SOVEREIGN SPECIALTY CHEMICALS INC - 10-Q Quarterly Report

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-Q
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(MARK ONE)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934.

For the quarterly period ended June 30, 2002

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934.

For the transition period from to
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Commission File Number 333-39373

SOVEREIGN SPECIALTY CHEMICALS, INC.
(Exact Name of Registrant as Specified in Its Charter)

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DELAWARE
36-4176637
(State or Other Jurisdiction of Incorporation or Organization)
(IRS Employer Identification No.)

225 W. Washington St. - Ste. 2200, Chicago, IL 60606
(Address of Principal Executive Offices)
(Zip Code)

Registrant's Telephone Number, Including Area Code: (312) 419-7100

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 (OR FOR SUCH SHORTER PERIOD THAT THE
REGISTRANT WAS REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH
FILING REQUIREMENTS FOR THE PAST 90 DAYS. YES [X] NO [ ]
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SOVEREIGN SPECIALTY CHEMICALS, INC.

FORM 10-Q

TABLE OF CONTENTS

SOVEREIGN SPECIALTY CHEMICALS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)

See accompanying notes to consolidated financial statements.

1

SOVEREIGN SPECIALTY CHEMICALS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN THOUSANDS)

See accompanying notes to consolidated financial statements

2

SOVEREIGN SPECIALTY CHEMICALS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(DOLLARS IN THOUSANDS)

See accompanying notes to consolidated financial statements

3

SOVEREIGN SPECIALTY CHEMICALS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2002
(Dollars in Thousands)

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BASIS OF PRESENTATION AND PRINCIPLES OF CONSOLIDATION

The consolidated financial statements as of and for the periods ended June
30, 2002 and 2001, respectively, include the accounts of Sovereign Specialty
Chemicals, Inc. and its wholly-owned subsidiaries (the "Company"). All
significant intercompany balances and transactions have been eliminated.

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.

INTERIM FINANCIAL INFORMATION

The unaudited interim consolidated financial statements of the Company, in
the opinion of management, reflect all necessary adjustments, consisting only of
normal recurring adjustments, for a fair presentation of results as of the dates
and for the interim periods covered by the financial statements. The results for
the interim periods are not necessarily indicative of the results of operations
to be expected for the entire year.

The unaudited interim consolidated financial statements have been prepared
in conformity with generally accepted accounting principles and reporting
practices. Certain information in footnote disclosures normally included in
financial statements prepared in accordance with accounting principles generally
accepted in the United States has been condensed or omitted pursuant to the
rules and regulations of the Securities and Exchange Commission; however, the
Company believes the disclosures are adequate to make the information not
misleading. The unaudited interim consolidated financial statements contained
herein should be read in conjunction with the audited financial statements and
notes thereto included in our 2001 Annual Report on Form 10-K.

RECLASSIFICATIONS

Certain prior year amounts have been reclassified to conform to current
year presentation.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In April 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 145, Rescission of FASB
Statements No. 4, 44, and 62, Amendment of FASB Statement No. 13, and Technical
Corrections. SFAS No. 145 requires that certain gains and losses on
extinguishments of debt be classified as income or loss from continuing
operations rather than as extraordinary items as previously required under SFAS
No. 4, Reporting Gains and Losses from Extinguishment of Debt. This statement
also amends SFAS No. 13, Accounting for Leases, to require certain modifications
to capital leases be treated as sale-leaseback and modifies the accounting for
sub-leases when the original lessee remains a secondary obligor (or guarantor).
The Company will be required to adopt SFAS No. 145 on January 1, 2003, and will
reclassify extraordinary items to continuing operations.

In August 2002, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 146 (SFAS 146), "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS 146 nullifies the guidance of
the Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs incurred in a Restructuring). SFAS 146 requires that a
liability for a cost that is associated with an exit or disposal activity be
recognized when the liability is incurred. SFAS 146 also establishes that fair

4

SOVEREIGN SPECIALTY CHEMICALS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

JUNE 30, 2002
(Dollars in Thousands)

value is the objective for the initial measurement of the liability. The
provisions of SFAS 146 are required for exit or disposal activities that are
initiated after December 31, 2002. At this time we do not believe the adoption
of SFAS 146 will have a material impact on our financial statements.

2. GOODWILL AND INTANGIBLE ASSETS

In June 2001, the Financial Accounting Standards Board issued SFAS No. 141,
Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets.

On January 1, 2002, the Company adopted SFAS No. 141 and 142. SFAS No. 141
requires that the purchase method of accounting be used for all business
combinations initiated after June 30, 2001 and also includes guidance on the
initial recognition and measurement of goodwill and other intangible assets
acquired in a business combination. The initial adoption of SFAS No. 141 did not
affect the Company's results of operations or its financial position.

