宣偉 (SHW) 2006 Q2 法說會逐字稿

Good morning. Thank you for joining the Sherwin-Williams Company's review of the second quarter 2006 financial results and expectations for the third quarter and full year. With us on today's call are Chris Connor, Chairman, President, and CEO; Sean Hennessy, Senior Vice President of Finance and CFO; John Alt, Vice President, Corporate Controller; and Bob Wells, Vice President, Corporate Communications.

This conference call is being webcast simultaneously in listen-only mode by v-call via the internet at www.sherwin.com. An archived replay of this webcast will be available approximately two hours after this conference call concludes. It can be accessed at www.sherwin.com and will be available until Tuesday, August 1, 2006, at 5:00 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 this 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.

After the Company's opening remarks, we will open the session to questions. I will now turn the call over to Mr. Bob Wells.

Thanks, Dan. In order to allow more time for questions, we've provided balance sheet items and other statistical data on our website at www.sherwin.com, under Investor Relations Second Quarter Press Release.

Summarizing overall Company performance for the second quarter 2006 versus second quarter 2005, consolidated net sales increased 8.4% to $2.13 billion, reflecting continued strength in domestic sales of architectural paints and industrial coatings and strong growth in many markets outside the U.S. Consolidated gross profit increased $98.4 million for the quarter to $936.6 million. Gross margin increased to 44% of sales from 42.6% in the second quarter last year due primarily to the implementation of price increases during the past four quarters. Selling, general, and administrative expenses decreased to 30.1% of sales in the second quarter this year from 30.2% last year.

Interest expense for the quarter increased by $3.2 million to $16.8 million due to an increase in short-term borrowings. However, this increase was more than offset by an increase of $5.1 million in income from investments made to maintain maximum financial flexibility.

Consolidated net income for the quarter increased by $31.4 million or 20.5% to $184.6 million from $153.2 million in the second quarter of 2005. Net income as a percent of sales improved to 8.7% in the second quarter this year from 7.8% last year due primarily to improved operations. Diluted net income per common share for the quarter increased 23.1% to $1.33 per share compared to $1.08 per share in the second quarter 2005.

Looking at our results by segment, sales for our Paint Store segment in second quarter 2006 increased 11.8% to $1.33 billion. Comparable store sales, or sales by stores open more than 12 calendar months, grew 9.6%. Sales growth for the segment was driven primarily by gains in architectural paint sales to contractors and do-it-yourself customers, and stronger industrial maintenance coating sales compared to the second quarter last year. Regionally in our Paint Store segment in the second quarter, our southwest division led the sales performance followed by southeast division, midwest division, and eastern division. Operating profit for the segment increased 18.9% to $217.2 million for the quarter. Operating margin increased to 16.3% from 15.5% last year due primarily to strong sales volume growth and effective SG&A expense control.

In the Consumer segment for the second quarter 2006, sales decreased 3.3% to $400.9 million. Volume growth through some of our retail accounts and the impact of selling price increases was more than offset by the elimination of a portion of a paint program with a large retail customer. Operating profit for the Consumer segment increased 17.3% in the quarter to $76.3 million. Operating profit as a percent of external sales improved to 19% from 15.7% in the same period last year due primarily to selling price increases, tight spending control, and favorable manufacturing absorption related to manufacturing volume increases through the Paint Store segment that offset continuing raw material cost increases.

Turning to our Global segment for the second quarter '06, sales in U.S. dollars increased 10.4% to $398.8 million. Sales in local currency grew by 7.8% in the second quarter due primarily to strong product finishes sales growth, volume growth in Mexico and South America, and selling price increases and improved automotive finishes sales. Operating profit for the Global segment increased 33.7% to $34 million for the quarter, and operating margin improved to 8.5% of sales from 7.1% last year. This improvement was mostly attributable to increased sales, operating efficiencies related to increased volume, and expense control. Currency exchange had no significant impact on operating profit.

I would like to now comment briefly on some of our balance sheet items. Our working capital ratio, accounts receivable plus inventories, less payables to sales, came in at 13.9% in the second quarter 2006 versus 16.6% for the same period last year. This is based on 12-month sales and average working capital. Our total debt on June 30, 2006, was $789 million, including total short-term borrowings of $279 million. Our invested cash balance at June 30, 2006, was $239.7 million compared to $12.5 million in 2005. Total borrowings to capitalization were 28.6% at the end of the quarter versus 34.5% at the end of second quarter 2005. Long-term debt to capitalization was 20.6% at the end of the first quarter this year compared to 22.6% last year.

