Summary
- SHW is a long-term compounder and has crushed the market over the past couple of decades.
- The company will be fine over the long term, but the near-term outlook isn't great, and management seems committed to arguably wasting capital on inflated share buybacks.
- Considering the issues, investors aren't really getting a deal on SHW today. It's a hold.
Sherwin-Williams (SHW) was an obvious choice for me to dig into as I look across the market for the best compounders. The company is a dividend aristocrat, with a soon to be 45-year dividend increase streak, carries significant brand equity, pricing power, and has a long history of beating the market.
Looking above, an investment of $10,000 in 2003 would have yielded a 17.45% annualized total return and you'd have ended up with about $250,000 versus around $52,000 in the S&P 500. It's no small feat to quintuple the market returns over the past two decades.
If you look back through the articles and coverage written about SHW over time, the vast majority discusses the company as too expensive. I've shifted my mindset somewhat. I definitely enjoy finding a good deal in the market, but I'd much rather own a winner. If the market assigns a premium multiple to that company, I'll buy it. However, I think the most useful thing you can do in that case is validate the company will both continue winning and continue to deserve its premium multiple.
There are obvious exceptions. I'm not going to pay any price for a company.
SHW transformed itself somewhat with its acquisition of Valspar in 2016. It pushed the company into an undisputed leadership position in paints and coatings and opened the doors to more international operations and an expansion in industrial coatings. SHW has historically excelled in the higher-margin residential market. The Valspar acquisition also helped the company seal an exclusive deal with Lowe's (NYSE: LOW ) in 2018, which set the company up for significant exposure to the DIY market on top of its professional customer base from the company branded stores.
Company Presentation Company Presentation
Across the board, the company's operating metrics look pretty solid. 2020 pulled forward quite a bit of demand in residential which the company is working off now. Adding to that pain, input cost inflation and supply chain woes have led to a pretty bleak outlook from management.
The most recent quarter saw 9.8% sales growth YOY, with full year 2022 sales growth coming in at 11.1%. EBITDA was up 10.4%. However, management outlook for the coming year is for flat to down mid-single digits sales growth, earnings per share of $7.95-8.65 per share with 80-100 new stores. At the low-end of guidance, SHW is trading at 28X forward earnings, which isn't great. Here's some color from the earnings call :
On the architectural side, it's no secret that U.S. housing will be under significant pressure this year. Single-family permits have been down year-over-year for 10 consecutive months, and single-family starts have been down year-over-year for eight consecutive months. Mortgage rates also remain elevated.
As a result, we believe our new residential volume could be down anywhere from 10% to 20% this year. We expect our other PRO end markets to be more resilient than this, but there are headwinds in these areas, too.
For example, existing home sales, which drive a portion of our repaint business have declined year-over-year for 16 straight months. Now while we see a backlog of new commercial construction, the Architectural Billing Index has contracted the last three months.
On the DIY side, we expect inflation to continue putting pressure on consumer behavior in the U.S. and in Europe. On the industrial side, the PMI numbers for manufacturing in the U.S., Europe, China and Brazil have been negative for multiple months.
We have already seen an industrial slowdown in Europe and the same is beginning to appear in the U.S. across several sectors. In China, COVID remains a wildcard and the trajectory of economic recovery is difficult to map. The U.S. housing slowdown will also impact some of our industrial businesses, namely industrial wood where we have already seen pressure and coil to some extent.
I know that's a wall of text, but it's the most perspective I've seen in a while from a management team on how many headwinds are facing the business in the coming year. SHW does maintain pretty substantial pricing power. Professional painters are not overly sensitive to price, with paint itself not a substantial part of the cost of a painting job. SHW maintains strong loyalty with its customers with its loyalty program, jobsite delivery, and innovations in their paint which removes the incentive for customers to switch away from a favored brand.
However, the outlook is not rosy, and explains why SHW has sold off pretty brutally.
Expenses show the SHW management team are shrewd operators. The company operates over 4,900 stores, and continues to grow the store count over time. With that, we are seeing here expenses growing slower than revenues for the company, which is great.
Management is projecting SG&A as a percentage of revenues increasing this next year. With revenue projecting to be flat to down, that's not surprising. SG&A expenses are expected to rise on mid single-digit increases in wages, energy and transportation costs.
I'm showing you a very zoomed out look at margins to show how stable SHW has been over the long term. There's a slightly positive slope on operating margin, but you're seeing a business that maintains costs and expenses throughout the economic cycle.
Returns on invested capital are a little less rosy. While ROIC is greater than WACC and shows shareholder value creation, I'd like to see higher returns on capital deployed. The big change here is likely the Valspar acquisition in 2016. What this shows me is less than ideal capital deployment to drive growth in the bottom line.
Long-term debt shot up on the Valspar acquisition, and management has discussed delevering the balance sheet over time. They are currently targeting 2-2.5X EBITDA leverage ratios. Free cash flow hasn't necessarily grown all that well over time, but capex has. SHW is currently working through a restructuring expected to yield $50-70M in savings over the next couple of years. Additionally, new store openings and improvements to the supply chain are all capital intensive operations.
But, adding to that is what I think is a deal-breaker for me. SHW is an expensive stock, and has been for a long time. However, management remains committed to buying back shares at what I think are inflated prices. This past year, the company spent $883M to repurchase 3.35M shares at an average price of $263.64. The current share price is $223 give or take. $263.64 puts the company at 33X the low-end of forward earnings guidance.
The dividend this coming year is getting hiked by 0.8%, or $.02 to $2.42 per share. I understand share buybacks can help boost EPS when you reduce the denominator. However, that money would be better spent either delevering or increasing the dividend further. With dividend aristocrats, though, management teams are often hesitant to overly increasing the dividend because they'll lose some of their investor base if they ever have to cut it. Either way, I can't get myself there on thinking these buybacks are a good idea.
The share price has been crushed since 2021's euphoric highs off of outsized 2020 demand. However, the stock still isn't cheap, and the outlook for sales and earnings growth is rough over the near term.
Based on analyst estimates for earnings growth, an investment today would yield <4% annualized if the company returns to its long-term average valuation against earnings.
If the company maintains its higher valuation of recent years, an investment today could yield closer to 11% annualized.
Looking at free cash flow, and as I discussed above they've taken a hit with recent investments. However, prior to that we saw a nice trend upwards of compounding free cash flow growth, and it's projected to continue starting in 2024.
Based on analyst estimates for cash flows and the company's long-term P/FCF multiple, investors could be looking at around a 10% annualized total return.
SHW is assuredly a strong operator. The company maintains a leadership position in paints and coatings, and has many levers to pull to maintain its pricing power. The company has done a good job of controlling expense growth as it expands its store footprint. There will come a point where they saturate the market with paint stores, but it doesn't appear to be in the near to medium term.
However, the near-term outlook is bleak. I'm willing to look past that in almost all cases, because SHW will do just fine in the long run. However, investors aren't really getting a deal on the company considering that outlook. The company is still trading at a premium to its own long-term premium averages.
Additionally, share buybacks at inflated prices is a terrible use of capital. ROIC's have declined since the Valspar acquisition, and you're definitely not buying this company for current income. All in all, SHW stock is a hold. I wouldn't sell over these concerns, but this isn't a company I'm looking to buy here. Give me some more Lowe's stock instead.
For further details see:
Sherwin-Williams: Inflated Buybacks, Bleak Near-Term Outlook