Management's Discussion and Analysis
of Results of Operations and Financial Condition
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our Consolidated Financial Statements include the accounts
of RPM International Inc. and its majority-owned subsidiaries,
except for certain subsidiaries that were deconsolidated on
May 31, 2010 (please refer to Note A(2) to the Consolidated
Financial Statements for further information). Preparation of
our financial statements requires the use of estimates and
assumptions that affect the reported amounts of our assets and
liabilities at the date of the financial statements and the reported
amounts of revenues and expenses during the reporting period.
We continually evaluate these estimates, including those related
to our allowances for doubtful accounts; inventories; allowances
for recoverable taxes; useful lives of property, plant and
equipment; goodwill and other intangible assets; environmental,
warranties and other contingent liabilities; income tax valuation
allowances; pension plans; and the fair value of financial
instruments. We base our estimates on historical experience,
our most recent facts, and other assumptions that we believe to
be reasonable under the circumstances. These estimates form
the basis for making judgments about the carrying values of our
assets and liabilities. Actual results, which are shaped by actual
market conditions, may differ materially from our estimates.
We have identified below the accounting policies and estimates
that are the most critical to our financial statements.
Revenue Recognition
Revenues are recognized when realized or realizable, and
when earned. In general, this is when title and risk of loss
pass to the customer. Further, revenues are realizable when
we have persuasive evidence of a sales arrangement, the
product has been shipped or the services have been provided
to the customer, the sales price is fixed or determinable and
collectibility is reasonably assured. We reduce our revenues for
estimated customer returns and allowances, certain rebates,
sales incentives and promotions in the same period the related
sales are recorded.
We also record revenues generated under long-term
construction contracts, mainly in connection with the installation
of specialized roofing and flooring systems, and related
services. In general, we account for long-term construction
contracts under the percentage-of-completion method, and
therefore record contract revenues and related costs as our
contracts progress. This method recognizes the economic
results of contract performance on a timelier basis than does
the completed-contract method; however, application of this
method requires reasonably dependable estimates of progress
toward completion, as well as other dependable estimates.
When reasonably dependable estimates cannot be made, or if
other factors make estimates doubtful, the completed-contract
method is applied. Under the completed-contract method,
billings and costs are accumulated on the balance sheet as
the contract progresses, but no revenue is recognized until the
contract is complete or substantially complete.
Translation of Foreign Currency Financial Statements and Foreign Currency Transactions
Our reporting currency is the U.S. dollar. However, the functional
currency for each of our foreign subsidiaries is its local currency.
We translate the amounts included in our Consolidated
Statements of Income from our foreign subsidiaries into
U.S. dollars at weighted-average exchange rates, which we
believe are representative of the actual exchange rates on
the dates of the transactions. Our foreign subsidiaries’ assets
and liabilities are translated into U.S. dollars from local
currency at the actual exchange rates as of the end of each
reporting date, and we record the resulting foreign exchange
translation adjustments in our Consolidated Balance Sheets as a
component of accumulated other comprehensive income (loss).
If the U.S. dollar strengthens, we reflect the resulting losses
as a component of accumulated other comprehensive income
(loss). Conversely, if the U.S. dollar weakens, foreign exchange
translation gains result, which favorably impact accumulated
other comprehensive income. Translation adjustments will be
included in net earnings in the event of a sale or liquidation of
any of our underlying foreign investments, or in the event that
we distribute the accumulated earnings of consolidated foreign
subsidiaries. If we determine that the functional currency of
any of our foreign subsidiaries should be the U.S. dollar, our
financial statements will be affected. Should this occur, we
will adjust our reporting to appropriately account for any
such changes.
As appropriate, we use permanently invested intercompany
loans as a source of capital to reduce exposure to foreign
currency fluctuations at our foreign subsidiaries. These loans,
on a consolidated basis, are treated as being analogous to
equity for accounting purposes. Therefore, foreign exchange
gains or losses on these intercompany loans are recorded
in accumulated other comprehensive income (loss). If we
determine that the functional currency of any of our subsidiaries
should be the U.S. dollar, we will no longer record foreign
exchange gains or losses on such intercompany loans.
