UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004. COMMISSION FILE NUMBER 1-5794 MASCO CORPORATION - -------------------------------------------------------------------------------- (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 38-1794485 - -------------------------------------------------------------------------------- (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.) 21001 VAN BORN ROAD, TAYLOR, MICHIGAN 48180 - -------------------------------------------------------------------------------- (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) (313) 274-7400 - -------------------------------------------------------------------------------- (TELEPHONE NUMBER) INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS REQUIRED TO BE FILED BY SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING THE PRECEDING 12 MONTHS AND (2) HAS BEEN SUBJECT TO SUCH FILING REQUIREMENTS FOR THE PAST 90 DAYS. YES [X] NO [ ] INDICATE BY CHECK MARK WHETHER THE REGISTRANT IS AN ACCELERATED FILER (AS DEFINED IN RULE 12b-2 OF THE EXCHANGE ACT). YES [X] NO [ ] INDICATE THE NUMBER OF SHARES OUTSTANDING OF EACH OF THE ISSUER'S CLASSES OF COMMON STOCK, AS OF THE LATEST PRACTICAL DATE. SHARES OUTSTANDING AT CLASS OCTOBER 31, 2004 ----- ------------------ COMMON STOCK, PAR VALUE $1 PER SHARE 448,000,000 MASCO CORPORATION INDEX PAGE NO. -------- Part I. Financial Information Item 1. Financial Statements: Condensed Consolidated Balance Sheets - September 30, 2004 and December 31, 2003 1 Condensed Consolidated Statements of Income for the Three Months and Nine Months Ended September 30, 2004 and 2003 2 Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2004 and 2003 3 Notes to Condensed Consolidated Financial Statements 4-17 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 18-25 Item 4. Controls and Procedures 26 Part II. Other Information Item 1. Legal Proceedings 27 Item 2. Unregistered Sale of Equity Securities and Use of Proceeds 27 Item 6. Exhibits 28 MASCO CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) SEPTEMBER 30, 2004 AND DECEMBER 31, 2003 (DOLLARS IN MILLIONS EXCEPT SHARE DATA) SEPTEMBER 30, DECEMBER 31, 2004 2003 ------------- ------------ ASSETS ------ Current assets: Cash and cash investments $ 969 $ 795 Accounts and notes receivable, net 1,908 1,674 Prepaid expenses and other 276 316 Inventories: Raw material 386 405 Work in process 153 142 Finished goods 587 472 ------- ------- 1,126 1,019 ------- ------- Total current assets 4,279 3,804 Property and equipment, net 2,165 2,339 Goodwill 4,445 4,491 Other intangible assets, net 330 344 Assets held for sale 175 -- Other assets 995 1,171 ------- ------- Total assets $12,389 $12,149 ======= ======= LIABILITIES ----------- Current liabilities: Notes payable $ 44 $ 334 Accounts payable 852 715 Accrued liabilities 1,130 1,050 ------- ------- Total current liabilities 2,026 2,099 Long-term debt 4,210 3,848 Liabilities held for sale 60 -- Deferred income taxes and other 851 746 ------- ------- Total liabilities 7,147 6,693 ------- ------- Commitments and contingencies SHAREHOLDERS' EQUITY -------------------- Preferred shares, par value $1 per share Authorized shares: 1,000,000; issued: 2004 - ---; 2003 - 20,000 -- -- Common shares, par value $1 per share Authorized shares: 1,400,000,000; issued: 2004 - 449,220,000; 2003 - 458,380,000 449 458 Paid-in capital 724 1,443 Retained earnings 3,856 3,299 Accumulated other comprehensive income (loss) 409 421 Less: Restricted stock awards (196) (165) ------- ------- Total shareholders' equity 5,242 5,456 ------- ------- Total liabilities and shareholders' equity $12,389 $12,149 ======= ======= See notes to condensed consolidated financial statements. 1 MASCO CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) FOR THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003 (DOLLARS IN MILLIONS EXCEPT PER SHARE DATA) THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ------------------ 2004 2003 2004 2003 ------ ------ ------ ------ Net sales $3,173 $2,823 $9,040 $7,803 Cost of sales 2,182 1,949 6,224 5,414 ------ ------ ------ ------ Gross profit 991 874 2,816 2,389 Selling, general and administrative expenses 502 459 1,491 1,312 (Income) regarding litigation settlement (2) (58) (30) (71) ------ ------ ------ ------ Operating profit 491 473 1,355 1,148 ------ ------ ------ ------ Other income (expense), net: Interest expense (55) (67) (160) (201) Other, net 24 7 117 54 ------ ------ ------ ------ (31) (60) (43) (147) ------ ------ ------ ------ Income from continuing operations before income taxes and minority interest 460 413 1,312 1,001 Income taxes 167 153 474 357 ------ ------ ------ ------ Income from continuing operations before minority interest 293 260 838 644 Minority interest 4 2 14 8 ------ ------ ------ ------ Income from continuing operations 289 258 824 636 Income (loss) from discontinued operations, after income taxes 70 61 (36) 78 ------ ------ ------ ------ Net income $ 359 $ 319 $ 788 $ 714 ====== ====== ====== ====== Earnings per common share: Basic: Income from continuing operations $ .66 $ .54 $ 1.84 $ 1.32 Income (loss) from discontinued operations, after income taxes .16 .13 (.08) .16 ------ ------ ------ ------ Net income $ .82 $ .67 $ 1.76 $ 1.48 ====== ====== ====== ====== Diluted: Income from continuing operations $ .64 $ .53 $ 1.81 $ 1.28 Income (loss) from discontinued operations, after income taxes .16 .13 (.08) .16 ------ ------ ------ ------ Net income $ .80 $ .65 $ 1.73 $ 1.44 ====== ====== ====== ====== Cash dividends per common share: Declared $ .18 $ .16 $ .50 $ .44 ====== ====== ====== ====== Paid $ .16 $ .14 $ .48 $ .42 ====== ====== ====== ====== See notes to condensed consolidated financial statements. 2 MASCO CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003 (DOLLARS IN MILLIONS) NINE MONTHS ENDED SEPTEMBER 30, ------------------ 2004 2003 ------- ------- CASH FLOWS FROM (FOR) OPERATING ACTIVITIES: Cash provided by operations $1,135 $ 817 (Increase) in receivables (333) (310) (Increase) decrease in inventories (163) -- Increase in accounts payable and accrued liabilities, net 334 417 ------ ------- Total cash from operating activities 973 924 ------ ------- CASH FLOWS FROM (FOR) FINANCING ACTIVITIES: Issuance of notes, net of issuance costs 299 -- (Decrease) increase in debt (40) 11 Payment of debt (3) (84) Retirement of notes (266) (300) Proceeds from settlement of swaps 55 -- Issuance of Company common stock 35 19 Purchase of Company common stock for: Retirement (777) (555) Long-term stock incentive award plan (40) (48) Cash dividends paid (227) (209) ------ ------- Total cash (for) financing activities (964) (1,166) ------ ------- CASH FLOWS FROM (FOR) INVESTING ACTIVITIES: Capital expenditures (188) (198) Purchases of marketable securities (304) (245) Proceeds (purchases) of other investments, net 34 (12) Proceeds from disposition of: Marketable securities 477 377 Businesses, net of cash disposed 178 282 Equity investment -- 76 Acquisition of companies, net of cash acquired (14) (208) Other, net 21 (17) ------ ------- Total cash from investing activities 204 55 ------ ------- Effect of foreign exchange rates on cash and cash investments (1) 28 ------ ------- CASH AND CASH INVESTMENTS: Increase (decrease) for the period 212 (159) Cash at businesses held for sale (38) -- At January 1 795 1,067 ------ ------- At September 30 $ 969 $ 908 ====== ======= See notes to condensed consolidated financial statements. 3 MASCO CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) A. In the opinion of the Company, the accompanying unaudited condensed consolidated financial statements contain all adjustments, of a normal recurring nature, necessary to present fairly its financial position at September 30, 2004 and the results of operations for the three months and nine months ended September 30, 2004 and 2003 and changes in cash flows for the nine months ended September 30, 2004 and 2003. The condensed consolidated balance sheet at December 31, 2003 was derived from audited financial statements. Certain prior-year amounts have been reclassified to conform to the 2004 presentation in the condensed consolidated financial statements. The results of operations related to discontinued operations have been reclassified and separately stated in the accompanying condensed consolidated statements of income for 2004 and 2003. In the Company's condensed consolidated balance sheet at September 30, 2004, the assets and liabilities of the businesses held for sale have been reclassified and separately stated. The assets and liabilities of the businesses held for sale have not been reclassified in the related accompanying condensed consolidated balance sheet as at December 31, 2003. In the Company's condensed consolidated statements of cash flows for the nine months ended September 30, 2004 and 2003, the cash flows of discontinued operations are not separately classified. 