The adoption of SFAS No. 142 eliminates the amortization of goodwill
beginning January 1, 2002 and instead requires that goodwill be tested for
impairment. The adoption of SFAS No. 142 will result in a $10.0 million decrease
in amortization expense in 2002. Amortization expense recognized was $2.4
million, $2.5 million, $2.3 million and $2.8 million, respectively for the four
quarters of 2001. We have completed the transitional intangible asset impairment
test required under SFAS No. 142 and have recorded an impairment loss of $27.6
million ($17.1 million, net of income tax benefit) in connection with our
adoption of the statement. The loss was recorded as a cumulative effect of
change in accounting principle. The impairment loss and write-down of goodwill
was recorded relative to the Company's European reporting unit. Our assessment
of the goodwill impairment charge for this reporting unit is reflective of both
lower operating performance in Europe and the use of lower market multiples. The
carrying value of goodwill associated with our other reporting units was not
impaired.

At June 30, 2002 the Company's unamortized definite lived intangible assets
of $0.1 million will be amortized over the remainder of 2002. Amortization
expense for intangible assets during the three and six months ended June 30,
2002 was $0.3 million and $0.4 million, respectively. Estimated amortization
expense for the remainder of 2002 will be $0.1 million.

Actual results of operations for the three and six months ended June 30,
2002 and the pro forma results of operations for the three and six months ended
June 30, 2001 had we applied the non-amortization provisions of SFAS No. 142 in
the prior period are as follows:

5

SOVEREIGN SPECIALTY CHEMICALS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

JUNE 30, 2002
(Dollars in Thousands)

3. INVENTORIES

Inventories are summarized as follows:

4. COMPREHENSIVE INCOME (LOSS)

For the three and six months ended June 30, 2002 and 2001, respectively,
the calculation of comprehensive loss is as follows:

5. SEGMENT REPORTING

The Company has two reportable segments: the Commercial segment and the
Construction segment. The Commercial segment consists of the Industrial and
Packaging, Converting & Graphic Arts divisions. Applications sold by the
Industrial division consist primarily of high performance, specialty adhesives
and coatings for automotive, aerospace, manufactured housing and textile
applications. The Packaging, Converting & Graphic Arts division produces
flexible packaging adhesives and coatings for a number of applications. Through
the Construction segment, the Company manufactures and sells housing repair,
remodeling and construction sealants and adhesives used in exterior and interior
applications.

The Company evaluates performance and defines segment profit based upon
operating income. The reportable segments' accounting policies are the same as
those of the Company as a whole. Segment profit is calculated as a reportable
segment's operating income. Total segment profits exceed consolidated operating
profits to the extent of unallocated corporate expenses included in selling,
general and administrative expenses. Unallocated corporate expenses were $2.8
million and $5.5 million for the three and six months ended June 30, 2002,
respectively; and $2.3 million and $4.2 million for the three and six months
ended June 30, 2001.

6

SOVEREIGN SPECIALTY CHEMICALS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

JUNE 30, 2002
(Dollars in Thousands)

The reportable segments are each managed and measured separately primarily
due to the differing customers, products sold and distribution channels. The
reportable segments are as follows:

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(1) Per the provisions of SFAS No. 142, beginning January 1, 2002, goodwill
amortization expense (included in segment profit during 2001) is no longer
recorded.

A reconciliation of the reportable segments to consolidated operating
income is as follows:

7. OTHER FINANCIAL INFORMATION

The Company is a holding company with no independent assets or operations.
Full separate financial statements of the Guarantor Subsidiaries have not been
presented as the guarantors are wholly-owned subsidiaries of the Company.
Management does not believe that inclusion of such financial statements would

7

SOVEREIGN SPECIALTY CHEMICALS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

JUNE 30, 2002
(Dollars in Thousands)

be material to investors. The unaudited financial statement data as of June 30,
2002 and 2001, respectively of the Guarantor Subsidiaries and the Non-Guarantor
Subsidiaries are below.

THE FOLLOWING SETS FORTH THE UNAUDITED FINANCIAL DATA AT JUNE 30, 2002 AND FOR
THE THREE AND SIX MONTHS THEN ENDED.

8

SOVEREIGN SPECIALTY CHEMICALS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

JUNE 30, 2002
(Dollars in Thousands)

9

SOVEREIGN SPECIALTY CHEMICALS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

JUNE 30, 2002
(Dollars in Thousands)

THE FOLLOWING SETS FORTH THE FINANCIAL DATA AT JUNE 30, 2001 AND FOR THE THREE
AND SIX MONTHS THEN ENDED.

10

SOVEREIGN SPECIALTY CHEMICALS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

JUNE 30, 2002
(Dollars in Thousands)

11

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (DOLLARS IN THOUSANDS)

The following discussion and analysis is provided to increase the
understanding of, and should be read in conjunction with, the consolidated
financial statements and accompanying notes included herein.

GENERAL

We were formed to acquire, consolidate and operate adhesives, sealants and
coatings businesses in the highly fragmented adhesives, sealants and coatings
business segment of the specialty chemicals industry. We have grown through
acquisition and integration of businesses. We plan to continue our growth
through a combination of new product development, continued market penetration,
international expansion, and in the longer term, strategic acquisitions.

CRITICAL ACCOUNTING POLICIES

Reserve for Inventory Obsolescence. We provide allowances for estimated
obsolescence or unmarketable inventory equal to the difference between the cost
of the inventory and the estimated market value based upon assumptions about
market conditions, future demand and expected usage rates.

