Monday, February 11, 2013

Sherwin-Williams, How Long Can This Run Keep Going?

The chart of coatings and paint company Sherwin-Williams (NYSE: SHW) has been a thing of beauty over the last year. One look at it reveals all you need to know about the progression of sentiment over the US housing market in 2012. A recovery has been a long time coming, but it looks to be finally here and SHW is doing all the right things by making acquisitions and expanding store rollouts. So is now the time to buy the stock?

Sherwin Williams a Year of Beating Estimates

It’s funny how much difference a year makes. SHW entered 2012 on a price of around $90 and guided to $5.52 in earnings. Meanwhile, the market was still highly skeptical of a rebound in housing after having seen a couple of false dawns before. Fast forward one year and SHW left 2012 priced at around $150, having hit earnings of $6.49. That's some difference.

Let me put it another way. Entering 2012, the market was willing to pay 16.3x forward earnings but now in 2013 it will pay 21.9x forward earnings (based on the mid-point of SHW’s guidance i.e. $7.45) for the stock. Is a recovery fully priced or is there upside to come?

SHW Price / Sales Ratio TTM data by YCharts

Looking at this chart you could make the case that the evaluation is justified if we are heading for a multi-year recovery in US housing but on the other hand it was never this high even going into the expansion from 2002-07.

The Case for Sherwin Williams

I can understand why the market loves the stock. The company is doing all the right things, and there are significant upside drivers here. Indeed market estimates for 2013 earnings are at $7.81, significantly higher that SHW’s guidance of $7.35-7.55.
Some of these factors below:
  • The purchase of Mexican coatings manufacturer Comex for a couple of billion should add to earnings (assumptions were not included in SHW’s guidance) and create synergies in an economy that is doing very well at the moment.
  • A multi-year recovery in the US housing market (new build included) starting from a low base
  • New store rollouts and the opportunity to expand further. SHW plans to get to 5,000 stores in North America, including around 300 from Comex plus the 78 planned for 2013 will still see it have less than 4,000 stores.
  • Industry consolidation: PPG Industries (NYSE: PPG) is buying Akzo Nobel’s US household paints division, and I think this might cause some firming of margins in the industry.
  • Pricing: The last pricing increase was in February 2012, and with a stronger housing market (and no pricing increases included in this year’s guidance) there is the potential to push through more.
These points are powerful arguments in favor of SHW but they come with a number of caveats.

Why I’m Not so Sure

Firstly, as noted above the evaluation of SHW does leave investors exposed to significant risk of any kind of change in sentiment on housing. Similarly, recall that its expansion plans are predicated on an improvement in US housing. I think it makes sense and I’m bullish on housing, but an investor needs to understand the risk/reward calculation. There is a long way down with SHW if I’m wrong about US housing and I could be.

Second, PPG Industries has much of a focus on global industrial production, so its development of Akzo Nobel’s former US household paint division will be somewhat affected by activities elsewhere. It’s a similar story with another rival Valspar (NYSE: VAL). The latter found it tough going in some of its international markets in 2012 but described Q4 volumes in its North America home improvement channel to be up low single digits with particular strength in retail.

Both PPG and Valspar are somewhat dependent on China, PPG on the industrial side (particularly automotive) and Valspar with housing.  My point is that any disappointments there could cause them to try to offset any earnings shortfall by being more competitive in the US. There is always a risk in assuming that market conditions will remain the same, and PPG is expanding into US housing so we can expect some increased competition here. By way of comparison PPG and VAL trade on nearly 22x earnings as opposed to SHW's 25x.

Third, input costs for things like titanium and propylene are always subject to uncertainty.
Finally, with regards to pricing SHW regards itself as an ‘input cost pricer’ to the marketplace. I suspect most companies would want to be seen as this to a certain degree  but it is the type of language used by corporations that are more in the ‘commodity’ type of pricing environment. In other words, they will lose market share if they increase pricing too much. Therefore, assuming any upside with pricing in 2013 for SHW is not advisable. Indeed, I got the sense the company was suggesting this on the conference call.

Where Next for Sherwin Williams?

The evaluation looks high enough for me, and as much as I like US housing there are probably other companies out there with a better risk/reward algorithm than SHW right now. The market has shifted from seeing the glass half empty to assuming that there is a free refill on tap.  As much as I like the stock, I am a fundamentals based investor and am willing to take a pass here when momentum based investors would just buy the stock. It's boring I know, but I'm investing my own money here.

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