4 MASCO CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED) Note A - concluded: STOCK OPTIONS AND AWARDS. The Company implemented the fair value method of accounting for stock-based compensation prescribed by Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation," effective January 1, 2003. The Company is using the prospective method, as defined by SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment to SFAS No. 123," for determining stock-based compensation expense. Accordingly, options granted, modified or settled subsequent to January 1, 2003 are accounted for using the fair value method, and options granted prior to January 1, 2003 continue to be accounted for using the intrinsic value method. In the first nine months of 2004, 4,941,000 option shares, including restoration option shares, were awarded. The following table illustrates the pro forma effect on net income and earnings per common share as if the fair value method were applied to all previously issued and outstanding stock options, in millions except per common share data: THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ----------------- 2004 2003 2004 2003 ------ ------ ------- ----- Net income, as reported $359 $319 $ 788 $ 714 Add: Stock-based employee compensation expense included in reported net income, net of tax 13 7 33 29 Deduct: Stock-based employee compensation expense, net of tax (13) (7) (33) (29) Stock-based employee compensation expense determined under the fair value method for stock options granted prior to 2003, net of tax (3) (3) (9) (10) ---- ---- ----- ----- Pro forma net income $356 $316 $ 779 $ 704 ==== ==== ===== ===== Earnings per common share: Basic as reported $.82 $.67 $1.76 $1.48 Basic pro forma $.81 $.67 $1.74 $1.46 Diluted as reported $.80 $.65 $1.73 $1.44 Diluted pro forma $.79 $.65 $1.71 $1.42 5 MASCO CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED) B. In the first quarter of 2004, the Company determined that several European businesses were not core to the Company's long-term growth strategy and, accordingly, embarked on a plan to sell such businesses. The dispositions are expected to be completed by March 31, 2005. In the first quarter of 2004, the Company recognized a pre-tax charge of $64 million for those businesses that are expected to be divested at a loss. In the second and third quarters of 2004, the Company recognized additional charges of $44 million and $31 million, respectively, principally related to the remaining businesses held for sale. The Company has reduced its estimate of expected proceeds for these operations as a result of lower-than-expected operating results as well as a weaker-than-expected demand for the businesses that the Company is divesting. The Company expects aggregate net proceeds to approximate $250 million. During the third quarter of 2004, in two separate transactions, the Company completed the sale of its Jung Pumpen and The Alvic Group businesses. Jung Pumpen manufactures a wide variety of submersible and drainage pumps and The Alvic Group manufactures kitchen cabinets; both of these businesses were included in discontinued operations. Total proceeds from the sale of these companies were $191 million, including cash of $185 million and notes receivable of $6 million. In the third quarter of 2004, the Company recognized a pre-tax, net gain on the disposition of these businesses of $108 million ($93 million or $.21 per common share, after tax). In the third quarter of 2003, the Company completed the sale of its Baldwin Hardware, Weiser Lock and Marvel Group divisions. In accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," the Company has accounted for the 2004 planned dispositions as well as operations which were sold in 2004 and 2003 as discontinued operations. Selected financial information for discontinued operations (through the date of disposition) is as follows for the three months and nine months ended September 30, 2004 and 2003, in millions: THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ------------------ 2004 2003 2004 2003 ----- ----- ----- ----- Net sales $ 99 $ 163 $ 302 $ 469 ===== ===== ===== ===== Income before income taxes $ 10 $ 12 $ 28 $ 39 Gain on disposal of discontinued operations, net 108 91 108 91 Impairment charge for assets held for sale (31) -- (139) -- Income taxes (17) (42) (33) (52) ----- ----- ----- ----- Income (loss) from discontinued operations, after income taxes $ 70 $ 61 $ (36) $ 78 ===== ===== ===== ===== 6 MASCO CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED) Note B - concluded: The charges for the impairment of assets held for sale for the three months and nine months ended September 30, 2004 are $31 million pre-tax ($31 million or $.07 per common share, after tax) and $139 million pre-tax ($151 million or $.33 per common share, after tax), respectively. The after-tax charge of $151 million for the nine months ended September 30, 2004 includes $12 million of expensed deferred tax assets. The unusual relationship between income tax expense and income before income taxes (including the loss on disposition of businesses) in 2004 results primarily from the expected loss providing no current tax benefit in the countries where the loss is anticipated to be incurred and from the expensing of deferred tax assets of the discontinued operations which are no longer expected to be realized. In the first nine months of 2004, the Company also recorded approximately $6 million of severance and termination benefit expenses related to the discontinued operations, included in income before income taxes in the above table. The Company expects such costs to approximate $7 million in aggregate, the balance of which are expected to be recognized over the next six months. The impairment charge for assets held for sale primarily includes the write-down of goodwill of $61 million and fixed assets of $54 million for the nine months ended September 30, 2004. Total assets and liabilities held for sale consist primarily of the following at September 30, 2004 (after the impairment charges recorded in the first nine months of 2004), in millions: Cash $ 38 Accounts receivable 50 Inventories 27 Property and equipment, net 56 Goodwill 4 ---- Total assets $175 ==== Accounts payable $ 22 Accrued salaries, wages and related benefits 27 Other accrued expenses 11 ---- Total liabilities $ 60 ==== The discontinued operations were previously included in each of the Company's segments, except the Installation and Other Services segment. 7 MASCO CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED) C. The changes in the carrying amount of goodwill for the nine-month period ended September 30, 2004, by segment, are as follows, in millions: BALANCE HELD FOR BALANCE DEC. 31, 2003 ADDITIONS(A) SALE (B) OTHER(C) SEP. 30, 2004 ------------- ------------ -------- -------- ------------- Cabinets and Related Products $ 708 $ -- $ (63) $ (3) $ 642 Plumbing Products 498 -- -- 3 501 Installation and Other Services 1,701 8 -- (1) 1,708 Decorative Architectural Products 398 -- -- 2 400 Other Specialty Products 1,186 7 (4) 5 1,194 ------ ----- ----- ---- ------ Total $4,491 $ 15 $ (67) $ 6 $4,445 ====== ===== ===== ==== ====== (A) Additions include several relatively small acquisitions and contingent consideration for prior acquisitions in the Installation and Other Services segment and contingent consideration for a prior acquisition in the Other Specialty Products segment. (B) During the first nine months of 2004, the Company reclassified the goodwill related to businesses held for sale. The Company also recognized charges for those businesses expected to be divested at a loss; the charge included a write-down of goodwill of $63 million (including $36 million related to a business sold in the third quarter of 2004). (C) Other principally includes foreign currency translation adjustments, reclassifications and other purchase price adjustments related to the finalization of certain purchase price allocations. Other indefinite-lived intangible assets include registered trademarks of $255 million at September 30, 2004. The carrying value of the Company's definite-lived intangible assets is $75 million at September 30, 2004 (net of accumulated amortization of $60 million) and principally includes customer relationships and non-compete agreements. Amortization expense for definite-lived intangible assets is $5 million and $15 million for the three months