Contents
Summary
- Following the 2017 Valspar acquisition, SHW is the leader in the highly fragmented coatings industry with the top 10 suppliers holding a ~55% market share.
- Goodwill and Intangible Assets now comprises over 64% of SHW’s Total Assets.
- SHW’s Long-Term Debt to EBITDA ratio upon completion of the Valspar acquisition rose to 4.5Xs. At its current ~4.1Xs, it is still elevated but management is diligently working toward deleveraging.
- I view SHW as a superior long-term investment than PPG.
- Despite a ~15% retracement from its 52 week high I still view SHW as being slightly overvalued and am of the opinion we will encounter further market turbulence which may reduce SHW’s share price further.
Introduction
This article regarding The Sherwin-Williams Company (NYSE: SHW) is a follow up to my recent Embrace Market Pullbacks and PPG Industries, Inc. (NYSE: PPG) articles.
In the Embrace Market Pullbacks article I suggested investors avoid panicking when markets encounter ‘speed bumps’ and to view pullbacks as opportunities to either add to existing positions or to initiate positions at more favorable valuations.
In my PPG article I indicated that I had given PPG and SHW a cursory review a few months ago and found both to be somewhat expensive for my liking. I didn’t bother writing about either company and simply moved on although I did diarize to analyze PPG and SHW subsequent to the release of their Q3 results (October 18th and October 25th respectively).
My reasoning for moving up my PPG and SHW reviews, however, was prompted by last week’s market pullback. What I noticed was that PPG’s share price ($95.02) is ~22% below its 52 week high and that for SHW ($406.97) is ~15% below its 52 week high and neither stock price experienced at least a bit of a ‘snap back’ following the 2 day pullback.
I have already indicated that I will PASS on investing in PPG. In this article I look at whether SHW is now attractively valued.
Overview
SHW, founded in 1866 and incorporated in Ohio in 1884, is engaged in the development, manufacture, distribution and sale of paint, coatings and related products to professional, industrial, commercial and retail customers primarily in North and South America with additional operations in the Caribbean region, Europe, Asia and Australia.
Source: SHW – 2017 Annual Report page 3 of 85
On June 1, 2017, SHW completed the acquisition of The Valspar Corporation in an all cash transaction for a total purchase price of $8.9B net of divestiture proceeds of $0.431B from the sale of Valspar's North American industrial wood coatings business to Axalta Coating Systems Ltd..
Following this acquisition, SHW reorganized into 3 reportable operating segments: The Americas Group, Consumer Brands Group and Performance Coatings Group. The following images provide an overview of how the segments have been realigned together with Sales and Profit results for Q2 2018.
Source: SHW – Operating Segment Reconciliation Q2 2018
SHW has the leading market share among professional painters, who value brand, quality, and store proximity far more than their do-it-yourself counterparts.
SHW charges a premium for its paints but since paint typically only accounts for ~10 – 20% of painting contractor costs, painting contractors are generally not especially price-sensitive about paint costs. SHW’s paint might cost a bit more than that of competitors but paint contractors save on overall costs by purchasing high-quality paint that reduces preparation and application time (ie. lower labor costs); SHW’s paint is well known in the industry for having desirable characteristics, including the need to apply fewer coats, longer lasting, ease of application, and less cure time.
In SHW’s May 22, 2018 Financial Community Presentation, SHW presenters discussed at length the following 5 reasons for solid growth prospects.
- New construction;
- Repaint and remodeling;
- Protective and marine;
- Global Manufacturing;
- Auto Refinish.
The following images show the extent to which the industry participants have changed in the last few years. This images reflect the industry in 2015.
Source: Financial Community Presentation - May 26, 2016
This image reflects the industry participants in 2017 following SHW's acquisition of Valspar.
Source: SHW - May 22, 2018 Financial Community Presentation
Financial Targets
Given that SHW will be releasing its Q3 results on October 25th, I will dispense with a review of Q2 results. Instead, I draw to your attention key pages from the Financial Overview section from SHW’s May 22, 2018 Financial Community Presentation.
With the magnitude of the Valspar acquisition, the investment community is focused on the extent to which SHW will realize synergies and by when these synergies will be realized.
Source: SHW - May 22, 2018 Financial Community Presentation
Management has indicated it is targeting a steady state of future Free Cash Flow of more than 11% of Sales. In addition, management is looking to reduce Long-Term Debt to EBITDA from 4.5Xs (at the close of the Valspar acquisition) to 2Xs to 2.5Xs.
Source: SHW - May 22, 2018 Financial Community Presentation
Credit Ratings
The following image reflects SHW’s credit ratings from 3 major ratings agencies.
Source: SHW - May 22, 2018 Financial Community Presentation
SHW’s objectives do not include the desire to attain a credit rating in excess of the top tier of the lower medium grade category. The BBB+ target key objective, however, is still an investment grade credit rating.
Source: SHW - May 22, 2018 Financial Community Presentation
SHW has a considerable amount of long-term debt due prior to 2023.
Source: SHW – Form 10-K Schedule of Long-Term Debt
Source: SHW - May 22, 2018 Financial Community Presentation
SHW, however, generates free cash flow which should enable it to meet its short-term objective of reducing total debt by $1B in 2018. I fully anticipate that significant debt reduction will continue to occur between 2019 and 2022.
