2023-09-11 12:58:14 ET
Summary
- Sherwin-Williams has achieved strong growth in its Paint Stores Group, driven by increased volume and pricing growth.
- The company actively manages its brand and business portfolios, making strategic acquisitions and divestments.
- The Consumer Brands Group and Performance Coatings Group contribute to overall revenue but face some challenges.
Sherwin-Williams ( SHW ) is engaged in the manufacturing of paints, coatings, and related products. They own several leading brands such as Sherwin-Williams, Valspar, Minwax, Purdy, and more. Over the past decade, they have achieved an average annual organic revenue growth rate of 6.4%, primarily driven by demand in residential repaints, property maintenance, and new residential projects. However, their Consumer Brands Group and Performance Coating business are experiencing declining volumes, partially offset by increasing pricing. I consider Sherwin-Williams to be a high-quality, moderately growing company with some near-term headwinds.
Strong Growth in the Paint Stores Group
The Paint Stores Group, formerly known as The Americas Group, accounts for approximately 56% of the company's revenue. As of December 31, 2022, this group owned 4,931 specialty paint stores in the United States, Canada, Latin America, and the Caribbean region. In recent years, this business segment has consistently achieved strong same-store sales growth.
As depicted in the chart below, the Paint Stores Group serves a highly diversified range of end markets, catering to both DIY enthusiasts and professionals. During Q2 FY23 , the Paint Stores Group exceeded the company's expectations, achieving a remarkable 10% year-over-year growth. This growth was propelled by a 5% increase in volume and robust pricing growth.
I believe that the Paint Stores Group will remain a primary growth driver for Sherwin-Williams for several reasons:
Strong Sherwin-Williams Brand : According to Brand Finance's 2023 ranking , Sherwin-Williams dominates the global paint brand landscape, boasting a brand value nearly double that of the next most valuable brand, PPG. The strength of the Sherwin-Williams brand is evident in its widespread recognition among both DIY enthusiasts and professional customers. This brand recognition has already translated into consistent growth over the past decade.
New Store Openings : As of the end of FY22, The Americas Group operated 4,931 company-owned stores. In FY22 alone, they opened a net total of 72 new stores. Considering the relatively small number of stores, I believe that Sherwin-Williams is underrepresented in the United States, Mexico, and South America. The company's continued investment in capital expenditure for new store openings has the potential to fuel further growth for The Americas Group.
Pricing Power : Price growth is an integral part of their overall growth strategy. Historically, The Americas Group has successfully passed on any cost inflation to their end customers. Given their leading brand position, both DIY and professional customers tend to be less price-sensitive when it comes to paint pricing, in my opinion.
These factors collectively position the Paint Stores Group as a key driver of Sherwin-Williams' growth trajectory.
Active Portfolio Management
Sherwin-Williams has been proactively managing both its brand and business portfolios. In 2017, the company successfully completed its acquisition of The Valspar Corporation , a move aimed at expanding their industrial product portfolio. This strategic decision positioned Sherwin-Williams as a leader in various sectors, including packaging coatings, coil coatings, general industrial coatings, and industrial wood coatings. The acquisition of Valspar has proven to be strategically sound, leading to significant synergies in distribution, manufacturing, and product categories. In hindsight, it's clear that Sherwin-Williams has effectively capitalized on these post-acquisition synergies in recent years.
Additionally, in April 2013, Sherwin-Williams entered into an agreement to divest its China architectural paint business. This business segment generated approximately $100 million in revenue, and the deal is expected to be finalized in Q3 FY23. In my opinion, this divestment is a shrewd move for Sherwin-Williams. The Chinese property market is currently experiencing a bubble, with several major developers facing financial challenges, such as Country Garden, the largest property developer in China, as reported by CNN . Given the sluggish economic growth in China, I don't anticipate a quick turnaround in the Chinese property market. In summary, Sherwin-Williams is actively and strategically managing its business portfolio.
Consumer Brands Group
The Consumer Brands Group manufactures a diverse portfolio of branded and private-label paints, stains, and some industrial products. Their primary distribution channels are major retailers like Walmart ( WMT ) and Lowe’s (LOW). While these brands may yield lower margins compared to the Sherwin-Williams brand, I believe that the Consumer Brands Group can strategically expand their range of paint products, offering customers a wider range of price points to choose from.