and nine months ended September 30, 2004, respectively. D. Depreciation and amortization expense is $176 million and $165 million for the nine months ended September 30, 2004 and 2003, respectively. E. The Company maintains investments in marketable securities (including marketable equity securities and bond funds) and a number of private equity funds, principally as part of its tax planning strategies, as any gains enhance the utilization of tax capital loss carryforwards. Included in other assets are the following financial investments, in millions: SEPTEMBER 30, DECEMBER 31, 2004 2003 ------------- ------------ Marketable equity securities $306 $392 Bond funds 40 125 Private equity funds 321 332 Metaldyne Corporation 82 76 TriMas Corporation 25 25 Other investments 9 9 ---- ---- Total $783 $959 ==== ==== 8 MASCO CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED) Note E - continued: The Company's investments in marketable equity securities and bond funds at September 30, 2004 and December 31, 2003 are as follows, in millions: PRE-TAX ---------------------- UNREALIZED UNREALIZED RECORDED COST BASIS GAINS LOSSES BASIS ---------- ---------- ---------- -------- SEPTEMBER 30, 2004 Marketable equity securities $294 $ 34 $(22) $306 Bond funds $ 35 $ 5 $ -- $ 40 DECEMBER 31, 2003 Marketable equity securities $361 $ 35 $ (4) $392 Bond funds $115 $ 10 $ -- $125 The following table summarizes the gross unrealized losses and fair value of the Company's investments in temporarily-impaired marketable equity securities, aggregated by investment category and length of time that such securities have been in a continuous unrealized loss position at September 30, 2004, in millions: LESS THAN 12 MONTHS 12 MONTHS OR GREATER TOTAL ----------------- ----------------- ----------------- FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED VALUE (LOSS) VALUE (LOSS) VALUE (LOSS) ----- ---------- ----- ---------- ----- ---------- Marketable equity securities $122 $(22) $ -- $ -- $122 $(22) ---- ---- ---- ---- ---- ---- Total temporarily- impaired securities $122 $(22) $ -- $ -- $122 $(22) ==== ==== ==== ==== ==== ==== The Company has investments in over 70 different marketable equity securities and bond funds at September 30, 2004. The Company reviews industry analyst reports, key ratios and statistics, market analyses and other factors for each investment to determine if an unrealized loss is other than temporary. The unrealized loss at September 30, 2004 is primarily related to one marketable equity security, Furniture Brands International (NYSE: FBN) common stock (four million shares), which was received in June 2002 from the Company's investment in Furnishings International Inc. debt. Based on its review, the Company considers the unrealized loss related to this investment to be temporary. The market price of FBN during 2004 has been above and below the Company's cost basis of $30.25 per share. If the price remains significantly below the Company's cost basis, the Company may record an other-than-temporary asset impairment charge in the fourth quarter of 2004. The remaining $1 million or six percent of the Company's total unrealized loss in marketable equity securities at September 30, 2004 relates to 11 marketable equity investments related to various industries. Based on its review, the Company believes that the cost basis of these investments is recoverable and that it has both the ability and intent to hold these investments until such time as the cost basis is recoverable. 9 MASCO CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED) Note E - concluded: Income from financial investments is included in other, net, within other income (expense), net, and is summarized as follows, in millions: THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ----------------- 2004 2003 2004 2003 ------- ------- ------- ------ Realized gains from marketable securities $ 7 $ 10 $ 42 $ 37 Realized losses from marketable securities (9) (3) (19) (13) Dividend income from marketable securities 3 3 12 12 Dividend income from other investments 5 3 10 7 Income from other investments, net 11 6 29 9 ---- ---- ---- ---- Income from financial investments, net $ 17 $ 19 $ 74 $ 52 ==== ==== ==== ==== Impairment charge: Investment in private equity funds $ -- $ (9) $ -- $ (9) ==== ==== ==== ==== F. The Company's total comprehensive income is as follows, in millions: THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ----------------- 2004 2003 2004 2003 ------- ------- ------- ------ Net income $359 $319 $788 $714 Other comprehensive income (loss): Cumulative translation adjustments 28 8 3 184 Unrealized (loss) gain on marketable securities, net -- (5) (15) 17 ---- ---- ---- ---- Total comprehensive income $387 $322 $776 $915 ==== ==== ==== ==== The unrealized (loss) gain on marketable securities is net of income tax (credits) of $(9) million for the nine months ended September 30, 2004, and $(3) million and $10 million for the three months and nine months ended September 30, 2003, respectively. The components of accumulated other comprehensive income (loss) are as follows, in millions: SEPTEMBER 30, DECEMBER 31, 2004 2003 ------------- ------------ Unrealized gain on marketable securities, net $ 11 $ 26 Minimum pension liability (61) (61) Cumulative translation adjustments 459 456 ---- ---- Accumulated other comprehensive income (loss) $409 $421 ==== ==== 10 MASCO CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED) Note F - concluded: The unrealized gain on marketable securities is reported net of income tax of $6 million and $15 million at September 30, 2004 and December 31, 2003, respectively. The minimum pension liability is reported net of income tax credit of $35 million at both September 30, 2004 and December 31, 2003. G. The Company owns 64 percent of Hansgrohe AG. The minority interest of $74 million and $70 million at September 30, 2004 and December 31, 2003, respectively, is recorded in the caption deferred income taxes and other liabilities on the Company's condensed consolidated balance sheets. H. In the first half of 2004, the Company retired the remaining $266 million of 6% notes due May 2004. On March 9, 2004, the Company issued $300 million of floating-rate notes due 2007, resulting in net proceeds of $299 million. The interest rate is calculated based on the three-month London Interbank Offered Rate ("LIBOR") plus .25%. In March 2004, the Company terminated two interest rate swaps relating to $850 million of fixed-rate debt. These swap agreements were accounted for as fair value hedges. The gain of approximately $45 million from the termination of these swaps is being amortized as a reduction of interest expense over the remaining term of the debt, through July 2012. In late March 2004, the Company entered into new interest rate swaps for the purpose of converting a portion of fixed-rate debt to variable-rate debt, which is expected to reduce interest expense, given current interest rates. The average variable interest rates are based on LIBOR plus a fixed adjustment factor. The average effective interest rate on the interest rate swaps is 2.275%. At September 30, 2004, the interest rate swap agreements covered a notional amount of $850 million of the Company's fixed-rate debt due July 15, 2012 with an interest rate of 5.875%. The interest rate swaps are considered 100 percent effective; therefore, the market valuation of $24 million at September 30, 2004 is recorded in other assets with a corresponding increase to long-term debt in the Company's condensed consolidated balance sheet at September 30, 2004. I. The net periodic pension cost for the Company's qualified defined-benefit pension plans is as follows, in millions: THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ----------------- 2004 2003 2004 2003 -------- -------- -------- ------- Service cost $ 3 $ 4 $ 9 $ 11 Interest cost 7 9 23 28 Expected return on plan assets (5) (7) (18) (22) Amortization of net loss 1 1 4 5 ---- ---- ---- ---- Net periodic pension cost $ 6 $ 7 $ 18 $ 22 ==== ==== ==== ==== 11 MASCO CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED) Note I - concluded: Net periodic pension cost for the Company's non-qualified unfunded supplemental pension plans was $6 million and $15 million for the three months and nine months ended September 30, 2004, respectively, and $4 million and $9 million for the three months and nine months ended September 30, 2003, respectively. In the first nine months of 2004, the Company contributed $60 million to its domestic qualified defined-benefit pension plans. 