges aggregating $23 million related to these investments in private equity funds. Therefore, these six funds now have a carrying value of $43 million at December 31, 2008. If automotive production were to decline further than expected in 2009 or continue for a period of time at lower than normal historical production rates, the Heartland Fund could have an additional impairment charge in a range of $1-$5 million. The Company expects that a continued decline in the residential and commercial construction markets would not have a significant impact on the five private equity funds that recorded an impairment charge in 2008, as their remaining investments are diversified outside the residential and commercial construction sectors.
The Company records the excess of purchase cost over the fair value of net tangible assets of acquired companies as goodwill or other identifiable intangible assets. In accordance with SFAS No. 142, "Goodwill and Other Intangible Assets," in the fourth quarter of each year, or as events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount, the Company completes the impairment testing of goodwill utilizing a discounted cash flow method. The Company selected the discounted cash flow methodology as the Company believes that it is comparable to what would be used by other market participants. The Company has defined its reporting units and completed the impairment testing of goodwill at the operating segment level, as defined by SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." The Company's operating segments are reporting units that engage in business activities, for which discrete financial information, including five-year forecasts, are available.
Determining market values using a discounted cash flow method requires the Company to make significant estimates and assumptions, including long-term projections of cash flows, market conditions and appropriate discount rates. The Company's judgments are based upon historical experience, current market trends, consultations with external valuation specialists and other information. While the Company believes that the estimates and assumptions underlying the valuation methodology are reasonable, different estimates and assumptions could result in different outcomes. In estimating future cash flows, the Company relies on internally generated five-year forecasts for sales and operating profits, including capital expenditures, and generally a one to three percent long-term assumed annual growth rate of cash flows for periods after the five-year forecast. The Company generally develops these forecasts based upon, among other things, recent sales data for existing products, planned timing of new product launches, estimated housing starts and repair and remodeling estimates for existing homes.
In 2008, for its reporting units that primarily sell to the new home construction market (including those in the Installation and Other Services segment), the Company utilized estimated housing starts growing from current levels to 1.55 million in 2013 (terminal growth year) and operating profit margins improving to approximate historical margins for those business units by 2013 (terminal growth year). The housing starts projections were obtained from independent industry sources and discounted by approximately ten percent. In 2007, the Company estimated housing starts growing from 1.0 million units in 2008 to 1.75 million units in 2012 (terminal growth year). In 2008 and 2007, the Company generally utilized its weighted average cost of capital (discount rate) of approximately nine percent to discount the estimated cash flows. Due to the market conditions in 2008, the Company increased the discount rate for certain of its reporting units, based upon a review of the current risks impacting its businesses.
In the fourth quarter of 2008, the Company estimated that future discounted cash flows projected for most of its reporting units were greater than the carrying values. Any increases in estimated discounted cash flows would have no effect on the reported value of goodwill.
If the carrying amount of a reporting unit exceeds its fair value, the Company measures the possible goodwill impairment based upon an allocation of the estimate of fair value of the reporting unit to all of the underlying assets and liabilities of the reporting unit, including any previously unrecognized intangible assets (Step Two Analysis). The excess of the fair value of a reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. An impairment loss is recognized to the extent that a reporting unit's recorded goodwill exceeds the implied fair value of goodwill.
In 2008, the Company recognized non-cash, pre-tax impairment charges for goodwill of $456 million ($438 million, after tax). The pre-tax impairment charges, related to three of the Company's United Kingdom manufacturers and distributors, recorded in 2008 were as follows: Cabinets and Related Products segment - $59 million; Plumbing Products segment - $203 million; and Other Specialty Products segment - $143 million; these impairment charges reflect the anticipated long-term outlook for the reporting units, including declining demand for certain products, as well as decreased operating profit margins. The pre-tax impairment charge in the Installation and Other Services segment, related to a small installation service reporting unit in North America, was $51 million, and reflects a decline in the reporting unit's anticipated long-term outlook.
A ten percent decrease in the estimated fair value of the Company's reporting units at December 31, 2008 would have resulted in a Step Two Analysis and probable goodwill impairment for one reporting unit in the Cabinets and Related Products segment, one reporting unit in the Installation and Other Services segment and one reporting unit in the Other Specialty Products segment.