Allowance for Doubtful Accounts. We maintain allowances for doubtful
accounts for estimated losses resulting from the failure of our customers to
make required payments. We evaluate the adequacy of our allowance for doubtful
accounts and make judgments and estimates in determining the appropriate
allowance at each reporting period. If a customer's financial condition were to
deteriorate, additional allowances may be required.

COMPONENTS OF INCOME AND EXPENSE

Revenue Recognition. Revenue is recognized when products are shipped to
the customer and title transfers.

Cost of Goods Sold. Cost of goods sold represents the actual cost of
purchased raw materials, direct and indirect labor, warehousing and
manufacturing overhead costs, including depreciation, utilized directly in the
production of products for which revenue has been recognized.

Selling, General & Administrative Expenses. Selling, general &
administrative expenses generally are those costs not directly related to the
production process and include all selling, marketing, research and development,
and customer service expenses as well as expenses related to general management,
finance and accounting, information services, human resources, legal and
corporate overhead expense.

SEGMENT REPORTING

We have two reportable segments: the Commercial segment and the
Construction segment. The Commercial segment consists of the Industrial division
and Packaging, Converting & Graphic Arts division. Applications sold by the
Industrial division consist primarily of high performance, specialty adhesives
and coatings for automotive, aerospace, manufactured housing, general assembly
and textile applications. The Packaging, Converting & Graphic Arts division
produces adhesives and coatings for a number of flexible packaging and paper
converting applications. Through the Construction segment, we manufacture and
sell housing repair, remodeling and construction sealants and adhesives used in
exterior and interior applications.

We evaluate the performance of each segment based on operating income.
Segment profit is calculated as a reportable segment's operating income. Total
segment profits exceed consolidated operating profits to the extent of
unallocated corporate expenses included in selling, general and administrative
expenses. Unallocated corporate expenses were $2.8 million and $5.5 million for
the three and six months ended June 30, 2002, respectively; and $2.3 million and
$4.3 million for the three and six months ended June 30, 2001.

12

RESULTS OF OPERATIONS

THREE MONTHS ENDED JUNE 30, 2002 COMPARED TO THREE MONTHS ENDED JUNE 30, 2001

Net Sales. Net sales were $94.9 million for the three months ended June
30, 2002, an increase of $3.2 million, or 3.5% from second quarter 2001 net
sales of $91.8 million. The year-to-year increase was driven by gains in both
segments. Construction segment sales were $31.1 million in the June 2002
quarter, up 7.6% from last year reflecting a good housing market and gains in
the retail do-it-yourself (DIY) channel. Commercial segment sales were $63.8
million, up 1.6% as some business gains from new products and market penetration
outpaced declines in a number of end-markets including aerospace, furniture and
graphic arts, particularly high end printing applications end markets. Sales of
adhesives for high pressure laminates were a significant source of sales growth,
with revenues increasing by $1.0 million (a 40% increase) due to the addition of
Formica-branded products.

Cost of Goods Sold. Cost of goods sold was $67.6 million for the three
months ended June 30, 2002, an increase of $1.3 million, or 1.9% from second
quarter 2001 cost of sales of $66.4 million. Gross profit as a percentage of net
sales increased in the quarter to 28.8% from 27.7% in 2001. A number of factors
contributed to the increase in gross profit margin. Our raw material costs are
lower than they were a year ago, and we have taken actions that have reduced our
manufacturing expense. Our raw material costs peaked in last year's second
quarter and recently have been relatively stable with some signs of increasing.
Manufacturing costs in the Commercial segment reflect savings from closing the
Ewing and Nashville plants in June 2001 and August 2001, respectively. However,
these benefits were partly offset by the effect of a shift in sales mix to lower
margin products. Lower sales in our aerospace business, which carries higher
than average margins for our products, was a contributor to this shift.

Selling, General and Administrative Expenses. Selling, general and
administrative expenses were $17.7 million for the three months ended June 30,
2002, an increase of $0.9 million, or 5.4% from second quarter 2001 expenses of
$16.8 million. As a percentage of net sales, excluding goodwill amortization,
selling, general and administrative expenses increased to 18.6% for the second
quarter 2002 from 18.3% in 2001. This increase was due primarily to the costs of
additions to our management team, extra professional fees related to financing
alternatives, higher insurance expenses and $0.4 million of outside consulting
costs related to implementation of lean manufacturing.

For financial reporting purposes, we have added a line to the income
statement to segregate the impact of the adoption of SFAS No. 142 and the
discontinuation of goodwill amortization expense. Amortization of goodwill for
the quarter ended June 30, 2001 was $2.5 million. The elimination of goodwill
amortization contributed greatly to the $3.5 million increase in operating
income in the second quarter 2002 over the prior year.

Interest Expense. Net interest expense was $6.6 million for the three
months ended June 30, 2002, a decrease of $0.3 million or 3.9% from $6.9 million
in the second quarter 2001. The decrease in interest expense was due primarily
to a decrease in the weighted average interest rate on our variable rate debt,
lower average debt levels year over year offset somewhat by slightly increased
amortization of deferred financing costs.

Income Taxes. Income tax expense was $1.4 million for the three months
ended June 30, 2002. Income tax benefit was $1.5 million in the second quarter
2001. Current income tax benefit for the quarter was $0.1 million and deferred
income tax expense for the quarter was $1.5 million. Although we have stopped
recording goodwill amortization for financial reporting purposes, we continue to
be able to deduct a portion of goodwill amortization expense for income tax
purposes. We are reflecting the tax benefit of this deduction as an increase in
deferred tax liability rather than a reduction of income tax expense.