Goodwill
We test our goodwill balances at least annually, or more
frequently as impairment indicators arise, using a fair-value
approach at the reporting unit level. Our reporting units have
been identified at the component level, which is the operating
segment level or one level below our operating segments.
We perform a two-step impairment test. In the first step, we
compare the fair value of each of our reporting units to its
carrying value. We have elected to perform our annual required
impairment tests, which involve the use of estimates related to
the fair market values of the reporting units with which goodwill
is associated, during our fourth fiscal quarter. Calculating the fair
market values of reporting units requires our use of estimates
and assumptions.
We use significant judgment in determining the most
appropriate method to establish the fair values of each of our
reporting units. We estimate the fair values of each of our
reporting units by employing various valuation techniques,
depending on the availability and reliability of comparable
market value indicators, and employ methods and
assumptions that include the application of third-party
market value indicators and the computation of discounted
future cash flows for each of our reporting unit’s annual
projected earnings before interest, taxes, depreciation and
amortization (“EBITDA”). For each of our reporting units, we
calculate a break-even multiple based on its carrying value
as of the testing date. We then compare each reporting unit’s
break-even EBITDA market multiple to guideline EBITDA
market multiples applicable to our industry and peer group, the
data for which we develop internally and through third-party
sources. The result of this analysis provides us with insight
and sensitivity as to which reporting units, if any, may have a
higher risk for a potential impairment.
We then supplement this analysis with an evaluation of
discounted future cash flows for each reporting unit’s projected
EBITDA. Under this approach, we calculate the fair value of each
reporting unit based on the present value of estimated future
cash flows. If the fair value of the reporting unit exceeds the
carrying value of the net assets of the reporting unit, goodwill
is not impaired. An indication that goodwill may be impaired
results when the carrying value of the net assets of a reporting
unit exceeds the fair value of the reporting unit. At that point,
the second step of the impairment test is performed, which
requires a fair value estimate of each tangible and intangible
asset in order to determine the implied fair value of the
reporting unit’s goodwill. If the carrying value of a reporting
unit’s goodwill exceeds its implied fair value, then we record an
impairment loss equal to the difference.
In applying the discounted cash flow methodology, we rely
on a number of factors, including future business plans,
actual and forecasted operating results, and market data. The
significant assumptions employed under this method include
discount rates; revenue growth rates, including assumed
terminal growth rates; and operating margins used to project
future cash flows for each reporting unit. The discount rates
utilized reflect market-based estimates of capital costs and
discount rates adjusted for management’s assessment of a
market participant’s view with respect to other risks associated
with the projected cash flows of the individual reporting
units. Our estimates are based upon assumptions we believe
to be reasonable, but which by nature are uncertain and
unpredictable. We believe we incorporate ample sensitivity
ranges into our analysis of goodwill impairment testing for each
reporting unit, such that actual experience would need to be
materially out of the range of expected assumptions in order
for an impairment to remain undetected.
Our annual goodwill impairment analysis for fiscal 2011 did
not result in any impairment loss. The excess of fair value
over carrying value for reporting units as of March 1, 2011,
ranged from approximately $0.7 million to $910.2 million. In
order to evaluate the sensitivity of the fair value calculations
of our goodwill impairment test, we applied a hypothetical
5% decrease to the fair values of each reporting unit. This
hypothetical 5% decrease would result in excess fair value
over carrying value ranging from approximately $0.6 million to
$854.7 million for our reporting units. Further, we compare the
sum of the fair values of our reporting units resulting from our
discounted cash flow calculations to our market capitalization
as of our valuation date. We use this comparison to further
assess the reasonableness of the assumptions employed in
our valuation calculations. As of the valuation date, the sum
of the fair values we calculated for our reporting units was
approximately 2.9% above our market capitalization.
Should the future earnings and cash flows at our reporting
units decline and/or discount rates increase, future
impairment charges to goodwill and other intangible assets
may be required.
Other Long-Lived Assets
We assess identifiable, non-goodwill intangibles and other
long-lived assets for impairment whenever events or changes in
facts and circumstances indicate the possibility that the carrying
values of these assets may not be recoverable over their
estimated remaining useful lives. Factors considered important
in our assessment, which might trigger an impairment
evaluation, include the following:
- significant under-performance relative to historical or
projected future operating results;
- significant changes in the manner of our use of the
acquired assets;
- significant changes in the strategy for our overall business; and
- significant negative industry or economic trends.