In the second quarter 2006, the Company repurchased 850,000 shares of our common stock in the open market. At June 30, 2006, the Company had authorization to purchase approximately 17.2 million shares of its common stock. We expect to continue from time to time our opportunistic purchase of Company stock for treasury since we continue to believe our stock is a good value.

In second quarter 2006, we spent $53 million on capital expenditures. Depreciation expense was $30.2 million and amortization expense was $5.6 million. For the full year 2006, capital expenditures will be approximately $160 million. The predominant share of the increase in capital expenditures will go toward expanding our manufacturing capacity, including the completion of a new emulsion plant in Nevada to serve the western United States. Depreciation will be about $133 million versus $120 million in 2005, and amortization will be $24 million versus $23 million in 2005.

I'll conclude this review with a brief update on the status of our lead litigation. As you know, in February 2006, a Rhode Island jury returned a verdict finding that the cumulative presence of lead pigment in paints and coatings on buildings throughout the state constitute a public nuisance and that Millenium Holdings, NL Industries, and Sherwin-Williams caused or substantially contributed to the creation of that public nuisance and should be ordered to abate it. No compensatory damages or punitive damages were awarded in this case. Following the verdict, the court requested input from both the state and the defendants as to what the abatement remedy should entail. These submissions have been made and argued, and the court has not yet rendered its decision on this matter. This verdict is only the first part of a long legal process. Post-trial motions, including a request for new trial, have been briefed and are pending before the court. No timetable has been indicated by the judge as to when he will render his decision. Should these motions be denied, the defendants intend to appeal the case to the Rhode Island Supreme Court.

Separately, on April 3, 2006, the Rhode Island Supreme Court heard oral arguments on whether the contingency fee agreement between the Attorney General and the outside lawyers representing the state is legally permissible. The court has indicated it will defer ruling on this issue to an undetermined future date.

In California, an appeals court recently reinstated certain claims of public nuisance, strict liability, negligence, and fraud against a group of defendant companies. These complaints were originally dismissed by the Superior Court for Santa Clara county in July, 2003, on statute of limitations grounds. The California Supreme Court declined to consider an appeal at this time, and the case has been returned to the trial court. No trial date has been set.

Although there are no new developments in the City of Milwaukee's public nuisance lawsuit against Mautz Paint and NL Industries, I want to remind you that the court has set a trial date of January 8, 2007.

That concludes our review of the quarter. So I'll turn the call over to Chris Connor, who will make some general comments and highlight our expectations for the balance of the year. Chris?

Thanks, Bob, and good morning, everybody. Thanks for joining us today. Now that we've got a solid first half of 2006 in the books, we're feeling pretty good about our prospects for the full year. And although we're going to face some tough comparisons for the second half, I'm confident that we can continue our strong operating momentum over the balance of this year. Consolidated sales remained strong for the Company in the second quarter, despite weaker than anticipated top-line results from our Consumer segment, and the double digit revenue growth in our Paint Stores and Global segments, I think for the quarter and first six months really illustrates the advantages of our controlled distribution and diverse customer base.

Our expectations for the balance of the year assume that we'll continue to generate strong revenue growth and positive earnings leverage from this model. You know we're often asked to explain how we can continue to achieve these numbers given the many indicators pointing to tougher market conditions ahead. Rising interest rates, declining housing starts that we've seen now for a couple of quarters, slower turnover of existing homes, and volatile energy prices to name just a few. And I guess our expectations are that we'll continue to grow sales and improve our operating profit performance regardless of these market conditions. Through good economic times and difficult ones, we've consistently invested in new distribution, continued to open stores, new capacity, and technology to drive our growth, and this year is no exception.

For example, during the second quarter, our Paint Store segment opened 29 net new stores, bringing our total opens for the year to 50. At this pace, we remain on track to open more than 100 net new stores during the calendar year. This ambitious new store opening program is complemented by a robust comp store sales increase of more than 13% through the first six months of 2006. Because the success of both new and existing stores is driven in part by the support they receive from sales reps in the field, we continue to aggressively open new sales territories and staff them with ambitious, well-trained men and women.

Despite the flat sales performance in the first half, our Consumer segment management team has taken some very effective steps to reduce operating costs, improve productivity, and implement necessary selling price increases. These steps have resulted in a 230 basis point improvement in operating margin for the segment year to date. We will continue to invest appropriately in new merchandising and marketing programs to drive sales of our key brands through our national, regional, and local retail partners, with the goal of expanding distribution and continuing to improve our share within these channels. This month, we will complete construction of our new emulsion plant in Nevada, which is scheduled to begin production in August. Once fully operational, the state-of-the-art facility will significantly increase our latex paint manufacturing capacity in the western region and eventually reduce our operating costs.

