The Company’s current ratio increased to 1.37 at December 31, 1997 from 1.35 at the end of 1996. Other current assets decreased $78.1 million due primarily to the receipt of approximately $53.9 million from various insurance companies related to environmental matters. Short-term borrowings, primarily related to the Company’s commercial paper program, decreased $61.0 million during the year. The Company’s commercial paper program had unused borrowing availability of $893.3 million at December 31, 1997. Outstanding borrowings under the commercial paper program are fully backed by the Company’s revolving credit agreements. Increases in other components of net working capital occurred during 1997 due to the effects of acquisitions combined with increased sales and manufacturing activity.

Deferred pension assets of $276.1 million at December 31, 1997 represent the excess of the fair market value of the assets in the Company’s defined benefit pension plans over the actuarially-determined projected benefit obligations. The 1997 increase in deferred pension assets of $21.7 million represents primarily the recognition of the current year net pension credit, described in Note 6, and the recording of a settlement of a portion of the accumulated benefit obligation in one of its defined benefit pension plans in accordance with Statement of Financial Accounting Standards (SFAS) No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits”. The assumed discount rate used to compute the actuarial present value of benefit obligations was lowered to 7.0 percent at December 31, 1997 due to decreased rates of high-quality, long-term investments, thereby increasing the benefit obligations and unrecognized net loss of the plans. The deferral of the increase in the actual return on plan assets during 1997 over the assumed return of 8.5 percent, which occurred due primarily to favorable returns on equity investments, caused an offsetting decrease to the cumulative unrecognized net loss of the plans. The net effect of these deferred items, combined with an increased asset base, will result in an increase to the net pension credit in 1998. Goodwill, which represents the excess cost over the fair value of net assets acquired in purchase business combinations, increased $614.7 million, and intangible assets, which represent items such as trademarks and patents, increased $206.0 million over 1996. These increases relate primarily to goodwill and intangible assets acquired during 1997 and other adjustments of $869.7 million reduced by amortization expense of $49.0 million during the year. The decrease in other assets of $60.1 million occurred primarily due to the reclassification of certain asset values associated with a previously unconsolidated foreign joint venture acquired in 1996 which was accounted for at cost and the reclassification of certain amounts to long-term liabilities.

Net property, plant and equipment increased $142.9 million to $692.3 million at December 31, 1997 due to net fixed assets acquired of $61.8 million and capital expenditures of $164.0 million offset by depreciation expense of $90.2 million and the disposition or retirement of certain assets. Capital expenditures in 1997 represented primarily the costs of installing or upgrading point-of-sale terminals in the paint stores and costs for the construction, capacity expansion or upgrade of manufacturing and distribution centers. The decrease in capital expenditures during 1997 in the Paint Stores Segment occurred due primarily to reduced spending related to the installation of point-of-sale terminals in the paint stores. The Coatings Segment’s increase in capital expenditures during 1997 relates to construction costs for three new powder coatings facilities in Texas, California and South Carolina, construction costs for a new manufacturing facility in Brazil, construction costs for a new distribution center in Nevada and costs for capacity expansion at some of its existing facilities. Capital expenditures in the Other Segment increased due to costs related to refurbishing vacant tenant space prior to re-leasing. In 1998, the Company expects that its most significant capital expenditures will relate to construction of new facilities in Brazil and Chile, various capacity and productivity improvement projects at manufacturing facilities and new or upgraded information systems equipment. The Company does not anticipate the need for any specific external financing to support these capital programs. Long-term debt increased $701.2 million during the year to $843.9 million at December 31, 1997. As more fully explained in Note 8 , the net increase relates to the February 1997 issuance of $400.0 million of debt securities under the Company’s $450.0 million shelf registration with the Securities and Exchange Commission, the February 1997 issuance of $300.0 million of debentures in private offerings not registered under the Securities Act of 1933, as amended (Securities Act), and the October 1997 issuance of the $50.0 million of debt securities remaining under the Company’s $450.0 million shelf registration. The net proceeds from these borrowings were used to refinance a portion of the Company’s commercial paper debt, which was incurred primarily to finance the acquisition of Thompson Minwax. In connection with the issuance of the long-term debt referenced above, in May 1997, the Company decreased the aggregate principal amount of unsecured short-term notes which may be issued under its commercial paper program to $1,000.0 million from $1,450.0 million, and in December 1997, the Company filed a new shelf registration with the Securities and Exchange Commission covering $150.0 million of debt securities. No securities have been issued pursuant to this shelf registration. The Company expects to remain in a borrowing position throughout 1998.