Net income (loss). Net income (loss) for the quarters ended June 30, 2002
and 2001 were $1.7 million income and $2.4 million loss, respectively. The
increase in net income from the prior year is primarily related to the $2.5
million of goodwill amortization not recorded in 2002 as a result of the
adoption of SFAS No. 142 and from the actions and results described above.

13

COMMERCIAL SEGMENT

The following table presents net sales and segment profit expressed in
millions of dollars and segment profit margin, which is segment profit expressed
as a percentage of net sales:

Net segment sales were $63.8 million in the second quarter 2002,
representing a $1.0 million increase from second quarter 2001. Net sales for the
Commercial segment increased due to some business gains from new products and
market penetration offsetting declines in a number of end-markets including
aerospace, furniture and graphic arts, particularly high end printing
applications end markets. Sales of adhesives for high-pressure laminates were a
significant source of sales growth, with revenues increasing $1.0 million (a 40%
increase) due to the addition of Formica-branded products. Segment profit was
$7.2 million in the second quarter 2002, representing a $1.0 million and 16.1%
increase from the second quarter 2001 $6.2 million segment profit excluding
goodwill amortization. This increase reflects management's focus on cost
containment and lower raw material costs offset somewhat by the effect of a
shift in sales due to lower margin products.

CONSTRUCTION SEGMENT

The following table presents net sales and segment profit expressed in
millions of dollars and segment profit margin, which is segment profit expressed
as a percentage of net sales:

Net sales for the Construction segment were $31.1 million for the quarter
ended June 30, 2002, representing a $2.2 million or 7.6% increase from $28.9
million for the quarter ended June 30, 2001. The increase in sales in 2002 was
primarily due to a good housing market and gains in the retail DIY channel.
Segment profit after exclusion of goodwill amortization increased by $1.1
million and 17.2% as a percentage of net sales in the quarter ended June 30,
2002 primarily as a result of increased sales volume and management actions to
reduce material costs and contain selling, general and administrative costs.

14

SIX MONTHS ENDED JUNE 30, 2002 COMPARED TO SIX MONTHS ENDED JUNE 30, 2001

Net Sales. Net sales were $181.7 million for the six months ended June 30,
2002, an increase of $1.1 million, or 0.6% from net sales of $180.6 million in
the prior year. The year-to-year increase was primarily due to gains in
Construction segment sales which were partially offset by a decrease in net
sales from the Commercial segment. Construction segment sales were $58.7 million
for the six months ended June 30, 2002, up 8.1% from last year reflecting a good
housing market and gains in the retail DIY channel. Commercial segment sales
were $123.0 million, down 2.6% from last year due to declines in a number of end
markets including aerospace, furniture, and graphic arts, particularly high-end
printing applications end markets.

Cost of Goods Sold. Cost of goods sold was $130.8 million for the six
months ended June 30, 2002, a decrease of $0.4 million, or 0.3%, from prior year
cost of sales of $131.1 million. Gross profit as a percentage of net sales
increased in the six months ended to 28.0% from 27.4% in 2001. The improved
gross profit margin was due to lower raw material costs and lower manufacturing
expenses, offset partially by the effect of a shift in sales mix to lower margin
products. Lower sales in our aerospace business, which carries higher than
average margins for our products, was a contributor to this shift. Manufacturing
costs in the Commercial segment were lower reflecting the benefit of plant
closures.

Selling, General and Administrative Expenses. Selling, general and
administrative expenses were $35.3 million for the six months ended June 30,
2002, an increase of $1.5 million, or 4.5% from 2001 expenses of $33.8 million.
As a percentage of net sales, excluding goodwill amortization, selling, general
and administrative expenses increased to 19.5% for the second quarter 2002 from
18.7% in 2001. This increase was due primarily to the costs of additions to our
management team including $0.4 million of one-time costs, extra professional
fees related to financing alternatives, higher insurance expenses and $0.4
million of outside consulting costs related to implementation of lean
manufacturing.

For financial reporting purposes, we have added a line to the income
statement to segregate the impact of the adoption of SFAS No. 142 and the
discontinuation of goodwill amortization expense. Amortization of goodwill for
the six months ended June 30, 2001 was $5.0 million. The elimination of goodwill
amortization contributed greatly to the $4.9 million increase in operating
income over the prior year.

Interest Expense. Net interest expense was $13.0 million for the six months
ended June 30, 2002, a decrease of $0.8 million or 5.9% from $13.8 million in
the first half of 2001. The decrease in interest expense was due primarily to a
decrease in the weighted average interest rate on our variable rate debt and
lower average debt levels partially offset by increased amortization of deferred
financing costs.

Income Taxes. Income tax expense was $1.2 million for the six months ended
June 30, 2002. Income tax benefit was $0.8 million in the prior year. Current
income tax benefit for the first half of 2002 was $0.3 million and deferred
income tax expense was $1.5 million. Although we have stopped recording goodwill
amortization for financial reporting purposes, we continue to be able to deduct
a portion of goodwill amortization expense for income tax purposes. We are
reflecting the tax benefit of this deduction as an increase in deferred tax
liability rather than a reduction of income tax expense.