Our Global segment also contributed significantly to our sales and profit improvement through the first half. We will continue to expand our international presence and improve our coverage of the global coatings market by adapting the model that has worked so well for us domestically. So far this year, we've made important additions to our Company-operated distribution by opening new stores in South America. We've accelerated the rate of new territory openings in our automotive finishes and product finishes businesses, and we've expanded our management training programs modeled after the successful program in our store segment. We believe investments like this will continue to pay dividends in the years ahead and will further improve our competitive position and enable us to grow even in times when perhaps the market does not.

During the second quarter, we continued to improve our gross margin performance. Through the first six months of '06, where consolidated gross margin increased by 100 basis points over the same period last year. This increase is primarily the result of the hard work and determination of our sales organizations in implementing the necessary price increases we announced last year, and also our favorable fixed cost absorption from increased manufacturing volumes. Despite the significant margin expansion we realized in the first half and our expectations to finish the year above the 42.8% consolidated gross margin reported in '05, our performance for the year will remain below the historical levels established in the '02 and '03 timeframe.

Raw material pricing remains challenging throughout the second quarter, and we're beginning to see some signs of stability returning to the market. We're optimistic that pricing of certain commodities might remain relatively stable for the balance of the year. Our optimism is fueled in part by the improved availability of some essential commodities such as TIO2, latex, and polyethylene and what appears to be a sustained drop in natural gas prices below $7 per million BTUs.

Of course, the wild card in all this is the continued volatility in the price of crude oil. High crude oil prices have driven up the cost of materials like resins and solvents. Given the tight supply demand balance and geopolitical instability in many crude oil production regions and market speculation, we expect that we're going to continue to deal with this volatility for some time. While it's extremely difficult to forecast in this current environment, our outlook remains for the industry to incur year-over-year raw material cost increases in the range of 8% on average for 2006.

You know, Bob mentioned briefly our working capital management, and I wanted to just take a moment to expand on this point. As most of you know, we take a very disciplined approach to managing our shareholders' money. I believe it's noteworthy that in the second quarter we were able to support a sales increase in excess of 8% on a reduction in working capital. This decrease in our working capital ratio from 16.6% of sales at 13.9% also represents a year-over-year reduction of nearly $50 million of working capital. This combined with our first-half profit improvement of more than $60 million has increased our operating cash by more than $100 million versus the first half of 2005, which has further allowed us to strengthen our balance sheet.

Let me conclude my remarks this morning by updating our outlook for the third quarter and the full year of 2006. We expect our third-quarter sales to increase 6 to 9% over the third quarter of 2005. With sales at that level, we expect diluted net income per common share to be in the range of $1.23 to $1.28 per share, compared to $1.07 per share for the third quarter of last year. For the full year, 2006, we expect sales to increase in the high single to low double-digit range over 2005. With sales of that level, we expect diluted net income per common share to be in the range of $4.00 to $4.10 per share compared to $3.28 per share last year. As a reminder, our guidance for 2006 includes an estimated $0.08 per share charge for the additional expense related to stock options. Again, thanks to all of you for joining us and now we'd be happy to take your questions.

Ladies and gentlemen, at this time we will be conducting a question-and-answer session. [OPERATOR INSTRUCTIONS] Our first question is coming from Chuck Cerankosky of Keybanc Mcdonald.

Good morning everyone. Great quarter. If we're looking at that Paint Stores group, Chris, can you give us a little more detail behind some of the numbers such as sales coming from new versus existing homes, residential versus commercial, architectural versus non-architectural?

Yes. I think, Chuck, in the past we've commented about the architectural and the industrial coatings performance inside this segment of the Company, and in this case, we would continue to give some guidance there. We've had strong, consistent, fairly comparable results in both of these segments that would put both the industrial and architectural in a double-digit environment. The new business versus the repaint market -- is that the second part of that question?

Yes. New versus -- new homes versus existing homes, then residential versus commercial.

Yes. We don't really break out the new versus the other in terms of our performance other than to just tell you that both these things have been strong. I think the new residential performance from our perspective is mainly coming from market share growth as a result of that segment not performing all that well. But we've seen strong performance across all these segments in our Stores group.