The increase in the Company’s long-term postretirement benefit liability occurred due to the excess of the net postretirement benefit expense over the costs for benefit claims incurred and the addition of postretirement obligations assumed in acquisitions. The current portion of the accrued postretirement liability, amounting to $9.5 million at December 31, 1997, is included in other accruals. The assumed discount rate used to calculate the actuarial present value of the postretirement benefit obligations was lowered to 7.0 percent at December 31, 1997 due to decreased rates of high-quality, long-term investments, thereby increasing the cumulative unrecognized net loss for the postretirement plans. The effect of this change on the net postretirement benefit expense for 1998 will be minimal as the cumulative unrecognized net loss is below the threshold for required amortization. See Note 7 for further information on the Company’s postretirement benefit obligations.

Other long-term liabilities include accruals for environmental-related liabilities and other non-current miscellaneous items. The increase of $69.1 million during 1997 primarily relates to the increased accruals for environmental-related liabilities and the reclassification of certain amounts from current liabilities and other assets. See Note 10 for additional information concerning the Company’s other long-term liabilities.

The Company and certain other companies are defendants in a number of lawsuits arising from the manufacture and sale of lead pigments and lead paints. It is possible that additional lawsuits may be filed against the Company in the future with similar allegations. The various existing lawsuits seek damages for personal injuries and property damages, along with costs involving the abatement of lead related paint from buildings and medical monitoring costs. The Company believes that such lawsuits are without merit and is vigorously defending them. The Company does not believe that any potential liability ultimately determined to be attributable to the Company arising out of such lawsuits will have a material adverse effect on the Company’s business or financial condition.

The operations of the Company, like those of other companies in our industry, are subject to various federal, state and local environmental laws and regulations. These laws and regulations not only govern our current operations and products, but also impose liability on the Company for past operations which were conducted utilizing practices and procedures considered acceptable under the laws and regulations existing at that time. The Company expects environmental laws and regulations to impose increasingly stringent requirements upon the Company and our industry in the future. The Company believes it conducts its operations in compliance with applicable environmental laws and regulations and has implemented various programs to protect the environment and promote continued compliance.

Capital expenditures and other expenses related to ongoing environmental compliance measures are included in the normal operating expenses of conducting business. The Company’s capital expenditures and other expenses related to ongoing environmental compliance measures were not material to the Company’s financial condition or net income during 1997, and the Company does not expect such capital expenditures and other expenses to be material to the Company’s financial condition or net income in the future.

The Company is involved with environmental compliance and remediation activities at some of its current and former sites (including former sites which were previously owned and/or operated by businesses acquired by the Company). The Company, together with other parties, has also been designated a potentially responsible party under federal and state environmental protection laws for the remediation of hazardous waste at a number of third-party sites, primarily Superfund sites. The Company may be similarly designated with respect to additional third-party sites in the future.

The Company accrues for certain environmental remediation-related activities relating to its past operations and third-party sites, including Superfund sites, for which commitments or clean-up plans have been developed or for which costs or minimum costs can be reasonably estimated. The Company also accrues for certain environmental remediation-related activities relating to sites obtained through acquisitions in a similar manner. The Company continuously assesses its potential liability for remediation-related activities and adjusts its environmental-related accruals as information becomes available upon which more accurate costs can be reasonably estimated and as additional accounting guidelines are issued, such as SOP 961 that was adopted in 1996, which require changing the estimated costs or the procedure utilized in estimating such costs. Actual costs incurred may vary from these estimates due to the inherent uncertainties involved including, among others, the number and financial condition of parties involved with respect to any given site, the volumetric contribution which may be attributed to the Company relative to that attributable to other parties, the nature and magnitude of the wastes involved, the various technologies that can be used for remediation and the determination of acceptable remediation with respect to a particular site.