The Company reviews its other indefinite-lived intangible assets for impairment annually, in the fourth quarter, or as events occur or circumstances change that indicate the assets may be impaired without regard to the reporting unit. The Company considers the implications of both external (e.g., market growth, competition and local economic conditions) and internal (e.g., product sales and expected product growth) factors and their potential impact on cash flows related to the intangible asset in both the near- and long-term. In 2008, the Company recognized non-cash, pre-tax impairment charges for other indefinite-lived intangible assets of $11 million ($7 million, after tax). The pre-tax impairment charges recorded in 2008 were as follows: Installation and Other Services segment - $1 million, and Other Specialty Products segment - $10 million.
Intangible assets with finite useful lives are amortized over their estimated useful lives. The Company evaluates the remaining useful lives of amortizable identifiable intangible assets at each reporting period to determine whether events and circumstances warrant a revision to the remaining periods of amortization.
The Company's 2005 Long Term Stock Incentive Plan (the "2005 Plan") provides for the issuance of stock-based incentives in various forms to employees and non-employee Directors. At December 31, 2008, outstanding stock-based incentives were in the form of long-term stock awards, stock options, phantom stock awards and stock appreciation rights.
The Company elected to begin recording expense for stock options granted or modified subsequent to January 1, 2003. Effective January 1, 2006, the Company adopted SFAS No. 123R, "Share-Based Payment," ("SFAS No. 123R") using the Modified Prospective Application ("MPA") method. The MPA method requires the Company to recognize expense for unvested stock options that were awarded prior to January 1, 2003 through the remaining vesting periods. The MPA method did not require the restatement of prior-year information. In accordance with SFAS No. 123R, the Company utilized the shortcut method to determine the tax windfall pool associated with stock options as of the date of adoption.
Long-term stock awards are granted to key employees and non-employee Directors of the Company and do not cause net share dilution inasmuch as the Company continues the practice of repurchasing and retiring an equal number of shares on the open market. The Company measures compensation expense for stock awards at the market price of the Company's common stock at the grant date. There was $155 million (eight million common shares) of total unrecognized compensation expense related to unvested stock awards at December 31, 2008, which was included as a reduction of common stock and retained earnings. Effective January 1, 2006, such expense is being recognized ratably over the shorter of the vesting period of the stock awards, typically 10 years (except for stock awards held by grantees age 66 or older, which vest over five years), or the length of time until the grantee becomes retirement-eligible at age 65. For stock awards granted prior to January 1, 2006, such expense is being recognized over the vesting period of the stock awards, typically 10 years, or for executive grantees that are, or will become, retirement-eligible during the vesting period, the expense is being recognized over five years, or immediately upon a grantee's retirement. Pre-tax compensation expense for the annual vesting of long-term stock awards was $43 million for 2008.
Stock options are granted to key employees and non-employee Directors of the Company. The exercise price equals the market price of the Company's common stock at the grant date. These options generally become exercisable (vest ratably) over five years beginning on the first anniversary from the date of grant and expire no later than 10 years after the grant date. The 2005 Plan does not permit the granting of restoration stock options, except for restoration options resulting from options granted under the Company's previous plan. Restoration stock options become exercisable six months from the date of grant.
The Company measures compensation expense for stock options using a Black-Scholes option pricing model. For stock options granted subsequent to January 1, 2006, such expense is being recognized ratably over the shorter of the vesting period of the stock options, typically five years, or the length of time until the grantee becomes retirement-eligible at age 65. The expense for unvested stock options at January 1, 2006 is based upon the grant date fair value of those options as calculated using a Black-Scholes option pricing model for pro forma disclosures under SFAS No. 123. For stock options granted prior to January 1, 2006, such expense is being recognized ratably over the vesting period of the stock options, typically five years. Pre-tax compensation expense for stock options was $36 million for 2008.
The fair value of stock options was estimated at the grant date using a
Black-Scholes option pricing model with the following assumptions for 2008:
risk-free interest rate - 3.25%, dividend yield - 4.96%, volatility factor -
32.00% and expected option life - 6 years. For SFAS No. 123R calculation
purposes, the
weighted average grant-date fair value of option shares, including restoration options, granted in 2008 was $3.72 per option share.
If the Company increased its assumptions for the risk-free interest rate and the volatility factor by 50 percent, the expense related to the fair value of stock options granted in 2008 would increase 64 percent. If the Company decreased its assumptions for the risk-free interest rate and the volatility factor by 50 percent, the expense related to the fair value of stock options granted in 2008 would decrease 69 percent.
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