Okay. Then if we look at that working capital management which was very good during the quarter, what's the interplay between the Paint Store segment and the other two -- and I'm thinking mostly of commercial -- excuse me, the Consumer segment, given that one's controlled distribution, the other is more dependent on third-party retailers.

I would tell you that both -- actually all three of our segments had very good working capital performance in the quarter and year to date, Chuck. They -- you're right, they have different levers. The Stores group has the ability to manage the inventory at the store level. At the Consumer segment, they spend a lot more time on the receivables and the inventory is flexed sometimes by the orders that occur at the end of a quarter. So the -- whether the shipment goes out, if it doesn't go out, it's in their inventory and so forth. But there's different levers in each segment. But in the -- the Global segment had very good improvement in receivables and inventory management. So I would tell you all three had good results, but there are different levers.

Sean, if we had seen say 5% sales increase in the commercial -- excuse me, the Consumer segment, would we have seen as much improvement in -- in working capital?

I believe so. I think that our receivables would have been higher. But I think with our inventory management systems that we have, I think we would have seen the same -- actually lower. With 5%, they would have a little more ability to --

They would have been better.

Yes. At the distribution centers.

Okay, and last question. I noticed in the -- the supplemental data that the deferred pension asset had gone down year over year, and I was wondering what was behind that.

I think if you take a look at the returns we're getting over a full 12 months, we're at about 7.8% return over the last 12 months. But as we've continued to -- part of that asset has been -- some of the newer employees are going into what we call the C-Pip, which is allowed to be -- we're allowed to fund part of the C-Pip out of it, defined benefit plan.

Got you. Thank you.

Our next question is coming from Jeff Zekauskas of J.P. Morgan. Please proceed with your question.

Hi, good morning.

Good morning.

Good morning, Jeff.

Maybe you can solve a few puzzles for me. Your earnings guidance for the third quarter means that your sequential earnings will go down. Why should they go down? Why shouldn't they go up?

I mean in the -- in our guidance is for -- the mid point would be $0.18. We had a $0.25 increase. Is that what you're --?

No, in other words, you reported $1.33. Your guidance, I think you said was something like $1.24 to $1.28.

Yes.

Why shouldn't you earn more in the third quarter than in the second? hat's sort of the historical pattern of the Company, and you're forecasting something like 6 to 9% revenue growth, which means the consolidated sales are about flat sequentially. So something has to be worse in the third quarter for you to report lower numbers.

I guess we don't look at it that way. We had a tough comp in the third quarter last year, Jeff.

Yes.

We are giving guidance that the sales will be up in the high single digits as opposed to the run rate we've been at, a little bit stronger than that. We think that's a pretty strong performance.

Second question is you talked about industry raw materials being up about 8%. You know, I think some of your competitors have talked about raws being up, you know, maybe 2% or 3%, but maybe they'd even be lower than that. It looks like acrylics have come down, TIO-2's coming down. Why are you so conservative about the raw material outlook?

Hey, Jeff, just a point of clarification there. They're saying TIO-2 is coming down versus last year?

I'm saying TIO-2 is coming down. What they say is that -- that raw materials for paints are going to be up maybe 2% this year. I think that's what PPG said this morning.

Is that 2% growth this year or year-over-year?

'05 to '06.

I can't comment on what other folks are saying, Jeff. This is a format we've used consistently now for sometime in the Company to follow the industry pricing. There is some speculation in this because we have to make some projections about what might happen out there. We've used these models to -- to run the Company and we share with you the best of our information at the time we have it. So if there is more current data out there, these things will continue to get updated. Right now, we think it's going to be around 8%.

Okay. Just a last question. So one of the big controversies with Sherwin-Williams is how much does the new housing market really matter to the Company? And I think over time you've said there have been various percentages that you've quoted and maybe it's 15% of sales, maybe it's 10. So is the right way to think about it that it's about $1 billion in sales to Sherwin-Williams? The question is is what's the volatility around the $1 billion in sales to the new construction market? Or is it some other way we should think about it?

I don't think we've ever given any kind of indication of what the dollar number is to your $1 billion point. I think a way for you to look at it is that first of all it's only in the Store segment to start with.

All right.

And within that segment we've commented that architectural coatings constitutes a certain portion of that segment. There's also industrial coatings in there as well. And within the architectural coatings piece of our Stores business, we've indicated that 80 to 90% of all coatings are used to maintain and redecorate existing structures, and only 10 to 20% are used for new construction. And that new construction is broken down further to residential and commercial. So the $1 billion number when you would go through that analysis and do the math would be very high.