Pursuant to a Consent Decree entered into with the United States of America, on behalf of the Environmental Protection Agency, filed in the United States District Court for the Northern District of Illinois, the Company has agreed, in part, to (i) conduct an investigation at its southeast Chicago, Illinois facility to determine the nature, extent and potential impact, if any, of environmental contamination at the facility, and (ii) implement remedial action measures, if required, to address any environmental contamination identified pursuant to the investigation. In addition, the Company is a defendant in a lawsuit brought by PMC, Inc. regarding one of the Company’s former Chemical Division’s manufacturing facilities which is located adjacent to the Company’s southeast Chicago, Illinois facility. This former manufacturing facility was sold to PMC, Inc. in 1985. PMC, Inc. is seeking an undisclosed amount for environmental remediation costs and other damages based upon contractual and tort theories, and under various environmental laws. The Company is vigorously defending this lawsuit.

With respect to the Company’s southeast Chicago, Illinois facility and its former manufacturing facility adjacent thereto, the Company has evaluated its potential liability and, based upon its preliminary evaluation, has accrued an appropriate amount. However, due to the uncertainties surrounding these facilities, the Company’s ultimate liability may result in costs that are significantly higher than currently accrued. In such event, the recording of the liability may result in a significant impact on net income for the annual or interim period during which the additional costs are accrued.

The Company does not believe that any potential liability ultimately attributed to the Company for its environmental-related matters will have a material adverse effect on the Company’s financial condition, liquidity, cash flow or, except as set forth in the preceding paragraph, net income. See Note 10 for discussion of the environmental-related accruals included in the Company’s consolidated balance sheets.

Shareholders’ equity increased more than $190.9 million during 1997 due primarily to the excess current year net income over dividends paid to shareholders. The par value of $101.9 million for additional common shares issued in the form of a two-for-one stock split in March 1997 was credited to common stock and a like amount charged to other capital. The Company did not acquire any of its own shares through open market purchases during this period. Approximately 160,700 shares of the Company’s common stock were received in exchange for stock issued in accordance with the Company’s stock plans. The Company acquires its own stock for general corporate purposes and, depending on its future cash position and market conditions, it may acquire additional shares in the future. In April 1997, the Board of Directors authorized the Company to purchase, in the aggregate, 10,000,000 shares of common stock. The increase of $14.1 million in the cumulative foreign currency translation adjustment occurred due primarily to the strengthening of the U.S. dollar over the Company’s foreign subsidiaries’ currencies. The Company’s Brazilian subsidiaries, which had been accounted for under highly inflationary accounting rules, are now accounted for under non-highly inflationary accounting rules beginning July 1, 1997. As of that date, the Brazilian Real is the functional currency for all Brazilian operations, and any resulting translation adjustments have been included in the cumulative foreign currency translation adjustment of shareholders’ equity.

The Company is engaged in a company-wide project to prepare the Company’s computer systems and applications for the change in date from the year 1999 to 2000. This project consists of identifying and taking appropriate corrective action to address the Year 2000 issue in affected systems and applications. The Company expects its Year 2000 project (including testing and implementation) to be completed on a timely basis. All costs and expenses incurred to address the Year 2000 issue are charged against income on a current basis. The Company does not expect these costs and expenses to be material to the Company’s financial condition, annual results of operation or cash flows.

In addition, the Company commenced a multiyear, company-wide information technology project to enhance the Company’s computer systems. The project will provide efficiencies and further integration of operations. The Company currently expects that full implementation of this project will involve significant capital expenditures over the next several years. Certain costs and expenses related to this project, including amortization costs, are charged against income on a current basis. While this project will reduce the Company’s cash flows from operations in the first year, anticipated benefits in subsequent years will reduce any impact on cash flows. The capital expenditures, costs and expenses are not expected to have a material adverse effect on the Company’s annual results of operations.