Additionally, we test all indefinite-lived intangible assets for
impairment at least annually during our fiscal fourth quarter.
Measuring a potential impairment of non-goodwill intangibles
and other long-lived assets requires the use of various estimates
and assumptions, including the determination of which cash
flows are directly related to the assets being evaluated, the
respective useful lives over which those cash flows will occur
and potential residual values, if any. If we determine that the
carrying values of these assets may not be recoverable based
upon the existence of one or more of the above-described
indicators or other factors, any impairment amounts would be
measured based on the projected net cash flows expected from
these assets, including any net cash flows related to eventual
disposition activities. The determination of any impairment
losses would be based on the best information available,
including internal estimates of discounted cash flows; quoted
market prices, when available; and independent appraisals, as
appropriate, to determine fair values. Cash flow estimates would
be based on our historical experience and our internal business
plans, with appropriate discount rates applied. Our fiscal
2011 annual impairment tests of each of our indefinite-lived
intangible assets did not result in any impairment loss.
Income Taxes
Our provision for income taxes is calculated using the liability
method, which requires the recognition of deferred income
taxes. Deferred income taxes reflect the net tax effect of
temporary differences between the carrying amounts of assets
and liabilities for financial reporting purposes and the amounts
used for income tax purposes and certain changes in valuation
allowances. We provide valuation allowances against deferred
tax assets if, based on available evidence, it is more likely than
not that some portion or all of the deferred tax assets will not
be realized.
In determining the adequacy of valuation allowances, we
consider cumulative and anticipated amounts of domestic
and international earnings or losses, anticipated amounts
of foreign source income, as well as the anticipated taxable
income resulting from the reversal of future taxable temporary
differences. We intend to maintain any recorded valuation
allowances until sufficient positive evidence (for example,
cumulative positive foreign earnings or additional foreign
source income) exists to support a reversal of the tax
valuation allowances.
Further, at each interim reporting period, we estimate an
effective income tax rate that is expected to be applicable for
the full year. Significant judgment is involved regarding the
application of global income tax laws and regulations and
when projecting the jurisdictional mix of income. Additionally,
interpretation of tax laws, court decisions or other guidance
provided by taxing authorities influences our estimate of the
effective income tax rates. As a result, our actual effective
income tax rates and related income tax liabilities may differ
materially from our estimated effective tax rates and related
income tax liabilities. Any resulting differences are recorded in
the period they become known.
Contingencies
We are party to claims and lawsuits arising in the normal course
of business. Although we cannot precisely predict the amount
of any liability that may ultimately arise with respect to any
of these matters, we record provisions when we consider the
liability probable and reasonably estimable. Our provisions
are based on historical experience and legal advice, reviewed
quarterly and adjusted according to developments. Estimating
probable losses requires the analysis of multiple forecasted
factors that often depend on judgments about potential actions
by third parties, such as regulators, courts, and state and federal
legislatures. Changes in the amounts of our loss provisions,
which can be material, affect our Consolidated Statements
of Income. Due to the inherent uncertainties in the process
undertaken to estimate potential losses, we are unable to
estimate an additional range of loss in excess of our accruals.
While it is reasonably possible that such excess liabilities, if
they were to occur, could be material to operating results in any
given quarter or year of their recognition, we do not believe that
it is reasonably possible that such excess liabilities would have
a material adverse effect on our long-term results of operations,
liquidity or consolidated financial position.
Our environmental-related accruals are similarly established
and/or adjusted as more information becomes available upon
which costs can be reasonably estimated. Actual costs may
vary from these estimates because of the inherent uncertainties
involved, including the identification of new sites and the
development of new information about contamination.
Certain sites are still being investigated; therefore, we have
been unable to fully evaluate the ultimate costs for those sites.