12 MASCO CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED) J. The following table presents information about the Company by segment and geographic area, in millions: THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30, ------------------------------------ ------------------------------------ 2004 2003 2004 2003 2004 2003 2004 2003 ------------------------------------ ------------------------------------ NET SALES (A) OPERATING PROFIT NET SALES (A) OPERATING PROFIT ---------------- ----------------- ---------------- ----------------- The Company's operations by segment were (B): Cabinets and Related Products $ 856 $ 761 $ 150 $ 122 $2,432 $2,114 $ 396 $ 314 Plumbing Products 775 692 101 96 2,299 1,990 314 277 Installation and Other Services 737 642 103 110 2,053 1,769 272 275 Decorative Architectural Products 433 418 102 52 1,254 1,099 267 162 Other Specialty Products 372 310 86 63 1,002 831 202 150 ------ ------ ------ ------ ------ ------ ------ ------ Total $3,173 $2,823 $ 542 $ 443 $9,040 $7,803 $1,451 $1,178 ====== ====== ====== ====== ====== ====== ====== ====== The Company's operations by geographic area were: North America $2,627 $2,369 $ 478 $ 431 $7,429 $6,494 $1,249 $1,080 International, principally Europe 546 454 64 12 1,611 1,309 202 98 ------ ------ ------ ------ ------ ------ ------ ------ Total $3,173 $2,823 542 443 $9,040 $7,803 1,451 1,178 ====== ====== ====== ====== General corporate expense, net (53) (31) (134) (88) Gains on sale of corporate fixed assets, net -- 3 8 3 Income regarding litigation settlement (C) 2 58 30 71 (Expense) related to accelerated benefits, net (D) -- -- -- (16) ------ ------ ------ ------ Operating profit 491 473 1,355 1,148 Other income (expense), net (31) (60) (43) (147) ------ ------ ------ ------ Income from continuing operations before income taxes and minority interest $ 460 $ 413 $1,312 $1,001 ====== ====== ====== ====== (A) Intra-segment sales were not material. (B) In accordance with SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets," the Company has accounted for the 2004 planned disposition of certain European businesses as discontinued operations. Accordingly, the assets and liabilities of those operations have been reclassified from the segments above. The reclassified assets, prior to any 2004 impairment charges, are as follows: Cabinets and Related Products - $242 million; Plumbing Products - $16 million; Decorative Architectural Products - $35 million; and Other Specialty Products - $107 million. (C) The Company recorded income regarding the litigation discussed in Note N related to the Company's subsidiary, Behr Process Corporation. Behr is included in the Decorative Architectural Products segment. (D) Due to the unexpected passing of the Company's President and Chief Operating Officer, certain benefits were accelerated and expensed in the first quarter of 2003, with an adjustment in the second quarter of 2003. 13 MASCO CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED) K. Other, net, which is included in other income (expense), net, includes the following, in millions: THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ------------------ 2004 2003 2004 2003 -------- -------- -------- -------- Income from cash and cash investments $ 3 $ 2 $ 6 $ 6 Other interest income 2 2 5 5 Income from financial investments, net (Note E) 17 19 74 52 Impairment charge: Investment in private equity funds -- (9) -- (9) Loss on early retirement of debt -- (3) -- (3) Gain from sale of equity investment -- -- -- 5 Other items, net 2 (4) 32 (2) ---- ---- ---- ---- $ 24 $ 7 $117 $ 54 ==== ==== ==== ==== Other items, net for the three months and nine months ended September 30, 2004 include $(1) million and $11 million, respectively, of currency transaction (losses) gains. Other items, net for the nine months ended September 30, 2004 also include a $5 million gain from the sale of non-operating assets. In the second quarter of 2003, the Company completed the sale of its 42 percent equity investment in Emco Limited for cash proceeds of approximately $75 million. The sale resulted in a pre-tax gain of $5 million. L. The following are reconciliations of the numerators and denominators used in the computations of basic and diluted earnings per common share, in millions: THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ------------------ 2004 2003 2004 2003 -------- -------- -------- -------- Numerator (basic and diluted): Income from continuing operations $ 289 $ 258 $ 824 $ 636 Income (loss) from discontinued operations, after income taxes 70 61 (36) 78 ----- ----- ----- ----- Net income, as reported $ 359 $ 319 $ 788 $ 714 ===== ===== ===== ===== Denominator: Basic common shares (based on weighted average) 440 474 447 483 Add: Contingent common shares 5 12 4 11 Stock option dilution 4 3 4 2 ----- ----- ----- ----- Diluted common shares 449 489 455 496 ===== ===== ===== ===== Income per common share amounts for the first three quarters of 2004 and 2003 do not total to the per common share amounts for the nine months ended September 30, 2004 and 2003 due to the timing of stock repurchases and the effect of contingently issuable shares. 14 MASCO CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED) Note L - concluded: During the third quarter of 2004, holders of 17,000 shares of the Company's convertible preferred stock converted all of their preferred stock to approximately 17 million shares of the Company's common stock. The convertible preferred shares carried substantially the same attributes as Company common stock and had been treated as if converted at a ratio of 1 share of preferred stock to approximately 1,000 shares of common stock for basic and diluted earnings per common share computations. For both the three months and nine months ended September 30, 2004 and 2003, approximately 24 million common shares related to the Zero Coupon Convertible Senior Notes due 2031 were not included in the computation of diluted earnings per common share since, at September 30, 2004 and 2003, they were not convertible according to their terms. Additionally, six million common shares for the nine months ended September 30, 2004, and three million and seven million common shares for the three months and nine months ended September 30, 2003, respectively, related to stock options were excluded from the computation of diluted earnings per common share due to their anti-dilutive effect, since the option exercise price was greater than the Company's average common stock price for these periods. M. In October 2004, the Emerging Issues Task Force ("EITF") Issue Summary No. 04-8, "Accounting Issues Related to Certain Features of Contingently Convertible Debt and the Effect on Diluted Earnings Per Share" was approved by the Financial Accounting Standards Board. EITF No. 04-8 will require the Company to include 24 million shares in the calculation of diluted earnings per common share related to the Company's Zero Coupon Convertible Senior Notes due 2031 ("Notes"), with the add-back of the related interest expense to net income. EITF No. 04-8 will be effective beginning in the fourth quarter of 2004 and will require the restatement of previously reported diluted earnings per common share amounts. Currently, the shares are not included in the Company's calculation of diluted earnings per common share, since the Notes are not convertible according to their terms. In early November 2004, the Company amended the terms of the Notes to remove the Company's option to satisfy the purchase price with shares of Company common stock when purchasing the Notes at the option of the holder. In the first quarter of 2004, the Company adopted Financial Accounting Standards Board ("FASB") Interpretation No. 46 - Revised ("FIN 46R"), "Consolidation of Variable Interest Entities." FIN 46R requires that a company that is the primary beneficiary of a variable interest entity consolidate the assets, liabilities and results of operations of the variable interest entity in the company's consolidated financial statements. The adoption of FIN 46R did not have a material impact on the Company's condensed consolidated financial statements. N. LITIGATION. The Company is subject to lawsuits and pending or asserted claims with respect to matters generally arising in the ordinary course of business. As the Company reported in previous filings, late in the second half of 2002, the Company and its subsidiary, Behr Process Corporation, agreed to two Settlements (the National Settlement and the Washington State Settlement) to resolve all class action lawsuits pending in the United States involving certain exterior wood coating products formerly manufactured by Behr. 15 MASCO CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED) Note N - continued: The following is a reconciliation of the Company's Behr Process Settlement liability, in millions: 2004 ------------------------------ WASHINGTON STATE NATIONAL SETTLEMENT SETTLEMENT ---------------- ---------- Balance at January 1 $ 53 $ 10 Payments on claims (12) (1) Insurance proceeds (9) (1) Adjustment of accrual (20) -- ---- ---- Balance at September 30 $ 12 $ 8 ==== ==== The deadlines for filing claims were September 2, 2003 for the National Settlement and January 17, 2004 for the Washington State Settlement. In the first quarter of 2004, the Company estimated the average cost per claim received related to the Washington State Settlement, and, as a result, estimated that the remaining unpaid claims and administration costs would be approximately $20 million less than estimated at December 31, 2003. Accordingly, the Company reduced the litigation accrual (recognizing income) by $20 million in the first quarter of 2004. Proceeds from insurance carriers are recognized as income when Behr and its carriers agree on such amounts. The Company expects that the evaluation, processing and payment of claims for both the Washington State Settlement and the National Settlement will be completed by March 31, 2005. Early in 2003, a suit was brought against the Company and a number of its insulation installation companies in the federal court in Atlanta, Georgia, alleging that certain practices violate provisions of federal and state antitrust laws. The plaintiff publicized the lawsuit with a press release and stated in that release that the Department of Justice was investigating the business practices of the Company's insulation installation companies. Although the Company was unaware of any investigation at that time, the Company was later advised that an investigation had been commenced but was subsequently closed without any enforcement action recommended. Two additional lawsuits were subsequently brought in Virginia making similar claims under the antitrust laws. Both of these lawsuits have since been dismissed without any payment or requirement for any change in business practices. During the second half of 2004, the same counsel who commenced the initial action in Atlanta filed six additional lawsuits on behalf of several of Masco's competitors in the insulation installation business. Recently, the plaintiffs dismissed five of these lawsuits and, represented by the same counsel, filed another action in the same federal court, seeking class representation for all independent insulation contractors against the Company, a number of its insulation installation companies and certain of their suppliers. Based upon the advice of its outside counsel, the Company believes that the conduct of the Company and its insulation installation companies, which has been the subject of any of the above-described lawsuits, has not violated any antitrust laws. 16 MASCO CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONCLUDED) Note N - concluded: STOCK PRICE GUARANTEE. The stock price guarantee as of September 30, 2004 is summarized as follows, in millions except dollar per share data: SHARES ISSUED SETTLEMENT - --------------- MINIMUM OPTIONS(A) # OF ISSUE STOCK PRICE -------------- MATURITY SHARES PRICE GUARANTEE SHARES CASH DATE - --------------- ----------- -------------- ---------------- 1 $30.00 $40.00 -- $ 9 12/31/04-4/30/05 (A) The amount is calculated based on the ten-day average of the Company common stock closing price ending September 30, 2004 of $34.17. Shares contingently issuable under this agreement are included in the calculation of diluted earnings per common share. In early August 2004, the Company recorded the issuance of approximately 160,000 shares of Company common stock related to a stock price guarantee, which matured on July 31, 2004. WARRANTY. The following is a reconciliation of the Company's warranty liability, in millions: 2004 ---- Balance at January 1 $ 90 Accruals for warranties issued during the period 40 Accruals related to pre-existing warranties 10 Settlements made (in cash or kind) during the period (36) Discontinued operations (2) Other, net (including foreign exchange impact) (3) ---- Balance at September 30 $ 99 ==== 17 MASCO CORPORATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THIRD QUARTER 2004 AND THE FIRST NINE MONTHS 2004 VERSUS THIRD QUARTER 2003 AND THE FIRST NINE MONTHS 2003 SALES AND OPERATING PROFIT MARGINS ---------------------------------- The following table sets forth the Company's net sales and operating profit margins by segment and geographic area, dollars in millions: THREE MONTHS ENDED SEPTEMBER 30, PERCENT INCREASE ------------------ ---------------- 2004 2003 2004 VS. 2003 ------ ------ ---------------- NET SALES: Cabinets and Related Products $ 856 $ 761 12% Plumbing Products 775 692 12% Installation and Other Services 737 642 15% Decorative Architectural Products 433 418 4% Other Specialty Products 372 310 20% ------ ------ Total $3,173 $2,823 12% ====== ====== North America $2,627 $2,369 11% International, principally Europe 546 454 20% ------ ------ Total $3,173 $2,823 12% ====== ====== NINE MONTHS ENDED SEPTEMBER 30, ------------------ 2004 2003 ------ ------ NET SALES: Cabinets and Related Products $2,432 $2,114 15% Plumbing Products 2,299 1,990 16% Installation and Other Services 2,053 1,769 16% Decorative Architectural Products 1,254 1,099 14% Other Specialty Products 1,002 831 21% ------ ------ Total $9,040 $7,803 16% ====== ====== North America $7,429 $6,494 14% International, principally Europe 1,611 1,309 23% ------ ------ Total $9,040 $7,803 16% ====== ====== THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ------------------ 2004 2003 2004 2003 ------------------ ------------------ OPERATING PROFIT MARGIN: (A) Cabinets and Related Products 17.5% 16.0% 16.3% 14.9% Plumbing Products 13.0% 13.9% 13.7% 13.9% Installation and Other Services 14.0% 17.1% 13.2% 15.5% Decorative Architectural Products 23.6% 12.4% 21.3% 14.7% Other Specialty Products 23.1% 20.3% 20.2% 18.1% North America 18.2% 18.2% 16.8% 16.6% International, principally Europe 11.7% 2.6% 12.5% 7.5% Total 17.1% 15.7% 16.1% 15.1% TOTAL OPERATING PROFIT MARGIN, AS REPORTED 15.5% 16.8% 15.0% 14.7% (A) Before general corporate expense of $53 million and $134 million for the three-month and nine-month periods ended September 30, 2004, respectively, and before income regarding the litigation settlement related to the Decorative Architectural Products segment of $2 million and $30 million for the three-month and nine-month periods ended September 30, 2004, respectively. Before general corporate expense of $31 million and $88 million for the three-month and nine-month periods ended September 30, 2003, respectively. Before accelerated benefit expense related to the unexpected passing of the Company's President and Chief Operating Officer of $16 million for the nine-month period ended September 30, 2003, and before insurance income regarding the litigation settlement related to the Decorative Architectural Products segment of $58 million and $71 million for the three-month and nine-month periods ended September 30, 2003. 18 MASCO CORPORATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company reports its financial results in accordance with generally accepted accounting principles ("GAAP") in the United States. However, the Company believes that certain non-GAAP performance measures and ratios, used in managing the business, may provide users of this financial information with additional meaningful comparisons between current results and results in prior periods. Non-GAAP financial measures and ratios should be viewed in addition to, and not as an alternative for, the Company's reported results. NET SALES --------- Net sales increased 12 percent and 16 percent, respectively, for the three-month and nine-month periods ended September 30, 2004 from the comparable periods in 2003. The following table reconciles reported net sales to net sales, excluding acquisitions and the effect of currency translation, in millions: THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ------------------ 2004 2003 2004 2003 ------ ------ ------ ------ Net sales, as reported $3,173 $2,823 $9,040 $7,803 Acquisitions (11) -- (39) -- ------ ------ ------ ------ Net sales, excluding acquisitions 3,162 2,823 9,001 7,803 Currency translation (49) -- (160) -- ------ ------ ------ ------ Net sales, excluding acquisitions and the effect of currency translation $3,113 $2,823 $8,841 $7,803 ====== ====== ====== ====== Net sales of Cabinets and Related Products increased 12 percent and 15 percent, respectively, in the three-month and nine-month periods ended September 30, 2004 compared with the same periods in 2003, primarily due to increased sales volume of assembled cabinets largely through North American retail distribution channels at major home centers and through the new construction market in the United States, as well as a more favorable product mix. Net sales of Plumbing Products increased 12 percent and 16 percent, respectively, in the three-month and nine-month periods ended September 30, 2004 compared with the same periods in 2003, primarily due to increased sales volume in the retail markets in North America and Europe and in the new construction markets in North America. In addition, the favorable impact of a weaker U.S. dollar increased International sales included in this segment in 2004 compared with 2003. Net sales of Installation and Other Services increased 15 percent and 16 percent, respectively, in the three-month and nine-month periods ended September 30, 2004 compared with the same periods in 2003, primarily due to increased sales volume of non-insulation products, increased selling prices for insulation products and increases in new residential construction and housing starts. 