Okay. Thank you very much.

Our next question is coming from Ivy Zelman of Credit Suisse. Please proceed with your question.

Hi, good morning, guys. Actually, it's Miguel on for Ivy. Just to clarify on the raw materials there, Chris. The guidance did come down, the expectations for the cost increase did come down relative to last quarter, correct?

That's correct. We're at 8 to 10 and we're now at the low end of that range.

Okay. On the sales front in the second quarter coming in below your expectations, you mentioned Consumer being a bit weaker than expected. Were the other segments in line with expectations, or did you see a deceleration there, as well?

No. They're in line.

Okay. And is that similar for the back half of the year realizing the guidance for the third and fourth is a bit lower? Is that related to Consumer?

Yes, we're very confident about the prospects going forward for Stores and Global. And I think as we've commented in the past, we had a particular retail customer in the Consumer segment that elected to take a significant number of distribution centers away from us and we're feeling the impact of that perhaps a little stronger than we anticipated.

Okay. And the -- the trial in Rhode Island, when the judge does come back with an abatement decision, assuming it is unfavorable for you, are there cash flow implications for that, or is that uncertain on what the requirement could be for your Company?

Well, it's very uncertain on what the requirement could be for the Company. There will be a series of appeal processes long before a dollar ever leaves this Company.

Okay. Just lastly, I'm following on the new construction comments a couple months ago that you guys signed a national agreement I believe with Pulte. Wondering if those type of agreements are something that you're targeting as the markets are coming down where you're able to maybe gain share in a falling market to offset that weakness?

Well, I think our teams are out there constantly looking for opportunities to secure new accounts. We did announce the Pulte contract some months ago. We continue to see good activity in the home building segment as our products and programs and services are compelling to this customer and we would expect to be taking share in this segment as we would in all of our segments going forward.

Do you have agreements with any other top 20 builders nationally?

Yes.

How many?

We're probably doing business with certainly the vast majority of them and we have some fairly secure single-source agreements with a handful of the top 10.

Okay. All right. Great. Thanks again, guys.

Our next question is coming from John Roberts of Buckingham Research. Please proceed with your question.

Good morning, guys.

Good morning, John.

In Rhode Island, you updated us on the remediation or abatement discussion, but I don't know if you made any comments about the motions for retrial. Could you update us there?

John, all we said was that those motions -- some argument's been made before the court. All those motions have been briefed and the decision is pending before the court. We don't have a timetable for when any rulings on those motions will be made.

I thought there was a hearing recently, that there was a key dispute over some of the blood level data that the state presented, that it was dated and not current?

That's correct. We argued that last Wednesday.

That was the basis for one of the motions for retrial.

Is that new data, or did you have -- did you dispute that during the trial, as well?

That's new data.

So it came out post trial, the data?

Correct.

Okay. And -- it --

It was available before the trial was over, but it was not made available to us until post trial.

So it was only available to the state and not to you?

That's my understanding.

That's my understanding.

Secondly, was your volumes up in the eastern region during the quarter? I mean the weather was pretty lousy in terms of rain at least in that one division. Were they still able to post up volume?

Well, that's an insightful question. Yes, they did have a positive quarter for the Company.

The answer is yes, they were slightly positive.

Okay. That's impressive. Thank you.

Our next question is coming from Lawrence Horan, and he's a private investor. Please proceed with your question.

Yes. You took a big draw-down in the first quarter in regards to your short-term line of credit and you maintain a large cash horde, shall we say, of -- in the hundreds of millions area. And there's a note in the recent filing that it was because -- the initial draw-down was because of the Rhode Island verdict. Are you anticipating maybe having to set up a reserve should there be an adverse abatement ruling?

Right now, if there was a -- we don't have a reserve on our books. There's -- or an accrual. When you take a look at the cash position we have been in, what happened right after the original Rhode Island verdict or decision, some of the commercial paper, we went to some shorter term duration. So just for daily -- to ensure the daily liquidity, we've increased the cash balance that we have. When you take a look at the abatement question and so forth, we're just keeping all our -- a lot of different variables open, whether it's a revolving letter of credit that we've set up, the $350 million, the account receivable securitization of $500 million, just in any -- just for any possibility.

Okay. Thank you.

Our next question is coming from Jay McCandless of Avondale Partners.

Good morning, everyone. I wanted to ask you first on the Consumer segment, could you talk about some of the initiatives you all are undertaking there to drive sales growth?

