First things first, specialty coatings company RPM International $RPM is not a cheap stock. Its current P/E ratio is close to 28, but
investing isn't really about where a stock has been. In the case of RPM,
Foolish investors are looking at a stock with significant leverage to
any upside to the U.S. commercial construction markets. Moreover, its
restructuring activities, new product launches and geographic growth
initiatives promise more growth in the future. It's not cheap, but if
you buy a recovery in commercial construction, then you might want to
Introducing RPM International
Paintings and coatings companies with large housing exposure like Valspar $VAL and Sherwin-Willliams $SHW outperformedin 2013 thanks to a recovering U.S. housing market. Meanwhile, a company with more of an industrial focus like PPG Industries $PPG
also outperformed, partly due to its household paints products, and
partly due to its convenient exposure to aerospace and automotive -- the
standout areas in the industrial sector.
But why has RPM underperformed the sector?
The answer is that RPM has much more exposure to
commercial construction, and growth in the industry has been lackluster
at best. For reference, RPM's consumer businesses only made up 35.6% of
its sales in the first half; it's the industrial business that counts.
The simple idea behind buying RPM is that,
historically speaking, the commercial construction sector (which its
industrial business is focused on) tends to lag behind residential. And
since the residential market started a recovery in 2013, then commercial
Unfortunately, this argument has been somewhat
weakened by recent falls in the commercial/industrial index from the
Architectural Billings Index. However, this is possibly due to the
unseasonally bad weather; a similar effect can be seen in the dip in the
Spring of 2013.
Ultimately, it only makes sense to buy RPM if you
believe that the commercial construction market will be stronger in
2014. However, there are many other reasons to like the stock.
Why RPM is attractive
the company has demonstrated an impressive ability to expand margins in
its consumer segment. For example, earnings before interest and taxes,
or EBIT, margins have expanded more than 360 basis points over the last
three years. This is partly due to new product introductions and
restructuring initiatives, but it's also due to a stronger housing
market pushing up its consumer sales up over the last two years. In
fact, consumer sales rose an impressive 11.2% in the last quarter.
Meanwhile, industrial margins have been lackluster.
However, if commercial construction picks up then it's reasonable to
expect its industrial margins to do so as well. And margin expansion
plus revenue growth equals larger profits.
Source: company presentation
Second, RPM has also restructured its European
operations and, according to management on the conference call, " modest
increases in this fiscal year in revenues are resulting in strong
bottom line leverage."
Third, in the commentary on the conference call,
management gave a cautious outlook on U.S. commercial construction. When
questioned on the matter in relation to its guidance for 2014, RPM's
We're not planning on any real pickup in end
markets. I think we're planning on -- but we're not planning on any
deterioration. I think you'll see continued sequential improvements, in
part because, from a cost perspective, we're better positioned to
leverage revenue growth to our bottom line
In other words, any upside from the U.S. commercial
construction market isn't baked into RPM's full-year EPS guidance of
Fourth, significant investments are being made to
expand its product reach in Latin America, and since RPM starts from a
low base, it should generate growth by grabbing market share alone.
Why RPM is unattractive
headline risk is obviously concerning the commercial construction
market, and it should be noted that RPM's management did not make
positive noises on the state of the current market.
In addition, the weather has been a factor for
construction activity, and RPM may disappoint in its next quarter.
Furthermore, its free cash flow is a bit of a concern. Excluding the
effects of a contingency payment, operating cash flow fell to $83.3
million in the first half from $127.6 million in last year's first half.
Around $18.1 million of the difference is due to spending more on
inventory (to support faster growth), but CEO, Frank Sullivan was candid
that he wasn't "satisfied" with RPM's working capital management.
The bottom line
above, RPM isn't conventionally cheap (cyclicals rarely are just before
their cycle is about to turn), and if commercial construction doesn't
pick up then the stock is likely to suffer.
On the other hand, it has raised guidance twice
already this fiscal year, and it's operationally leveraged to a market
that could turn up in 2014. If you like its end markets, then this is a
stock well worth watching in order to buy some in the current market