19 MASCO CORPORATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net sales of Decorative Architectural Products increased 4 percent and 14 percent, respectively, in the three-month and nine-month periods ended September 30, 2004 compared with the same periods of 2003, primarily due to increased sales volume of paints and stains as well as increased sales of decorative hardware. Sales of paints and stains were strong for the nine months ended September 30, 2004, with increases in the mid-teens compared to the same period in 2003. Sales increases in the third quarter of 2004 were less robust reflecting unusually strong sales in the third quarter of 2003 (which increased over 2002 in excess of 20 percent) as a result of a very slow first half of 2003 due to adverse weather conditions. In addition, third quarter of 2004 sales were negatively impacted by adverse weather, which affected sales in certain parts of the country. Net sales of Other Specialty Products increased 20 percent and 21 percent, respectively, in the three-month and nine-month periods ended September 30, 2004 compared with the same periods of 2003, primarily due to increased sales of vinyl and fiberglass windows and doors in North America. In addition, the favorable impact of a weaker U.S. dollar increased International sales included in this segment in 2004 compared with 2003. Net sales from North American operations for the three-month and nine-month periods ended September 30, 2004 increased 11 percent and 14 percent, respectively, compared with the same periods of 2003, primarily due to the reasons discussed above. Net sales from International operations for the three-month and nine-month periods ended September 30, 2004 increased 20 percent and 23 percent, respectively, compared with the same periods of 2003, primarily due to increased sales of cabinets and plumbing products, benefitting from additional penetration of the retail markets, as well as a weaker U.S. dollar, principally against the Euro, which increased International sales by approximately 11 percent and 12 percent for the three-month and nine-month periods ended September 30, 2004. OPERATING MARGINS ----------------- The Company's gross profit margins increased to 31.2 percent for both the three-month and nine-month periods ended September 30, 2004 from 31.0 percent and 30.6 percent, respectively, for the comparable periods in 2003. The increase in gross profit margins reflects increased sales volume, offset in part by increased sales in segments which have somewhat lower margins as well as increased material costs. In addition, operating results for the three-month and nine-month periods ended September 30, 2003 were reduced by non-cash, pre-tax charges of $42 million and $59 million relating to two United Kingdom business units, one in the Decorative Architectural Products segment and the other in the Plumbing Products segment. Offsetting the charges related to the United Kingdom business units discussed above, operating profit for the three-month and nine-month periods ended September 30, 2003 also benefited from $58 million and $71 million, respectively, of Behr litigation income. Operating profit for the three-month and nine-month periods ended September 30, 2004 includes $2 million and $30 million, respectively, of Behr litigation income. The Company's operating profit margins, as reported, were 15.5 percent and 15.0 percent, respectively, for the three-month and nine-month periods ended September 30, 2004 compared with 16.8 percent and 14.7 percent for the same periods of 2003. The Company's operating profit margins, excluding the Behr litigation income of $2 million and $30 million for the three-month and nine-month periods ended September 30, 2004, respectively, and $58 million and $71 million for the three-month and nine-month periods ended September 30, 2003, respectively, and the accelerated benefit expense of $16 million for the nine-month period ended September 30, 2003, were 15.4 percent and 14.7 percent for the three-month and nine-month periods ended September 30, 2004, respectively, and 14.7 percent and 14.0 percent for the three-month and nine-month periods ended September 30, 2003, respectively. The Company's operating profit margins, reflecting the adjustments discussed above, increased for the three-month and nine-month periods ended September 30, 2004 compared with the same periods of 2003, principally due to the reasons discussed. Selling, general and administrative expenses as a percentage of sales were 15.8 percent and 16.5 percent, respectively, for the three-month and nine-month periods ended September 30, 2004 and 16.3 percent and 16.8 percent, respectively, for the comparable periods of the prior year. Selling, general and administrative expenses for the three-month and nine-month periods ended September 30, 2004 were positively impacted by lower promotion and advertising costs compared with the same period in 2003. This improvement was partially offset by increased costs and expenses associated with complying with the new requirements of the Sarbanes-Oxley Legislation. Selling, general and administrative expenses for the nine-month period ended September 30, 2003 include $16 million of accelerated benefit expense related to the unexpected passing of the Company's President and Chief Operating Officer. Excluding the accelerated benefit expense, selling, general and administrative expense for the nine-month period ended September 30, 2003 would have been 16.6 percent. 20 MASCO CORPORATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Operating profit margins for the Cabinets and Related Products segment for the three-month and nine-month periods ended September 30, 2004 were 17.5 percent and 16.3 percent, respectively, compared with 16.0 percent and 14.9 percent for the same periods in 2003, and reflect the positive impact of higher sales volume and a more favorable product mix offset in part by increased costs related to wood and particleboard materials. Operating profit margins for the Plumbing Products segment were 13.0 percent and 13.7 percent, respectively, for the three-month and nine-month periods ended September 30, 2004 compared with 13.9 percent for both of the same periods of 2003, primarily due to an increase in sales of lower-margin products included in this segment as well as increased material costs offset in part by increased sales volume. As previously discussed, operating profit in the first nine months of 2003 for this segment was negatively affected by a non-cash, pre-tax charge of $4 million relating to a United Kingdom business unit where an employee had circumvented internal controls to misstate operating profit in 2002 and 2003. Operating profit margins for the Installation and Other Services segment were 14.0 percent and 13.2 percent, respectively, for the three-month and nine-month periods ended September 30, 2004 compared with 17.1 percent and 15.5 percent for the same periods of 2003. The operating profit margin decline in this segment is primarily attributable to increased material costs as well as an increase in sales of generally lower-margin, non-insulation products. Historically, the Company has generally been able to increase its selling prices to reflect certain material cost increases. Typically, the benefits of such selling price increases are reflected in subsequent periods, as there is a time lag as a result of existing contractual obligations. Within the Installation and Other Services segment, the availability of fiberglass