Net income (loss) before cumulative effect of change in accounting
principle. Net income (loss) before the cumulative effect of change in
accounting principle for the six months ended June 30, 2002 and 2001 was $1.4
million of income and $2.4 million of loss, respectively. The increase in income
from the prior year is primarily related to the $5.0 million of goodwill
amortization not recorded in 2002 as a result of the adoption of SFAS No. 142.

Cumulative effect of change in accounting principle. In connection with
Company's completion of the transitional goodwill impairment test required by
SFAS No. 142, we have recorded a $27.6 million ($17.1 million, net of income tax
benefit) goodwill impairment loss and write-down of goodwill associated with its
European reporting unit. Our assessment of our goodwill impairment for this
reporting unit is reflective of both lower operating performance in Europe and
the use of lower market multiples. The carrying value of goodwill associated
with our other reporting units was not impaired.

15

COMMERCIAL SEGMENT

The following table presents net sales and segment profit expressed in
millions of dollars and segment profit margin, which is segment profit expressed
as a percentage of net sales:

Net segment sales were $123.0 million in the first half of 2002,
representing a $3.3 million decrease from the prior year. Net sales for the
Commercial segment decreased due to declines in a number of end markets
including aerospace, furniture, and graphic arts, particularly high-end printing
applications. Segment profit was $12.3 million for the six months ended June 30,
2002, representing a $0.3 million and 2.5% increase from the prior year $12.0
million segment profit excluding goodwill amortization. This increase reflects
management's focus on cost containment and lower raw material costs offset
somewhat by lower sales volume and a shift in sales mix to products, with lower
profit margins.

For the three months ended September 30, 2001, commercial segment revenues
from external customers, goodwill amortization and segment profit were $62.6
million, $1.1 million and $6.5 million respectively. For the three months ended
December 31, 2001, commercial segment revenues from external customers, goodwill
amortization and segment loss were $56.4 million, $1.7 million and $(0.3)
million, respectively.

CONSTRUCTION SEGMENT

The following table presents net sales and segment profit expressed in
millions of dollars and segment profit margin, which is segment profit expressed
as a percentage of net sales:

Net sales for the Construction segment were $58.7 million for the six
months ended June 30, 2002, representing a $4.4 million or 8.1% increase from
$54.3 million for the six months ended June 30, 2001. The increase in sales in
2002 was primarily due to resilience of its end markets and strength at major
retail accounts. Segment profit after exclusion of goodwill amortization
increased by $0.8 million and 2.0% as a

16

percentage of net sales in the six months ended June 30, 2002 primarily as a
result of increased sales volume and management actions to reduce material
costs.

For the three months ended September 30, 2001, construction segment
revenues from external customers, goodwill amortization and segment profit were
$29.8 million, $0.7 million and $3.5 million, respectively. For the three months
ended December 31, 2001, construction segment revenues from external customers,
goodwill amortization and segment profit were $27.2 million, $0.7 million and
$3.1 million, respectively. Unallocated corporate expense for the three months
ended September 30, 2001 were $2.0 million. Unallocated corporate expense for
the three months ended December 31, 2001 were $2.0 million.

LIQUIDITY AND CAPITAL RESOURCES

Net cash provided by operating activities for the six months ended June 30,
2002 was $9.0 million. Net loss adjusted for non-cash charges, such as
depreciation and amortization, cumulative effect of a change in accounting
principle, amortization of deferred financing costs and foreign exchange gains
and losses accounted for approximately $7.9 million of positive cash flow. An
increase in the accounts receivable balance at June 30, 2002 decreased operating
cash flow by an aggregate of $3.9 million. While the accounts receivable balance
has increased from the year-end level, the second quarter is a significantly
higher sales volume quarter than the fourth quarter. As a result of our focus on
working capital reduction, receivables at June 30, 2002 were $1.5 million lower
than the June 30, 2001 balance despite the fact that sales for the quarter ended
were $3.1 million higher than that of the prior year. Inventory at June 30, 2002
has decreased $1.7 million from its December 31, 2001 balance again reflecting
management's progress on working capital. Compared to June 30, 2001, inventories
are $5.7 million lower. Accounts payable and other liabilities increased by $3.4
million in the first half of 2002. Accounts payable at June 30, 2002 were lower
than a year ago reflecting lower purchases related to reducing inventory levels
as well as lower capital spending.

Net cash used in investing activities was $2.5 million and $10.2 million in
the six months ended June 30, 2002 and 2001, respectively. In the current year
to date we incurred $2.5 million in capital expenditures that was $1.6 million
less than during the same period in 2001. This decrease was due to the
construction of a manufacturing facility in Brazil in 2001 as well as moderate
spending levels to date this year. In the prior year we incurred $6.1 million in
acquisition related costs relative to acquisitions completed in the last quarter
of 2000.

Net cash used in financing activities was $17.4 million and $2.9 million in
the six months ended June 30, 2002 and 2001, respectively. We repaid $7.5
million of principle required under our Term A loan and $8.6 million under our
revolving credit facility during the first half of 2002. We incurred $0.7
million of deferred financing costs associated with the amendment of our credit
facility on March 1, 2002.