As a result, accruals have not been estimated for certain of
these sites and costs may ultimately exceed existing estimated
accruals for other sites. We have received indemnities for
potential environmental issues from purchasers of certain
of our properties and businesses and from sellers of some
of the properties or businesses we have acquired. We also
have purchased insurance to cover potential environmental
liabilities at certain sites. If the indemnifying or insuring party
fails to, or becomes unable to, fulfill its obligations under those
agreements or policies, we may incur environmental costs in
addition to any amounts accrued, which may have a material
adverse effect on our financial condition, results of operations
or cash flows.
Several of our industrial businesses offer extended warranty
terms and related programs, and thus have established a
corresponding warranty liability. Warranty expense is impacted
by variations in local construction practices and installation
conditions, including geographic and climate differences.
Additionally, our operations are subject to various federal, state,
local and foreign tax laws and regulations that govern, among
other things, taxes on worldwide income. The calculation of our
income tax expense is based on the best information available
and involves our significant judgment. The actual income
tax liability for each jurisdiction in any year can ultimately be
determined, in some instances, several years after the financial
statements have been published.
We maintain accruals for estimated income tax exposures for
many different jurisdictions. Tax exposures are settled primarily
through the resolution of audits within each tax jurisdiction or
the closing of a statute of limitation. Tax exposures can also
be affected by changes in applicable tax laws or other factors,
which may cause us to believe a revision of past estimates is
appropriate. We believe that appropriate liabilities have been
recorded for income tax exposures; however, actual results may
differ materially from our estimates.
Allowance for Doubtful Accounts Receivable
An allowance for anticipated uncollectible trade receivable
amounts is established using a combination of specifically
identified accounts to be reserved and a reserve covering trends
in collectibility. These estimates are based on an analysis of
trends in collectibility, past experience and individual account
balances identified as doubtful based on specific facts and
conditions. Receivable losses are charged against the allowance
when we confirm uncollectibility. Actual collections of trade
receivables could differ from our estimates due to changes in
future economic or industry conditions or specific customer’s
financial conditions.
Inventories
Inventories are stated at the lower of cost or market, cost
being determined on a first-in, first-out (FIFO) basis and market
being determined on the basis of replacement cost or net
realizable value. Inventory costs include raw materials, labor
and manufacturing overhead. We review the net realizable
value of our inventory in detail on an on-going basis, with
consideration given to various factors, which include our
estimated reserves for excess, obsolete, slow moving or
distressed inventories. If actual market conditions differ from
our projections, and our estimates prove to be inaccurate,
write-downs of inventory values and adjustments to cost of
sales may be required. Historically, our inventory reserves
have approximated actual experience.
Marketable Securities
Marketable securities, included in other current and longterm
assets, are composed of available-for-sale securities and
are reported at fair value. Realized gains and losses on sales
of investments are recognized in net income on the specific
identification basis. Changes in fair values of securities that
are considered temporary are recorded as unrealized gains
and losses, net of applicable taxes, in accumulated other
comprehensive income (loss) within stockholders’ equity.
Other-than-temporary declines in market value from original
cost are reflected in operating income in the period in which the
unrealized losses are deemed other than temporary. In order to
determine whether an other-than-temporary decline in market
value has occurred, the duration of the decline in value and
our ability to hold the investment to recovery are considered in
conjunction with an evaluation of the strength of the underlying
collateral and the extent to which the investment’s amortized
cost or cost, as appropriate, exceeds its related market value.
Pension and Postretirement Plans
We sponsor qualified defined benefit pension plans and various
other nonqualified postretirement plans. The qualified defined
benefit pension plans are funded with trust assets invested in
a diversified portfolio of debt and equity securities and other
investments. Among other factors, changes in interest rates,
investment returns and the market value of plan assets can
(i) affect the level of plan funding, (ii) cause volatility in the net
periodic pension cost, and (iii) increase our future contribution
requirements. A significant decrease in investment returns
or the market value of plan assets or a significant decrease in
interest rates could increase our net periodic pension costs and
adversely affect our results of operations. A significant increase
in our contribution requirements with respect to our qualified
defined benefit pension plans could have an adverse impact on
our cash flow.
Changes in our key plan assumptions would impact net periodic
benefit expense and the projected benefit obligation for our
defined benefit and various postretirement benefit plans. Based
upon May 31, 2011 information, the following tables reflect the
impact of a 1% change in the key assumptions applied to our
defined benefit pension plans in the U.S. and internationally:
