RPM - RPM International: Wait A Little Longer

2023-06-13 05:58:58 ET

Summary

• RPM International's stock has dropped 14.5% and still appears overvalued.
• The company's revenue growth and profitability are driven by government spending, which may not be sustainable in the long term.
• Any drop in interest rates and increase in the spending power of the consumer could drive this stock higher.
• Many things have to go just right for this stock to succeed in this environment.

In my January analysis , I stated that RPM International ( RPM ) was so highly valued that its execution had to be flawless. The analysis proved correct; the stock has dropped 14.5% based on a total return basis, while the S&P 500 Index has gained 11.5%. The stock has underperformed despite the boost the company continues to receive from Federal spending. Even after this drop, the stock looks overvalued or, at best, fully valued. There is no margin of safety for a long-term investor at these prices. RPM may have to return to its 52-week low of $75 before investors consider it. Even at those prices, RPM stock would be trading at a P/E of 17.6x based on an estimated $4.26 EPS in 2023.

Revenue growth is driven by government spending in the U.S.

RPM International grew sales by 8% in North America in Q3 2023 (Exhibit 1) . Europe saw sales decline by 3.6%, while Asia-Pacific saw a decline of 0.9%. The company depends on North America, generating about 76% of total sales. The company has some ways to go in its fight against inflation to recover its margins. However, most companies in the sector have suffered gross margin erosion in 2022 (Exhibit 2) . The company achieved a gross margin of 36.2% in 2022 compared to 37.7% in 2019. The company's quarterly gross margins were even lower, at 35.4% in the quarter ending February 2023, compared to 38.5% in November 2022 (Exhibit 3) , indicating the company continues to fight an uphill battle against inflation. The company's operating margins have recovered nicely, surpassing its 2019 levels (Exhibit 4) . It might also be difficult for most companies to achieve the record-high margins of 2021, where extraordinary demand driven by low-interest rates and Federal and state stimulus spending drove record demand and helped push margins to highs never seen before.

Exhibit 1:

Exhibit 2:

Exhibit 3:

Exhibit 4:

The company touted "management execution" as the primary reason behind its revenue growth and profitability in Q3 (Exhibit 5) . The challenge I have with RPM International and many other companies in the industrial, materials, and other sectors is that they benefit from the largesse of the U.S. Federal Government or, more specifically, the U.S. taxpayer. Many people are surprised by the strength of the labor market in the U.S. after record-breaking interest rate hikes by the Federal Reserve. The primary reason behind that strength may be the spending by the Federal government.

Exhibit 5:

The various laws passed over the past few years, the Infrastructure Investment and the Jobs Act, the Inflation Reduction Act, and the CHIPS Acts, are helping prop up the U.S. Economy. These tax subsidies and credits fund the "EV revolution," near-shoring of manufacturing, and the economically unviable renewable fuels . The tax subsidies are the only reason why the Tesla Model 3 is now cheaper than the Toyota Camry . A family in the upper echelon of income in the U.S., making over $250,000, would be foolish not to buy an EV and grab nearly $10,000 in tax credits [Federal + State tax credits]. It turns out the EV revolution is primarily benefitting the rich . It is not just Tesla benefitting from tax subsidies; it is companies such as RPM International and many more, from Caterpillar ( CAT ) to Micron ( MU ) and Intel ( INTC ) to Darling Ingredients ( DAR ).

In Q2 2023, its Construction Products Group was negatively impacted due to its exposure to Europe and new residential home construction in North America. This shows that organic demand is dropping, replaced by Federal spending. The company mentioned the following in the Q2 2023 earnings call:

"We also generated volume growth in several of our businesses that benefited from continued reshoring and infrastructure spending, as well as from improved material availability."

In the Q3 2023 earnings presentation, the company explicitly acknowledged the benefits it would continue to reap from various Federal and State subsidies (Exhibit 6) . Long-term investors must ask what happens to revenue growth and profitability, and more importantly, shareholder returns, when these Federal Government subsidies are no longer available in a few years.

Exhibit 6:

The U.S. economy is facing an aging demographic which, coupled with increased spending on healthcare that comes with an aging population, will likely be a negative for economic growth in the coming years. Recently consumer credit card debt in the U.S. crossed a trillion dollars . Even people between ages 50-64 owed, on average, over $7,000, and people above 65 years owed, on average, over $4,700 in average credit card debt in 2023. This segment of the population is closest to retirement, and they carry a high debt load. Given these headwinds to consumer spending, the U.S. stock market could see little or no returns, in essence, flat returns, over this decade. It remains to be seen if technological advancements, such as artificial intelligence, will boost productivity, lifting income and economic growth. Such a boost to growth would be most welcome and benefit all companies, including RPM International. Even if AI offers substantial cost savings to various companies, would the economic value accrue to the AI vendors or the technology users?

RPM International lacks momentum

RPM International has had a bad year in terms of its stock's performance. It has dropped 4.7% over the past three months, compared to 2.3% for the materials sector. Over the past year, the stock has dropped 1.8% over the past year, while the materials sector has dropped 11.8%. Over a 10-year period, the stock has almost kept pace with the S&P 500 Index with a total return of 214% compared to 216% for the S&P 500 Index (Exhibit 7) . The stock has outperformed the index by 1000 basis points over the past five years and has significantly lagged behind the index over a three-year period.

Exhibit 7:

The stock has a beta of 0.93 , meaning it moves almost in line with the market. Given this beta, the stock's significant underperformance may be an aberration, and either the market will catch up to the stock or vice versa. The market's volatility has dropped in recent months, with the S&P 500 VIX Index ( VIX ) at 14.7%, close to the lows attained before the pandemic lockdowns in 2020. Given the numerous headwinds facing the U.S. consumer, it is more likely for the market's volatility to increase and the S&P 500 to dive lower in the coming months.

The lack of breadth in the current rally in the market is another worrying sign. A few technology companies , such as NVIDIA and Microsoft, have driven the market to new heights, while the rest of the S&P 500 index companies are either flat or down for the year. This narrow breadth cannot last, and pretty soon, investors will have to get confirmation of this bull market from the rest of the companies in the S&P 500 Index. The technology companies fueling this rally have already seen their valuation multiples expand.

The direction of the economy is still unclear. The Federal Reserve is unsure whether the U.S. economy will continue to see receding inflationary pressure. If inflation continues to recede, interest rates might have finally peaked, paving the way for a potential drop in rates in the coming month if unemployment rises. The U.S. Bureau of Labor Statistics will release its Consumer Price Index report on Tuesday, July 13 , which may shed more light on the direction of inflation.

The residential construction market could see a boom in demand if mortgage rates drop, spurring a new round of increased consumer spending. RPM's product portfolio is also geared toward repair and maintenance projects, which could see a massive rebound as inflation fades, rates decline, and consumer spending rebounds. In short, the stock is richly valued in the face of too much uncertainty facing the stock market. Long-term investors may be better off waiting for clarity before buying the stock, or the stock has to drop further and give investors some safety in owning it.

Dividend

The drop in the stock price has increased the dividend yield to above 2% , and the payout ratio is a safe 37.6%. The company has grown its dividend at a respectable CAGR of 5.6% CAGR over the past five years. RPM's debt-to-EBITDA ratio of 2.9x is on the high side for the current rate environment. The company carried $2.8 billion in long-term debt at the end of its Feb 2023 quarter and generated $936 million in EBITDA over the past four quarters (Source: Seeking Alpha) . The company made $211 million in total dividend payments in 2022, easily covered by cash generated by its operations. Even at a 2% yield, the stock's dividend is low.

RPM International's stock has fallen as predicted, and it may suffer more as the economic headwinds in the U.S. take their toll. The spending by the Federal government is a bright spot, not just for RPM International but for many companies across various industrial, materials, and technology sectors. Even after this pullback, the stock is fully valued at best. Long-term investors may have to wait for a better buying opportunity in RPM International.

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