Historically, this segment has done a terrific job of innovation in term of new products, new packaging, new marketing. We recently updated our color pallette for our Pratt Lambert line. We continue to advertise and promote these brands. We have some terrific programs going with our retailing partners for the selling season. So just typical types of activities along with continuing to approach non-current customers of the segment to articulate the benefits of our programs.

And then also wanted to ask you on the raw materials front, as you stated before, the price of oil stayed high over the past year. Just wanted to see what your outlook for pricing increases and how much ability you all are going to have to pass those through going forth?

I think currently there's no -- our ability to pass price increase through, I think can be seen in the margin performance of the Company this year. We've commented in the past about the ability through our own stores to -- to get that leverage, tougher in some of the other segments, and currently we're not talking about any kind of price increases yet.

Okay. Thank you.

Our next question is coming from Eric Bosshard of Cleveland Research Company. Please proceed with your question.

Good morning.

Hi, Eric.

Two questions. First of all, on the April 20 conference call, I think you raised the sales guidance from a high single low double to low to mid teen, and now you've I think 90 days later kind of taken it back to where it was. Can you explain what changed between then and now that forced your -- or encouraged you to make such an adjustment in the sales guidance?

If you take a look at the first quarter, Consumer was up in the first quarter. And when we've continued to take a look 90 days later to see the results of the second quarter Consumer, and then forecasting the remainder of the year out, that's what the change.

Okay. So Consumer was up like 1% in the first quarter, and it's down 3% in the second?

Yes.

Down 3% in the second quarter?

Yes.

And is the expectation that Consumer is going to get, I guess, worse in the second half than the second quarter to suggest or to push you to make such a -- ?

No, I think what happened was, back to the results in the first quarter while we were going through the transition at the large retailer, we were still able to get a 1%, a little over 1% sales gain. In the second quarter, we still continued to forecast that we thought we were going to have a sales gain in the Consumer segment. We didn't hit that. And when you start to take a look at the different pieces and parts of the Consumer segment and we started doing the forecast for the third and fourth quarter, we brought it back down to where we thought we would be at the beginning of the year rather than where we thought we'd be at the end of the first quarter.

Within the other businesses, from growth in the Stores business, that's no different than what you had assumed 90 days ago?

That's correct, Eric.

Okay. And then secondly, within the delta between 1Q and 2Q in Stores, is price -- similar level price and mix contribution of similar level and just the difference is that gallonage growth is different in 2Q relative to 1Q?

Yes. I think when you take a look at, as we've commented in the past, you look at their sales and especially comp store increase at a little over 9.5%. Slightly more than half is volume and the rest is price.

I mean, does that mean that I think -- I think you made a similar comment about the first quarter.

Right, which means that the gallonage increase, the percentage increase in the first quarter was higher than the gallonage increase in the second quarter.

The same holds true for price?

Yes, because as we annualized, we had a price increase in late March of '05. So we went through that whole first quarter with -- and then we had another one in October. So we actually went through the whole first quarter with two price increases. In the second quarter, we were only annualizing one price increase.

Okay. Great. And then lastly, in terms of the gross margin, can you just state again the 42.8 gross margins, the expectation that gross margins will be up relative to that number this year?

Yes, when you look at the 42.8, we believe that it will be in the range of where we are year to date at the end of the second quarter, which is in that 43.8 range.

Okay. Okay. And then lastly on CapEx, the CapEx number I think is up perhaps a little bit from where it was previously. Can you just talk about or explain a little better? You indicated it was going to expand your capacity and also save you and create cost savings, and I guess what I want to understand is is it on a relative basis there's cost savings or is there absolute cost savings which I guess I don't quite understand in adding capacity that you -- ?

Well, if you take a look at the western emulsion plant, the CapEx is up because we're implementing or building that plant out west. When we complete that and we take a look at the incremental costs, the variable costs at that plant will be lower than the plant that the paint is being produced at today.

Okay. Is it your intent to close whatever it is, San Jose or Oakland, whatever it is, is it your intent to close that facility?

Yes.

So you're going to operate with both of them for a point in time and then you'll shut down that west coast facility? And you'll then, the net capacity addition will be less, it'll be there but it will be less than it otherwise would have been?

Yes. If you take a look at our total capacity when we closed the Oakland plant, total capacity will be lower. But at the same time, the western emulsion plant will be ramping up. So our total capacity a year from now will be higher than it is today.

Okay. Perfect. Thank you.

Our next question is coming from Armando Lopez of Morgan Stanley. Please proceed with your question.

Yes, hi, good morning, everyone.

Hi, Armando.