In recent years, Sherwin-Williams has made strategic investments in retail partnerships to broaden their distribution channels. Furthermore, the Consumer Brands Group has demonstrated robust pricing power over its customers, with the group achieving a mid-single-digit pricing growth in Q2 FY22 .
Performance Coatings Group
Performance Coatings Group accounts for approximately 30% of group revenue and 20% of operating profits. The end markets include automotive, coil, general industrial, packaging, and protective and marine. The business growth is more tied with the general industrial production growth. Sherwin-Williams is operating with a local service model with great efforts on product innovation. I think Performance Coatings Group’s business cyclicality is quite different from the other two business lines, as the other two are tied with residential and commercial property markets. The end-market diversification enables Sherwin-Williams to reduce the overall cyclicality of their business.
Recent Financials
In Q2 FY23 , they achieved a remarkable 6.3% revenue growth and an impressive 38.9% growth in diluted EPS. Consequently, they revised their full-year guidance for adjusted diluted EPS, now expecting it to fall within the range of $9.3 to $9.7 per share, a significant increase from the previous guidance of $7.95 to $8.65 per share.
On the cost front, they anticipate a mid-to-high single-digit percentage decrease in raw material costs for 2023 compared to 2022, spanning several commodity categories. However, they foresee wages and other input costs rising in the mid-to-high-single digit range, according to management.
As previously mentioned, Sherwin-Williams wields pricing power over its customers, contributing approximately 5% to top-line growth in the quarter. This mitigates concerns about cost inflation.
Regarding working capital, the management aims to reduce it to a target range of 11% to 11.5% going forward. They are facing some challenges with accounts payables due to low production volume. Overall, I view this as a quite decent quarter, particularly with the guidance raise.
In addition, Sherwin-Williams' gross debt leverage stands at around 3x, demonstrating a significant reduction from the 5.1x level observed when they acquired Valspar.
On the cash flow, Sherwin-Williams generated $1.29 billion in operating cash during the first six months of FY23, an increase of 102% year over year. They returned $848.7 million in dividends and repurchased 2.3 million shares. I think their cash generation is quite strong and the company is managing their working capital and costs well.
Key Risks
Softness of New Residential Housing Market: In the U.S. market, the new residential market is estimated to represent 12% of total paint volume. The new residential market is quite volatile, partially driven by the interest rate.
With the Federal Reserve initiating interest rate hikes, the new residential housing market is encountering some difficulties. Overall, housing starts have been declining, although they remain higher than pre-2019 levels. The management team at Sherwin-Williams has acknowledged the challenges in the new residential market and has factored this weakness into their full-year guidance.
TiO2 Costs: Titanium dioxide (TiO2) and other white pigments are crucial raw materials in the paint manufacturing process. TiO2 costs have historically been subject to significant volatility. According to their management, key input costs like chlorine for TiO2 are currently elevated, leading to higher TiO2 costs. However, they anticipate a more favorable trend in TiO2 costs in the second half of FY23.
TiO2 costs have exhibited high volatility in the past, often correlated with crude oil prices. While predicting TiO2 price movements can be challenging, I believe that Sherwin-Williams possesses the capability to pass on any cost inflation to their customers.
Valuation
I estimate that in FY23, Sherwin-Williams will experience limited revenue growth of approximately 4% due to weak volume growth. This estimate is based on a normalized revenue growth assumption, comprising 5% organic growth and an additional 1% from acquisitions.
In the DCF model, I've estimated that the operating margin and free cash flow margin will reach 17.5% and 16.8%, respectively, by FY32. Overall, I believe Sherwin-Williams can achieve a high-single-digit operating profit growth and low-double-digit EPS growth. The model employs a 10% discount rate, a 4% terminal growth rate, and a 20% tax rate. Based on my estimates, the fair value of the stock price is estimated to be $220 per share.
Grand Finale
I acknowledge that Sherwin-Williams is a well-managed coatings company with moderate growth prospects. However, their volume growth is currently facing economic challenges, and the stock price appears to be overvalued. Therefore, I give it a 'Hold' rating.
For further details see:
Sherwin-Williams: A Well-Managed Business In A Turbulent Economic Landscape