insulation to support the Company's installation and distribution activities has been constrained in 2004. The high level of demand for fiberglass insulation as a result of the strength of the new residential construction market has outpaced the industry's capacity to produce additional product. The Company believes that these conditions will persist over the balance of 2004 and is working with its diverse supplier base to secure as much material as possible. At the current time, the Company does not believe that this material shortage will have a significant impact on its operations. Operating profit margins for the Decorative Architectural Products segment were 23.6 percent and 21.3 percent, respectively, for the three-month and nine-month periods ended September 30, 2004 compared with 12.4 percent and 14.7 percent for the same periods of 2003. The margin improvement includes the effect of increased sales volume of paints and stains and decorative hardware offset in part by increased material and promotion costs. As previously discussed, operating profit in this segment for the three-month and nine-month periods ended September 30, 2003 was negatively affected by non-cash, pre-tax charges of $35 million and $55 million, respectively, related to a United Kingdom business unit. The charge resulted from a business system implementation failure which allowed former management of the business to circumvent internal controls and artificially inflate the unit's operating profit in years prior to 2003. 21 MASCO CORPORATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Operating profit margins for the Other Specialty Products segment were 23.1 percent and 20.2 percent, respectively, for the three-month and nine-month periods ended September 30, 2004 compared with 20.3 percent and 18.1 percent for the same periods of 2003. The margin improvement is primarily attributable to increased sales of vinyl and fiberglass windows and doors. OTHER INCOME (EXPENSE), NET --------------------------- Other, net, for the three-month and nine-month periods ended September 30, 2004 includes $(2) million and $23 million, respectively, of realized (losses) gains, net, from the sale of marketable securities, dividend income of $8 million and $22 million, respectively, and $11 million and $29 million, respectively, of income, net, regarding other investments. Other items, net for the three-month and nine-month periods ended September 30, 2004 includes $(1) million and $11 million, respectively, of currency transaction (losses) gains. Other items, net for the nine-month period ended September 30, 2004 also includes a $5 million gain from the sale of non-operating assets. Other, net, for the three-month and nine-month periods ended September 30, 2003 includes $7 million and $24 million, respectively, of realized gains, net, from the sale of marketable securities, dividend income of $6 million and $19 million, respectively, and $6 million and $9 million, respectively, of income, net, regarding other investments. Other, net for the three-month and nine-month periods ended September 30, 2003 includes a $9 million impairment charge for the write-down of an investment in a private equity fund. Other, net for the nine-month period ended September 30, 2003 also includes a $5 million gain from the sale of the Company's equity investment in Emco Limited. Interest expense for the three-month and nine-month periods ended September 30, 2004 decreased $12 million and $41 million, respectively, to $55 million and $160 million, compared with interest expense of $67 million and $201 million, respectively, for the same periods of 2003 primarily due to debt repurchases as well as the effect of the interest rate swap agreements that converted a certain amount of fixed-rate debt to lower variable-rate debt. 22 MASCO CORPORATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INCOME AND EARNINGS PER COMMON SHARE FROM CONTINUING OPERATIONS --------------------------------------------------------------- Income from continuing operations for the three-month and nine-month periods ended September 30, 2004 was $289 million and $824 million, respectively, compared with $258 million and $636 million, respectively, for the comparable periods of 2003. Diluted earnings per common share from continuing operations for the three-month and nine-month periods ended September 30, 2004 were $.64 and $1.81 per common share, respectively, compared with $.53 and $1.28 per common share, respectively, for the comparable periods of 2003. The Company's effective tax rate was 36.3 percent and 36.1 percent, respectively, for the three-month and nine-month periods ended September 30, 2004, compared with 37.0 percent and 35.7 percent, respectively, for the same periods in 2003. The Company estimates that its effective tax rate should approximate 36 percent for 2004. However, because the American Jobs Creation Act of 2004, recently signed into law in the fourth quarter of 2004, contains changes that impact the U.S. tax on the distribution of accumulated foreign earnings, the Company may consider making a significant dividend distribution from its foreign subsidiaries. This possible dividend, along with the potential effect of other new provisions, may impact the Company's effective tax rate in the fourth quarter of 2004 or in 2005. The increase in the tax rate for the nine-month period is principally due to a change in the mix of foreign earnings in countries with higher tax rates. OTHER FINANCIAL INFORMATION --------------------------- The Company's current ratio was 2.1 to 1 at September 30, 2004 compared with 1.8 to 1 at December 31, 2003. For the nine months ended September 30, 2004, cash of $973 million was provided by operating activities. Cash used for financing activities was $964 million, including $266 million for the retirement of notes, $227 million for cash dividends paid, $777 million for the acquisition and retirement of Company common stock in open-market transactions, $40 million for the acquisition of Company common stock for the Company's long-term stock incentive award plan and $43 million for a net decrease in bank debt. Cash provided by financing activities included $299 million from the issuance of notes (net of issuance costs), $55 million from interest rate swap transactions and $35 million from the issuance of Company common stock, primarily for the exercise of stock options. Cash provided by investing activities was $204 million and primarily included $207 million from the net sales of marketable securities and other investments and $178 million from the disposition of businesses (net of cash disposed). Cash used for investing activities primarily included $188 million for capital expenditures. Cash at businesses held for sale was $38 million at September 30, 2004. In the first half of 2004, the Company retired the remaining $266 million of 6% notes due May 2004. The Company is subject to lawsuits and claims pending or asserted with respect to matters generally arising in the ordinary course of business. Note N to the Condensed Consolidated Financial Statements discusses specific claims pending against the Company. The Company believes that its present cash balance, its cash flows from operations and, to the extent necessary, bank borrowings and future financial market activities, are sufficient to fund its working capital and other investment needs. 