Credit Facilities

As amended to date, our credit agreement provides for aggregate borrowings
of $125 million, including (1) a $50.0 million revolving credit facility, and
(2) a $75.0 million term loan facility. Borrowings under the revolving credit
facility are available on a revolving basis and may be used for general
corporate purposes, excluding; however, loans, advances and investments,
including acquisitions, by us other than specified exceptions. The revolving
credit facility will mature on December 30, 2005. Scheduled quarterly repayments
of amounts outstanding under the term loan facility began on September 30, 2001
and through December 31, 2003 amount to 50% of the amount outstanding under that
facility on September 30, 2001. The remaining 50% is scheduled to be repaid in
equal quarterly payments through December 30, 2005. At June 30, 2002 we had
$60.0 million outstanding under our Term Loan A facility, $20.6 million drawn
under our revolving credit facility and $1.9 million in letters of credit
outstanding. We also had $1.0 million drawn under a local $1.1 million
sub-facility for our Singapore-based sales office. Approximately $1.1 million of
our outstanding letters of credit are used to secure the Singapore facility. At
June 30, 2002, we had approximately $27.5 million of borrowing availability
under our revolving credit facility, which, after giving effect to the amendment
discussed below, left us with $17.5 million of effective availability.

17

On March 1, 2002, we and our lenders amended our credit agreement. The most
significant effects of the amendment are:

- amendment of our financial covenants to decrease the restrictiveness of
those covenants for the quarter ended December 31, 2001 and each of the
fiscal quarters in 2002,

- a new covenant by us to maintain borrowing availability under our
revolving credit facility (a) of at least $10.0 million at all times
prior to December 31, 2002 and (b) of at least $12.5 million from
December 31, 2002 through March 30, 2003 (the practical effect of this
covenant is to reduce our revolving credit availability by $10.0 million
and $12.5 million and to effectively increase the cost of our standby
commitment fee),

- a limitation on the use of advances under the revolving credit facility
to prohibit the use of advances for, among other things, acquisitions and
investments in non-guarantor, offshore entities, other than very limited
amounts,

- an increase of 50 to 100 basis points, depending on our leverage level,
in the applicable margin included in our interest rates,

- amendment of our investment covenant to prohibit any significant
acquisitions unless only capital stock is used as the purchase
consideration and, if the acquisition is completed before April 1, 2003,
no indebtedness is assumed or acquired (the practical effect of this
amendment is to prohibit any significant acquisition prior to April 1,
2003), and

- a decrease in our permitted levels of capital expenditures and
indebtedness outside the credit facilities.

Borrowings under the credit facilities bear interest at a rate per annum
equal, at our option, to either (1) the higher of (a) the current base rate as
offered by JPMorgan Chase or (b) 1/2 of 1% per annum above the federal funds
rate plus, in either case, an applicable margin or (2) a eurodollar rate plus an
applicable margin. The applicable margin is based on our ratios of total debt to
earnings before interest taxes, depreciation and amortization, or EBITDA, (which
is more specifically defined in our credit agreement) and senior debt to EBITDA
and varies for revolving credit facility borrowings and for loans under the term
loan facility, from 2.50% to 3.75% for eurodollar rate loans and from 1.50% to
2.75% for base rate loans. Our credit ratings do not affect the interest rates
for our borrowings under our credit facilities.

Our credit facilities obligate us to make mandatory prepayments in certain
circumstances with the proceeds of asset sales or issuance of capital stocks or
indebtedness and with certain excess cash flow. Our credit facilities include
covenants that restrict our and our subsidiaries' ability to incur additional
indebtedness, incur liens, dispose of assets, prepay or amend other
indebtedness, pay dividends or purchase our stock, and change the business
conducted by us or our subsidiaries. In addition, the credit agreement requires
us to comply with specified financial ratios and tests including maintenance of
specified total debt to EBITDA ratios, senior debt to EBITDA ratios, fixed
charge coverage ratios and cash interest expense coverage ratios (each of these
ratios and the terms used to calculate them are specifically defined in our
credit agreement). The table below sets out our actual ratios at June 30, 2002
and the ratios we must meet (i.e., debt to EBITDA ratios may not be exceeded;
coverage ratios must be met or exceeded) over the next three fiscal quarters.

- -------------------------
(1) Under the credit agreement definition of EBITDA, management fees and certain
one-time costs are added back.

(2) A ratio of EBITDA to interest expense.

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(3) A ratio of EBITDA to the sum of interest expense, principal payments on
indebtedness and capital expenditures.

Each of these covenants continues for the term of the credit agreement at
the latest level above, or a more restrictive level. A deterioration in our
current operating performance could result in our failure to satisfy our
financial covenants. In addition, unless our operating performance significantly
improves during the next three fiscal quarters, we may not satisfy the financial
covenants at March 31, 2003. A failure by us to satisfy the covenants under the
credit agreement would trigger the lenders' right to require immediate repayment
of all or part of the indebtedness; such acceleration, in turn, would also give
rise to a right to require immediate repayment by holders of our subordinated
notes. In the event of such acceleration, we can give no assurance that we will
have sufficient available funds to make such repayment. Our obligations under
our credit facilities are secured by substantially all of our assets and are
guaranteed by our domestic subsidiaries.