Just a -- most of my questions have been asked. Just a quick question. You guys commented, and I think you made this comment in a couple of the previous quarters as well, about tight expense control and cost control in terms of helping to keep SG&A as a percent of sales lower. Can you just maybe give a little more color in terms of what levers you have there and what actions you're doing to take costs out of the business?

I think when you take a look at first of all at admin, we're continually looking at the admin piece, the costs of accounting, costs of different things. We're looking at -- we've continued to benchmark ourselves versus others and taken a look at that. I think inside the Consumer division as well as Stores division, they've continued to look around for efficiencies in the admin and -- and in SG&A at the store level. And I think that over time, just give you an example, a couple of years ago we put that color mansion equipment in. I think that has helped us on our SG&A side, not only just on the color matching but also just on the SG&A side for some of the expenses and the matching's quicker so I think that's helped us in the SG&A expenses.

Okay. All right. And then another quick one. In terms of just the overall environment that you're seeing out there now, I mean, could you comment -- what are you seeing from like employment of paint contractors and the like? I mean, are -- could you just comment on that?

Yes, the environment looks good, Armando. Our customers all have a significant amount of work in front of them. Their buying habits are staying strong. And from that ability through our 3,000-plus stores to see these folks every day, we have confidence that we're going to have a good second half.

Okay. All right. Great. Thanks a lot, guys.

Our next question is coming from Dmitry Silversteyn of Longbow Research. Please proceed with your question.

Good morning. A couple of questions, as a lot of them have already been answered. Can you give us an idea of what pricing played as a percentage of sales for the Consumer segment as well as for the Store segment, if it was different in one versus the other?

In terms of the pricing impact and the revenue performance for the quarter, Dimitri?

That's correct.

Go ahead, Sean.

Our gallonage was actually negative for the quarter. And I would tell you --

In Consumer.

In Consumer.

But that included the cost? If you exclude that, what would the price contribution versus volume contribution be?

I don't think we had --

We don't have that broken out that way.

Okay. Then -- all right. So --

I'll tell you why. Because inside the Consumer division, we've got brushes and rollers from the Purdy acquisition, and we have Minwax quarts and so forth. In a total number, we really don't track that because it's not as meaningful.

Okay. But you haven't had any price increases since October of last year it sounds like. So you've anniversaried your March price increase from 2005 so the pricing contribution in the second quarter would have been lower than the first for both segment?

Yes, it would.

Okay. And then secondly, in your Store sales, can you give us an idea if it was a -- if there was a difference in performance of paints versus sundries and other things that are sold through the stores or were all segments fairly strong?

All segments were strong. They were consistent across the board. Our associated products and our coatings were pretty comparable.

Okay. Then just finally to make sure I understand what you were guiding for for raw materials, you're looking for raw materials to basically be flat in the second half of the year with the first half of the year, or actually down versus the first half of the year?

I don't know that I -- we've given that kind of guidance. We tend to give it for the year, for the industry, and we just reiterate that we believe year over year, it's going to be up 8%.

But it was up more than that, I thought, in the first half of the year.

We gave guidance that we thought it would be up to 8 to 10. We are coming into more favorable comparisons, that's clear. But I just don't have those exact numbers in front of me.

Okay, so when you talk about more favorable comparisons, that's on a year-over-year basis?

Correct.

Okay. Thank you very much.

Our next question is coming from Jeff Zekauskas of J.P. Morgan. Please proceed with your question.

Hi, a few questions. Can you remind me what the bonding policy is in Rhode Island? That is, if there's an abatement award or what percentage of the abatement award that applies to you would you have to post?

Well, first of all, it's -- it's standard procedure in Rhode Island is usually 10%. So if -- if the abatement is $500 million, the bonding would be $50 million. When you take a look at that -- but there's also a chance because usually you're talking about compensatory damages or punitive damages, when it comes to abatement, we're going to argue that because of -- that we really don't have to put a bond up. So -- but that would be the argument and it's usually 10%.

Well because you've -- you've taken all of the steps to really increase your liquidity, but if you only have to put up 10%, I'm just puzzled that -- why you've taken all these different steps. It doesn't seem like the cash outlay is all that much.

Well, Jeff, we don't know is the real answer and it's all speculative. You've written in what you foresee the number to be and others have had other analysis. We just are doing what we think is prudent to prepare the Company for any eventuality and we're waiting for this judge to come to some of those decisions.

Do you have any general sense of the timing that, that is do we expect a decision by the judge this year?