While SHW has a somewhat elevated debt level as a result of the Valspar acquisition, I take comfort that managing debt is the first item listed under ‘Uses of Cash’. Despite SHW’s credit ratings from the major ratings agencies being a few notches below those accorded to PPG, I am reasonably comfortable that SHW’s management and Board of Directors have investors’ best interests at heart and will strive not to let SHW’s credit ratings deteriorate to non-investment grade.
Goodwill and Intangible Assets
In my recent PPG article I noted that PPG had recently finally completed the divestiture of non-core businesses. When you look at PPG’s acquisitions in recent years they have been primarily bolt-on acquisitions versus transformational acquisitions.
SHW, however, made a transformational acquisition when it completed its acquisition of Valspar in mid-2017. That acquisition resulted in the ballooning of SHW’s Goodwill and Intangible Assets.
As at the end of FY2016, SHW only had ~$1.127B of Goodwill and ~$0.255B of Intangible Assets on its Balance Sheet. By the end of FY2017, Goodwill was $6.814B and Intangible Assets was $6.002B.
Both Goodwill and Intangible Assets represented ~20.4% of Total Assets at the end of FY2016. At FY2017, these Balance Sheet categories represented over 64% of SHW’s Total Assets! This strikes me as an inordinately high level but I have utmost confidence that SHW was fully aware of what their Balance Sheet would look like post Valspar acquisition hence the reason debt reduction is of utmost priority.
Valuation
SHW’s Q3 results are scheduled to be released October 25th so at the moment Q2 results released July 24th are the most recent results available.
Unlike PPG, SHW has given the investment community no indication that its previously provided forecast requires a downward revision.
The following is what SHW communicated to the investment community on July 24th.
‘We are updating our full year 2018 diluted net income per share to be in the range of $15.00 -$15.20/share, including charges of $3.80 - $3.90/share for acquisition-related costs and $0.25/share for environmental expense provisions.’
‘We are raising our full year 2018 adjusted diluted net income per share to be in the range of $19.05 - $19.35/share, excluding acquisition costs and environmental expense provisions.’
Source: SHW – Operating Segment Reconciliation Q2 2018 Presentation
When these results were released July 24th, SHW was trading at ~$420 thus resulting in a forward PE of ~27.8 (using EPS of $15.10) and a forward adjusted diluted PE of ~21.88 (using diluted EPS of $19.20).
On the basis of SHW’s current ~$407 share price, the forward PE is ~27 and the forward adjusted diluted PE is ~21.
The current forward PE, subsequent to the ~15.15% retracement from SHW’s 52 week high of ~$480 reached less than 1 month ago, is now close to the 5 year average PE of ~27.5.
In my opinion SHW is slightly overvalued with a price closer to $390 being a fair value. If we experience further volatility as evidenced October 10 – 11, I would not be surprised to see SHW retrace to the $390 level.
Historical Performance
Unlike PPG, SHW has performed well relative to the S&P 500 within the short-term and the long-term.
SHW has also vastly outperformed PPG.
Source: Tickertech
Investors insistent upon an attractive dividend yield would be wise to look elsewhere as SHW’s current dividend yield is sub 1%.
Whenever I look at a company’s website and find that the section related to Dividend History is not being maintained current I view this as a telltale sign that the company’s dividend is not a top priority.
When you look at the section from SHW’s dividend history found in its May 22 2018 Financial Community Presentation you see that SHW has increased its dividend on a regular basis for ~39 years but dividend growth has dropped dramatically in recent years.
Source: SHW - Financial Community Presentation May 2018
Share Repurchases have also taken a back seat as evidenced from the following image.
Source: SHW - Financial Community Presentation May 2018
My observation regarding SHW’s reduction in dividend growth does not insinuate that I think SHW’s dividend is at risk; SHW is profitable and generates ample Free Cash Flow to service its dividend. I am merely pointing out that you should temper your expectations as to dividend growth (and share repurchases) while SHW focuses on digesting its Valspar acquisition; in the May 22 2018 Financial Community Presentation , management indicated cash would be allocated toward:
- Debt management;
- CAPEX;
- Dividends;
- Acquisitions;
- Share buybacks.
Source: SHW - Financial Community Presentation May 2018
On the stock split front…the last time SHW split its shares was in 1997. I do not envision a stock split in the foreseeable future.
Final Thoughts
Despite the ~15% retracement from its 52 week high I am of the opinion that SHW is still moderately overvalued. Given that SHW did not experience a ‘snap back’ following the October 10th and 11th market pullback I wonder whether the investment community is of the same opinion.
Having said this, I view SHW as a more attractive long-term investment opportunity than PPG even though PPG’s valuation is currently slightly more attractive.
I will continue with my ‘wait and see’ approach as I am of the opinion we will encounter further market turbulence in the short-term which may hopefully reduce SHW’s share price further.
I wish you much success on your journey to financial freedom.
Thanks for reading!
Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
Disclosure: I do not currently hold a position in SHW and have no intention of initiating a position within the next 72 hours.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.