Senior Subordinated Notes

At June 30, 2002 the aggregate principal amount of our 11 7/8% senior
subordinated notes due 2010 was $149.2 million. The 11 7/8% senior subordinated
notes mature on March 15, 2010. Interest is payable semi-annually in arrears
each March 15 and September 15. On or after March 15, 2005, we may redeem these
notes, at our option, in whole or in part, at specified redemption prices plus
accrued and unpaid interest. The redemption price is 105.938% in 2005 and
decreases in equal annual increments to 100.000% in 2008 and thereafter. In
addition, at any time on or prior to March 15, 2003, we may redeem, in the
aggregate, up to 35% of the original aggregate principal amount of 11 7/8% notes
(calculated after giving effect to the issuance of additional notes, if any)
with the net cash proceeds of one or more public equity offerings by us, at a
redemption price in cash equal to 111.875% of the principal amount, plus accrued
and unpaid interest. In the event of a change in control, we would be required
to offer to repurchase the notes at a price equal to 101.0% of the principal
amount plus accrued and unpaid interest.

The notes are general obligations for us, subordinated in right of payment
to all existing and future senior debt and are guaranteed by our domestic
subsidiaries. The indenture under which the 11 7/8% senior subordinated notes
were issued contains certain covenants that, among other things, limit our
ability to incur additional indebtedness, incur liens, dispose of assets, prepay
or amend other indebtedness, pay dividends or purchase our stock, and engage in
transactions with affiliates.

Liquidity and Capital Requirements

We have a management agreement with AEA Investors Inc. pursuant to which
AEA Investors Inc. provides us with advisory and consulting services. The
management agreement provides for an annual aggregate fee of $1.0 million plus
reasonable out-of-pocket costs and expenses.

Interest payments on the amounts drawn under the credit facilities, as well
as other indebtedness and obligations, represent significant obligations for us.
Our remaining liquidity demands relate to capital expenditures and working
capital needs. Our capital expenditures were approximately $8.0 million in 2001
and management currently anticipates capital expenditures will be approximately
$7.0 million in 2002 and approximately $8.0 to $10.0 million in 2003. While we
engage in ongoing evaluations of, and discussions with, third parties regarding
possible acquisitions, as of the date of this report, due to the terms of our
credit agreement we have no current expectations with respect to any
acquisitions. Exclusive of the impact of any future acquisitions, joint venture
arrangements or similar transactions, management does not expect capital
expenditure requirements to increase materially in the foreseeable future.

The following summarizes certain of our contractual obligations at December
31, 2001 and the effect of such obligations are expected to have on our
liquidity and cash flow in future periods. During the ordinary

19

course of business, we enter into contracts to purchase raw materials and
components for manufacture. In general, these commitments do not extend for more
than a few months.

- -------------------------
(3) Represent principal amounts, but not interest.

Our primary sources of liquidity are cash flows from operations and
borrowings under our credit facilities. Based on current and anticipated
financial performance, we expect cash flow from operations and borrowings under
the credit facilities will be adequate to meet anticipated requirements for
capital expenditures, working capital and scheduled interest payments, including
interest payments on the amounts outstanding under the subordinated notes, the
credit facilities and other indebtedness through March 31, 2003. As discussed
above, our operating performance will need to improve significantly in order for
us to comply with our financial covenants under our credit facilities at March
31, 2003. As a result, our ability to satisfy capital requirements will be
dependent upon our future financial performance. Additionally our ability to
repay or refinance our debt obligations will also be subject to economic
conditions and to financial, business and other factors, many of which are
beyond our control. Factors that could affect our future financial performance
and our ability to repay or refinance our debt obligations are discussed below
and in Exhibit 99.1 to our Form 10-K under "Factors Affecting Future Operating
Results."

INFLATION

The costs of certain raw materials increased during the first half of 2001,
but stabilized by mid year. To offset these increases we raised our prices
selectively. We believe that our price increases were sufficient to recover new
raw material cost increases, but net to maintain our margins. During the second
half of 2001 some raw material costs decreased, however, a portion of this
relief was used to meet competitive pressures and maintain market share. There
can be no assurance, however, that our business will not continue to be affected
by inflation in the future.

FORWARD-LOOKING STATEMENTS

Some of the information presented in, or connection with, this report
include "forward-looking statements" based on our current expectations and
projections about future events and involve potential risks and uncertainties.
Our future results could differ materially from those discussed in this report.
Some of the factors that could cause or contribute to such differences include:

Changes in economic and market conditions that impact the demand for
our products and services;

Risks inherent in international operations, including possible
economic, political or monetary instability;

Uncertainties relating to our ability to consummate our business
strategy, including realizing synergies and cost savings from the
integration of acquired businesses.

The impact of new technologies and the potential effect of delays in
the development or deployment of such technologies; and,

Changes in raw material costs and our ability to adjust selling
prices.