23 MASCO CORPORATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OUTLOOK FOR THE COMPANY ----------------------- The Company continues to experience better than expected sales performance as sales of assembled cabinets, paints and stains, installation services and windows have continued strong in the first nine months of 2004. The Company also continues to experience increases in certain operating expenses, particularly for certain material costs, as well as costs associated with complying with the new requirements of the Sarbanes-Oxley Legislation. Based on current business trends and the record sales and earnings achieved in the first nine months of 2004, the Company expects to achieve record sales and earnings for the full year of 2004. FORWARD-LOOKING STATEMENTS -------------------------- Certain sections of this Quarterly Report contain statements reflecting the Company's views about its future performance and constitute "forward-looking statements" under the Private Securities Litigation Reform Act of 1995. These views involve risks and uncertainties that are difficult to predict and, accordingly, the Company's actual results may differ materially from the results discussed in such forward-looking statements. Readers should consider that various factors, including changes in general economic conditions, competitive market conditions and pricing pressures, relationships with key customers, industry consolidation of retailers, wholesalers and builders, shifts in distribution, the influence of e-commerce and other factors discussed in the Company's Annual Report on Form 10-K and its other filings with the Securities and Exchange Commission, may affect the Company's performance. The Company undertakes no obligation to update publicly any forward-looking statements as a result of new information, future events or otherwise. The Company is in the process of evaluating its internal control system over financial reporting in accordance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002. Because of the Company's historical growth through acquisition and its decentralized organizational structure with over 50 reporting units and over 600 operating locations worldwide, the Company estimates that it has well in excess of 20,000 key controls over financial reporting. As part of this initiative, the Company has invested a substantial amount of time and resources in documenting and testing its system of internal control. During the course of this comprehensive process, the Company and its independent auditors have identified control deficiencies. The Company has corrected a number and is remediating others of these control deficiencies. However, there can be no assurance that one or more deficiencies will not constitute what the Company or its independent auditors conclude is a material weakness in internal control over financial reporting. Additionally, there can be no assurance in light of the Company's decentralization, the number of its operating units and magnitude of the overall initiative, that the Company will be able to complete the process in time to allow its independent auditors to finish their assessment and issue their audit report on a timely basis. The Company believes, however, based on its current knowledge, that its documentation, testing and final assessment will be completed on a timely basis. 24 MASCO CORPORATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company owns four million shares of Furniture Brands International common stock, which was received in June 2002 from the Company's investment in Furnishings International Inc. debt. The market price during 2004 has been above and below the Company's cost basis. If the price remains significantly below the Company's cost basis, the Company may record an other-than-temporary asset impairment charge in the fourth quarter of 2004. At September 30, 2004, the Company has a $1.25 billion, 5-year revolving credit agreement (due November 2005) and a $750 million, 364-day revolving credit agreement (due November 2004) which are currently being renegotiated. The Company expects to finalize a new 5-year, $2 billion revolving credit agreement in early November 2004, which will replace both of the existing agreements. 25 MASCO CORPORATION ITEM 4. CONTROLS AND PROCEDURES a. Evaluation of Disclosure Controls and Procedures. The Company's principal executive officer and principal financial officer have concluded, based on an evaluation of the Company's "disclosure controls and procedures" (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) or 15d-15(e)) as required by paragraph (b) of Exchange Act Rules 13a-15 or 15d-15, that, as of September 30, 2004, the Company's disclosure controls and procedures were effective and designed to ensure that information required to be disclosed by the Company in the reports it files under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. b. Changes in Internal Control Over Financial Reporting. There has been no change in the Company's internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Rules 13a-15 or 15d-15 that occurred during the Company's last fiscal quarter (the Company's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. 26 MASCO CORPORATION PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS - ------------------------- Information regarding this item is set forth in Note N to the Company's Condensed Consolidated Financial Statements included in Part I, Item 1 of this Report. ITEM 2. UNREGISTERED SALE OF EQUITY SECURITIES AND USE OF PROCEEDS - ------------------------------------------------------------------ The following table provides information regarding the repurchase of Company common stock for the three months ended September 30, 2004, in millions except average price paid per common share data: TOTAL NUMBER OF MAXIMUM NUMBER OF SHARES PURCHASED SHARES THAT MAY TOTAL NUMBER AVERAGE PRICE AS PART OF YET BE PURCHASED OF SHARES PAID PER PUBLICLY ANNOUNCED UNDER THE PLANS PERIOD PURCHASED(A) COMMON SHARE PLANS OR PROGRAMS OR PROGRAMS ------ ------------ ------------- ------------------ ----------------- 7/1/04- 7/31/04 1 $29.81 1 23 8/1/04- 8/31/04 2 $32.30 1 22 9/1/04- 9/30/04 1 $33.40 1 21 ----- ----- Total for the quarter 4 $31.47 3 (A) Includes 1 million shares (i) acquired on the open market for the long-term stock incentive award plan, (ii) surrendered for the exercise of stock options or (iii) withheld for the payment of taxes upon vesting of stock awards. In December 2003, the Company's Board of Directors authorized the repurchase of up to 50 million shares of the Company's common stock in open-market transactions or otherwise. ITEMS 3, 4 AND 5 ARE NOT APPLICABLE. 27 MASCO CORPORATION PART II. OTHER INFORMATION - CONTINUED ITEM 6. EXHIBITS - ---------------- 4 - Amendment No. 2 to First Supplemental Indenture dated as of November 2, 2004 between Masco Corporation and J.P. Morgan Trust Company, National Association, as Trustee 10ai - Forms of awards under the Masco Corporation 1991 Long Term Stock Incentive Plan, Restricted Stock Award Agreement 10aii - Forms of awards under the Masco Corporation 1991 Long Term Stock Incentive Plan, Restoration Stock Option 10aiii - Forms of awards under the Masco Corporation 1991 Long Term Stock Incentive Plan, Stock Option Grant for officers 10aiv - Forms of awards under the Masco Corporation 1991 Long Term Stock Incentive Plan, Stock Option Grant for directors 10bi - Form of awards under the Masco Corporation 1997 Non-Employee Directors Stock Plan, Restricted Stock Award Agreement 10bii - Form of awards under the Masco Corporation 1997 Non-Employee Directors Stock Plan, Stock Option Grant 12 - Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends 31a - Certification of Chief Executive Officer required by Rule 13a-14(a) or 15d-14(a) of the Securities and Exchange Act of 1934 31b - Certification of Chief Financial Officer required by Rule 13a-14(a) or 15d-14(a) of the Securities and Exchange Act of 1934 32 - Certifications required by Rule 13a-14(b) or 15d-14(b) of the Securities and Exchange Act of 1934 and Section 1350 of Chapter 63 of Title 18 of the United States Code 28 MASCO CORPORATION PART II. OTHER INFORMATION - CONCLUDED SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. MASCO CORPORATION (Registrant) DATE: NOVEMBER 4, 2004 BY: /s/ Timothy Wadhams ----------------------- -------------------------------------- Timothy Wadhams Senior Vice President and Chief Financial Officer 29 MASCO CORPORATION EXHIBIT INDEX EXHIBIT - ------- Exhibit 4 Amendment No. 2 to First Supplemental Indenture dated as of November 2, 2004 between Masco Corporation and J.P. Morgan Trust Company, National Association, as Trustee Exhibit 10ai Forms of awards under the Masco Corporation 1991 Long Term Stock Incentive Plan, Restricted Stock Award Agreement Exhibit 10aii Forms of awards under the Masco Corporation 1991 Long Term Stock Incentive Plan, Restoration Stock Option Exhibit 10aiii Forms of awards under the Masco Corporation 1991 Long Term Stock Incentive Plan, Stock Option Grant for officers Exhibit 10aiv Forms of awards under the Masco Corporation 1991 Long Term Stock Incentive Plan, Stock Option Grant for directors Exhibit 10bi Form of awards under the Masco Corporation 1997 Non-Employee Directors Stock Plan, Restricted Stock Award Agreement Exhibit 10bii Form of awards under the Masco Corporation 1997 Non-Employee Directors Stock Plan, Stock Option Grant Exhibit 12 Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends Exhibit 31a Certification of Chief Executive Officer required by Rule 13a-14(a) or 15d-14(a) of the Securities and Exchange Act of 1934 Exhibit 31b Certification of Chief Financial Officer required by Rule 13a-14(a) or 15d-14(a) of the Securities and Exchange Act of 1934 Exhibit 32 Certifications required by Rule 13a-14(b) or 15d-14(b) of the Securities and Exchange Act of 1934 and Section 1350 of Chapter 63 of Title 18 of the United States Code