We really don't know, Jeff. He has not indicated what the timing of any of these proceedings are.

So it could be next year?

I -- We don't know. Again we'd be speculating.

You didn't buy back many shares in the quarter. Why is that?

Well we bought back 850,000. Last year we bought back 1 million in the second quarter so we're down 150,000 from last year. When you take a look at it, we're not on a -- we look at buying the stock back opportunistically. In the second quarter, we felt we were holding on to the cash because on a daily basis, on a daily basis, we were making sure that we have daily liquidity. But as I can tell you right now, we're continuing to look at buying back stock, and -- and we'll continue to buy opportunistically over the remainder of the year.

In terms of your overall gallonage, was it up a couple of percent in the quarter? I mean, if -- if Stores -- if the Stores business looked like it was up low single digits and I guess Consumer is down some, is that what it comes to, gallonage up about, I don't know, 2%?

Jeff, about the only -- the only clarity we provide on gallonage is that we break down sales for our segments by, we've said that more than half of the sales increase was volume in Global and Stores and that Consumer was down in volume.

Right. Because you know in the course of the call, you've talked about how you've had a very strong quarter. So like does that reflect mid single-digit gallonage growth or low single-digit gallonage growth? What does strong mean in this context?

Well, I think we've said that we're given you the segment sales reports on both Stores and Global. More than half of their sales performance came from volume growth and the Consumer segment is soft in both sales and gallons.

I guess lastly, do you think any other states will file suit on a public nuisance basis this year?

Again, that would be totally speculative. The fact that none have filed since the February 22 Rhode Island verdict we think is positive.

But you can speculate. You know, I'm not going to hold you to it, Chris.

This is not an area I speculate in, Jeff.

Okay. Thank you very much.

As a reminder, ladies and gentlemen, if you do have a question, it's star-one on your telephone keypad at this time. Our next question is coming from Ivy Zelman of Credit Suisse. Please proceed with your question.

Hi guys, just one quick follow-up. On the environmental reserve up until last year, it had always been a fourth-quarter issue and now two years in a row, we have it in the second quarter. Is it just an anomaly, or is that something that's turning into twice a year?

No, basically we actually are looking at this at all accruals on a quarterly basis. A few years ago, with the Sarbanes-Oxley and some of the other rule changes, each and every quarter has to stand on its own. Therefore all reserves have to be evaluated on a quarterly basis, not just the end of the year.

It was just coincidence that we have one in the second quarter as last year's?

Yes, exactly.

Were you expecting this within the guidance?

We were expecting --

Some of it --

Some of it. Most of it actually.

Okay.

Hey guys? It's Ivy. I just jumped on. Just wanted to ask you a question on your current trends. I know that you indicated you haven't seen any deceleration outside the Consumer business. I believe you said that, Chris. Were you referring to the sort of current environment in July? And then secondly, a lot of people are questioning your level of confidence with the housing market generally slowing, existing home sales slowing. Is there things in the pipeline that you guys have a level of confidence about, whether it's new products or commitments that you've gotten from major customers that you have a lot of more visibility than maybe the market is giving you credit for?

I would comment that the deceleration outside of the Consumer segment, I think we were asked about, was our expectations for the quarter in line with the results. And that answer is correct, it is. I recall also the first quarter we said that this was really a -- an incredible quarter for the Company. We didn't intend to maintain that kind of sales pace. So while the Stores' sales pace has softened from the first quarter, we're still very bullish on the segment, on the opportunities. We had a 9.6% comp store sales gain. And our insight, Ivy, looking forward is again from the ability to be face to face with these customers on a daily basis and understand that the work that they have lined up. We've put the new home construction market in context for our Company and our industry repeatedly and we think that the maintenance and redecoration drivers are strong, and they look terrific to us going out.

So if you look out in terms of your back half of '06, I guess the question relates to how much of the demand would be coming outside of residential construction. Is there industrial, multi-family, commercial, that you've got significant projects coming that make you feel even more confident? Again, the market perceives the risks here?

Yes, and again, I take you back to the numbers, that 80% to 90% of all these coatings are applied outside of the new residential construction environment. nd in that 80% to 90%, we have terrific share and compelling products, and a great distribution platform, and we see good growth coming there.

Great. Thanks, Chris.

Gentlemen, we show no further questions in the queue at this time. I'd like to turn the floor back over for any further remarks.

Great, Dan. Thank you, everyone, for joining us this morning. Again as a reminder, I will be around all afternoon to answer your -- any other questions you might have and again, we appreciate your interest in the Company.

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.