The Company is exposed to market risk through various financial instruments, including fixed rate debt instruments and interest rate swaps. The Company does not believe that any potential loss related to these financial instruments in future earnings, fair values or cash flows from possible near-term market movements will have a material adverse effect on the Company’s financial condition or results of operations.

At a meeting held February 4, 1998, the Board of Directors increased the quarterly dividend to $.1125 per share. This represents the nineteenth consecutive annual increase and a compounded annual rate of increase of 27.2 percent since the dividend was reinstated in the fourth quarter of 1979. The 1997 annual dividend of $.40 per share marked the eighteenth consecutive year that the dividend approximated our payout ratio target of 30 percent of the prior year’s earnings.

Results of Operations - 1997 vs 1996
Consolidated net sales increased 18.1 percent over 1996 to $4.88 billion in 1997. Excluding incremental sales from Thompson Minwax and other smaller domestic and foreign acquisitions (collectively, the 1997 Acquisitions) which occurred at various times since December 31, 1996, net sales for 1997 increased 3.7 percent.

The Paint Stores Segment’s sales during 1997 increased 8.1 percent, or 6.6 percent excluding the 1997 Acquisitions, due primarily to increased paint gallons sold to wholesale customers combined with wholesale volume increases in the remaining major product lines. Wholesale customers include professional painters, contractors and industrial and commercial maintenance customers. Although volume sales to retail customers were soft in the second half of the year, overall retail sales increased in 1997 compared to 1996, thereby contributing to the sales improvement in the Paint Stores Segment.

External sales in the Coatings Segment increased 32.5 percent during 1997 due primarily to incremental sales from the 1997 Acquisitions. Excluding the 1997 Acquisitions, sales declined 0.5 percent. Sales were affected by the loss of certain business due to our unwillingness to match or exceed the low prices offered by our competition. The Company expects sales from new products and product lines and the expansion of its presence at several retailers to offset the lost sales; however, the Segment’s overall expected sales increase will be tempered during the first half of 1998 as compared to the first half of 1997. Reduced gallons sold to national accounts and home center customers, which resulted from poor out-the-door sales and the loss of certain product lines at one of its customers, accounted for a slight sales decline in the Consumer Brands Division after excluding the 1997 Acquisitions. External sales in the Automotive Division were higher than last year on both an as-reported basis and excluding the 1997 Acquisitions due primarily to sales gains in its automotive branches and at original equipment manufacturers combined with foreign sales gains resulting from increased market penetration in those areas. In the Diversified Brands Division, sales gains in the industrial and applicator product lines were offset by reduced sales to some customers in the retail national (formerly hardware) and cleaning solutions businesses, leading to slightly lower sales excluding the 1997 Acquisitions as compared to last year. External sales in the Coatings Segment’s consolidated foreign subsidiaries increased significantly during 1997 and represented 11.3 percent of the Company’s consolidated net sales due primarily to the Company’s acquisition activity. Revenue generated by real estate operations in the Other Segment was lower than last year due to the loss of a large tenant in one of its office buildings at the end of 1996.

Consolidated gross profit as a percent of sales increased to 43.0 percent from 41.8 percent in 1996 due in part to the effects of the 1997 Acquisitions, although improved gross profit margins were also obtained excluding the 1997 Acquisitions. The Paint Stores Segment’s 1997 gross margin excluding the 1997 Acquisitions was higher than last year due primarily to sales gains in its higher-margin paint and paint-related product lines. Margins in the Coatings Segment were higher than last year due to above-average margins realized from some of the 1997 Acquisitions’ businesses combined with a favorable sales mix in most of its divisions and favorable factory operations in the Automotive Division.

Consolidated selling, general and administrative expenses as a percent of sales increased to 32.2 percent from 31.7 percent in 1996. Excluding the 1997 Acquisitions, SG&A expenses as a percent of sales were even with last year. The Paint Stores Segment’s SG&A expenses as a percent of sales were favorable to last year on both an as-reported basis and excluding the 1997 Acquisitions due to cost containment combined with the sales gains achieved. Increased merchandising and administrative costs related to new products, new customers and improved service levels led to an unfavorable SG&A ratio in the Coatings Segment for 1997 compared to 1996.

