RPM - RPM International Offers Underated Revenue And Margin Leverage

2023-10-18 18:09:35 ET

Summary

• RPM International has outperformed its peer group, helped by strength in infrastructure, re-shoring, and repair/maintenance activity.
• Infrastructure and re-shoring should remain strong drivers in 2024 and consumer destocking should be largely over, though weaker non-resi new-build and repair remain threats.
• Margin leverage could surprise to the good, as management continues with an efficiency drive and as commodity prices ease.
• RPM seldom gets exceptionally cheap, but today's price offers a decent prospective return.

A couple of years ago I called RPM International ( RPM ) a “borderline buy”, and investors who took advantage of a few of the dips since then, including one earlier this year, are now sitting on pretty solid 20% gains as the company has been picking some steam on expectations of respectable top-line growth in FY’24 and improving margin leverage.

Since that last article , RPM has handily outperformed the broader industrial space, as well as coating companies like Axalta (AXTA), PPG (PPG), and Sherwin Williams (SHW), as well as construction chemical/materials specialist Sika (SXYAY). Valuation is never simple with RPM, as the Street has long awarded the stock with a premium (not uncommon for specialty chemical companies), despite a more mundane track record of FCF growth and capital returned to shareholders than you might otherwise expect (around 6% and 8%).

There’s nothing wrong with a “slow and steady wins the race” structure, though, and at the right price I think RPM is definitely worth considering. With decent top-line drivers in place, opportunities for both external and internal cost/margin leverage, and a reasonable valuation, it’s not a bad GARP idea even within 10% of its highs.

A Shakier Top-Line Outlook, But With Areas Of Strength

RPM has a fairly diverse end-market mix, which is both a blessing and a curse at this point in the cycle.

On the negative side, residential construction is likely to remain around where it is for another three or four quarters, and I don’t see much ongoing uplift from repair/remodel or DIY demand. I don’t expect significant destocking from here (from major retailers like Home Depot ( HD ) and Lowes ( LOW ) particularly), but I also don’t expect a lot of tailwinds either. I also see weaker demand for housing-driven categories like furnishings and furniture, which will keep pressure on the Specialty segment.

Also on the negative side, non-resi new-build is weakening and likely to weaken further in the face of higher rates, macro uncertainties, and softer recent trends in areas like office, retail, and warehouse. I also see some potential risk to the repair market that has been a source of strength, as declining appraisal values in some areas of commercial real estate won’t be so supportive for ongoing reinvestment.

On the positive side, infrastructure isn’t a huge part of the business (5% to 10%), but this sector should ramp significantly in 2024 and beyond as federal stimulus works itself into actual projects and procurements (contract awards for roads and bridges have been growing at a double-digit pace in recent months).

I also do still see ongoing leverage to new-build in areas like industrial tied to reshoring, and while I think some segments of non-resi will start deferring maintenance and repair, there’s still a sizable addressable market opportunity to help drive growth in 2024. Lastly, more niche demand from stronger industrial end-markets like oil/gas should provide some incremental upside.

Margin Leverage Could Drive Upside

Not all commodity costs have come down equally (titanium dioxide prices have been pretty sticky, for instance), and higher oil prices remain a risk for petroleum-derived materials, but overall the environment looks supportive for lower input costs in 2024 and beyond. At the same time, while I don’t see much incremental pricing power for RPM from here, I also don’t the company cutting prices.

There will be some lag because of the company’s accounting, but I think every 5% reduction to costs in its commodity COGS could drive around $0.80-$1.00/share in incremental profits.

On top of that, management has ongoing restructuring efforts to draw upon. Management launched another round of restructuring (focusing on procurement and manufacturing optimization) a year ago with a $465M run-rate target by 2025, and incremental progress here should be supportive for margins.

Given the numerous acquisitions made by the company over the past decade-plus, and the company’s generally hands-off approach, the business eventually became too sprawling and inefficient, and reining this back in should be relatively low-hanging fruit. I’d also note that this restructuring opportunity could drive further cross-selling opportunities as units become more integrated and less independent in their operations.

The Outlook

RPM exceeded my revenue expectations in the last two years, but came up shorter on EBITDA margin leverage and free cash flow generation. Higher costs (commodities, labor, transport, et al) can explain some of this, but I’ve been waiting for more sustained improvement in margins and free cash flows for some time now and that wait goes on.

I’m looking for around 4% to 5% growth over the next three years and longer-term annualized revenue growth in the neighborhood of 4%. Acquisitions could still add to this, but RPM’s getting to a size where it’s harder to find needle-moving tuck-in/bolt-on deals.

On margins, I’m looking for around 250bp of EBITDA margin improvement over the next three years, and I’ve pushed out my expectations for double-digit FCF margins to FY’28/29 (five years). If management can drive FCF margins into the low-double-digits over time, mid-teens FCF growth is achievable.

Between discounted cash flow and margin/return-driven multiples-based valuation, I think near-term fair value is in the $100 to $106 range, with longer-term annualized total return potential on the low end of the high single-digits.

The Bottom Line

RPM isn’t dirt-cheap, but it would take a pretty dire macroeconomic outlook or a significant stumble from management to dive the shares to that point. Given a respectable revenue outlook and possible additional upside from margins in FY’24/25, I think these shares are at least worth consideration.

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