You should not place undue reliance on these forward-looking statements,
which are applicable only as of August 14, 2002. All written and oral
forward-looking statements attributable to us are expressly qualified in their
entirety by the foregoing factors and those identified in Exhibit 99.1
incorporated by reference into this

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report. We undertake no obligation to revise or update these forward-looking
statements to reflect events or circumstances that arise after August 14, 2002
or to reflect the occurrence of unanticipated events. New risks emerge from time
to time and it is not possible for us to predict all such risks, nor can we
assess the impact of all such risks on our business or the extent to which any
risks, or combination of risks, may cause actual results to differ materially
from those contained in any forward-looking statement.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The principal market risks, which are potential losses in fair values, cash
flows or earnings due to adverse changes in market rates and prices, to which we
are exposed, as a result of our holdings of financial instrument and commodity
positions, are:

- interest rates on debt;

- foreign exchange rates; and

- commodity prices, which affect the cost of raw materials.

Our financial instruments include short-term debt and long-term debt. Trade
accounts payable and trade accounts receivable are not considered financial
instruments for purposes of this item because their carrying amount approximate
fair value. We do not maintain a trading portfolio and do not utilize derivative
financial instruments to manage our market risks. In the future, we may enter
into foreign exchange currency hedging agreements in connection with our
international operations.

MARKET RISK MANAGEMENT

We have measured our market risk related to our financial instruments based
on changes in interest rates and foreign currency rates utilizing a sensitivity
analysis. The sensitivity analysis measures the potential loss in fair values,
cash flows and earnings based on a hypothetical change (increase and decrease)
in interest rates and a decline in the U.K. pound/dollar exchange rate. We used
market rates as of June 30, 2002 on our financial instruments to perform the
sensitivity analysis. We believe that these potential changes in market rates
are reasonably possible in the near-term (one year or less). We have conducted
an analysis of the impact of a 100 basis point change in interest rates and a
10% decline in the U.K. pound/dollar exchange rate, discussed below.

INTEREST RATE EXPOSURE

Our primary interest rate exposure relates to our short-term debt and
long-term debt. We utilize a combination of variable rate debt, primarily under
our credit agreement, and fixed rate debt, primarily under our subordinated
notes. Our credit facilities require that, at least 45% of our funded
indebtedness be fixed-rate or subject to interest rate hedging agreements to
reduce the risk associated with variable-rate debt. At June 30, 2002
approximately 65% of our funded indebtedness was fixed-rate. The variable rate
debt is primarily exposed to changes in interest expense from changes in the
U.S. prime rate, the federal funds effective rate and the eurodollar borrowing
rate, while the fixed rate debt is primarily exposed to changes in fair value
from changes in medium term interest rates. Based on our indebtedness at June
30, 2002, we estimate that an immediate 100 basis point rise in interest rates
would result in $0.8 million increase in interest expense for the period July 1,
2002 to June 30, 2003. For purposes of this estimate, we have assumed a constant
level of variable rate debt and a constant interest rate over the period equal
to those existing on June 30, 2002.

CURRENCY RATE EXPOSURE

Our primary foreign currency exchange rate exposure relates to the U.K.
pound which results in our exposure to changes in the dollar exchange rate. Our
exposure to changes in U.S. dollar exchange rates with currencies other than the
U.K. pound are not currently material. Changes in translation risk are reported
as adjustments to stockholders' equity. We estimate that the impact of a 10%
decline in the dollar/U.K. pound exchange rate from $1.53/L1.00 to $1.38/L1.00
at June 30, 2002 would result in a decrease in our earnings before taxes of $1.3
million for the period from July 1, 2002 to June 30, 2003.
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These sensitivity analyses are estimates and are based on certain
simplifying assumptions. These analyses should not be viewed as predictive of
our future financial performance. Additionally, we cannot give any assurance
that the actual impact in any particular year will not.

COMMODITIES

We are subject to market risk with respect to commodities because our
ability to recover increased raw materials costs through higher pricing may be
limited by the competitive environment in which we operate.

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PART II -- OTHER INFORMATION

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

4.9 -- Second Supplemental Indenture dated as of July 9, 2002,
among Sovereign Specialty Chemicals Inc., the Guarantor
party thereto and the Bank of New York, as Trustee.
99.1 -- Factors Affecting Future Operating Results, incorporated
by reference to Exhibit 99.1 to the Company's Form 10-K
dated March 29, 2002.

(b) Reports on Form 8-K

The Company filed a report on Form 8-K, dated May 10, 2002, under Item 5,
other business, to provide an update on operations.

The Company filed a report on Form 8-K, dated July 26, 2002, under Item 5,
other business, to provide an update on operations and to announce the
appointment of a new Chief Executive Officer.

The Company filed a report on Form 8-K, dated August 13, 2002, under Item
5, other business, to provide an update on operations.

The Company filed a report on Form 8-K, dated August 14, 2002, under Item
9, regulation FD disclosures, containing the certifications required by Section
906 of the Sarbanes-Oxley Act of 2002.

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SOVEREIGN SPECIALTY CHEMICALS, INC.

SIGNATURES

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.

SOVEREIGN SPECIALTY CHEMICALS, INC.

/s/ NORMAN E. WELLS
--------------------------------------
Norman E. Wells, Chief Executive
Officer

/s/ JOHN R. MELLETT
--------------------------------------
John R. Mellett, Chief Financial
Date: August 14, 2002 Officer

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