Consolidated operating profits increased 21.6 percent in 1997, or 7.2 percent excluding the 1997 Acquisitions. Operating profits of the Paint Stores Segment increased 9.3 percent, or 8.9 percent excluding the 1997 Acquisitions, due primarily to increased paint volume combined with containment of selling, general and administrative expenses. The Coatings Segment’s operating profits excluding the 1997 Acquisitions were 6.6 percent higher than last year due primarily to the realization of manufacturing efficiencies in certain business units. Operating profits of the Coatings Segment’s consolidated foreign subsidiaries represented 12.6 percent of the Company’s consolidated operating profits due primarily to profits from the Company’s acquisitions. There are certain risks in transacting business internationally, such as changes in applicable laws and regulatory requirements, political instability, general economic and labor conditions, fluctuations in currency exchange rates and expatriation restrictions, which could adversely affect the financial condition or results of operation of the Company’s consolidated foreign subsidiaries. The operating profits of the Other Segment decreased in 1997 due primarily to vacant lease space during part of the year related to the loss of a large tenant in one of its office buildings. Corporate expenses increased in 1997 due primarily to increased interest expense and net losses relating to translation of certain foreign investments which are not directly associated with or allocable to any individual operating segment. Follow this link for additional Business Segment Information.

Interest expense increased significantly in 1997 due to the increases in long-term debt related to the financing of the 1997 Acquisitions. As a result, interest coverage decreased to 6.3 times from 16.3 times in 1996. Our fixed charge coverage, which is calculated using interest and rent expense, declined to 3.2 times from 3.9 times in 1996.

Net interest and investment income increased in 1997 due primarily to higher average cash and short-term investment balances and higher average yields. See Note 4 for further detail on other costs and expenses. As shown in Note 14 the effective income tax rate in 1997 remained unchanged from the 1996 rate.

Net income increased 13.7 percent in 1997 to $260.6 million from $229.2 million in 1996. Excluding the Acquisitions, net income increased 14.9 percent. Net income per common share-basic, calculated in accordance with SFAS No. 128 adopted for the fourth quarter ended December 31, 1997, increased 12.7 percent to $1.51 from $1.34 (as restated to conform to SFAS No. 128). See Note 1 for additional discussion on the Company’s adoption of SFAS No. 128 and Note 16 for detailed computations. As a consequence of the lost external sales in the Coatings Segment in 1997, the Company’s anticipated increase in net income during the first half of 1998 will be slightly impacted.

Although the costs and expenses of the Company’s Year 2000 project and the expenses associated with the information technology project will slightly impact operating profits and net income in 1998, the Company expects that 1998 sales and earnings will exceed the sales and earnings recorded in 1997.

Results of Operations - 1996 vs 1995
Consolidated net sales increased to $4.13 billion in 1996, a 26.2 percent increase over 1995. Excluding incremental sales from Pratt & Lambert United, Inc. and other smaller acquisitions (collectively, the 1996 Acquisitions) after date of acquisition, net sales for 1996 increased 7.5 percent.

Sales in the Paint Stores Segment increased 13.1 percent over 1995, or 9.1 percent excluding the 1996 Acquisitions, due primarily to increased paint gallons sold to both retail and wholesale customers. Comparable store sales were up 10.0 percent for the year. Despite selling price reductions on certain non-paint product lines in 1996, volume gains generated overall sales increases in all non-paint product lines except window treatments.

Incremental sales from the 1996 Acquisitions led to an external sales increase of 51.4 percent over 1995 in the Coatings Segment. Excluding the 1996 Acquisitions, external sales increased 4.7 percent. Increased gallons sold to national accounts and independent dealers led to a net external sales increase excluding the 1996 Acquisitions over 1995 in the Consumer Brands Division. In the Automotive Division, 1996 external sales gains excluding the 1996 Acquisitions were generated primarily from sales growth in its branch distribution network. The addition of new products and new customers in the Diversified Brands Division during 1996 helped achieve sales gains in its custom, automotive, hardware and industrial product lines excluding the 1996 Acquisitions. Revenue generated by real estate operations in the Other Segment decreased slightly compared to 1995 due to the disposition of certain properties in late 1995 and in 1996.

Lower gross profit margins from some of the 1996 Acquisitions’ businesses caused consolidated gross profit as a percent of sales to decline to 41.8 percent from 42.7 percent in 1995. Excluding the 1996 Acquisitions, gross profit margins increased to 44.4 percent. Gross profit margins in the Paint Stores Segment, both including and excluding the 1996 Acquisitions, were higher than 1995 due to increased sales of its higher margin product lines combined with increased retail sales. Stable product costs combined with a favorable sales mix led to improved gross profit margins over 1995 in the Coatings Segment excluding the 1996 Acquisitions.

Consolidated selling, general and administrative (SG&A) expenses as a percent of sales were favorable to 1995, declining to 31.7 percent from 32.8 percent, due to lower-than-average expenses in the 1996 Acquisitions’ businesses. Excluding the 1996 Acquisitions, SG&A expenses as a percent of sales increased to 33.5 percent. The Paint Stores Segment’s controlled spending throughout 1996 combined with its sales gains led to favorable SG&A expenses as a percent of sales on both an as-reported basis and excluding the 1996 Acquisitions. The Coatings Segment’s SG&A expenses as a percent of sales excluding the 1996 Acquisitions were unfavorable to 1995 due primarily to increased merchandising costs, advertising and promotional expenses related to product introductions in the Consumer Brands and Diversified Brands Divisions.

Consolidated operating profits increased 30.3 percent over 1995, or 19.2 percent excluding the 1996 Acquisitions. Operating profits of the Paint Stores Segment increased 30.2 percent, or 28.1 percent excluding the 1996 Acquisitions, due to volume gains and the continued containment of SG&A expenses. The Coatings Segment’s operating profits excluding the 1996 Acquisitions increased 11.9 percent due to stable raw material costs and manufacturing efficiencies resulting from volume gains. The operating profits of the Other Segment increased in comparison to 1995 primarily due to the reduction in costs associated with disposed properties. Corporate expenses increased over 1995 due to increased interest expense, decreased net investment income and increases in other costs and expenses which are not directly associated with or allocable to any individual operating segment. Follow this link for additional Business Segment Information.

The increases in long-term debt and short-term borrowings which occurred in 1996 due to the financing of the 1996 Acquisitions caused interest expense to increase significantly over 1995. Correspondingly, interest coverage decreased to 16.3 times from 126.8 times in 1995. Fixed charge coverage, which is calculated using interest and gross rent expense, declined to 3.9 times from 4.2 times in 1995.

Net interest and investment income was lower than 1995 due to lower average cash and short-term investment balances offset partially by higher average yields. Other costs and expenses increased in 1996 due to increased provisions for dispositions and termination of operations and for environmental remediation-related matters and other items as more fully discussed in Note 4. The effective income tax rate increased in 1996, as shown in Note 14 primarily due to the increase in non-deductible tax items, primarily goodwill.

Net income increased 14.2 percent in 1996 to $229.2 million from $200.7 million in 1995. Excluding the 1996 Acquisitions, net income increased 12.6 percent. Net income per share increased 13.7 percent in 1996 to $1.34 from $1.18 (as restated in accordance with SFAS No. 128).

In accordance with the consensus guidance in Emerging Issues Task Force No. 8711, “Allocation of Purchase Price to Assets to be Sold”, all 1996 results of operations exclude the results of operations of certain Pratt & Lambert United, Inc. subsidiaries through their respective dates of sale. These subsidiaries, which were sold during the third quarter of 1996, include essentially all operations of Pierce & Stevens Corp., a manufacturer of specialty chemicals, and Miracle Adhesives Corporation, a manufacturer of adhesives for the construction industry. The total operating profit related to these subsidiaries prior to their sale, approximately $3.0 million in 1996, has been excluded from the statement of consolidated income. The net gain realized on the sale of these subsidiaries was insignificant to the allocation of purchase price pursuant to APB Opinion No. 16.