2023-12-28 17:13:00 ET
Summary
- Sherwin-Williams exhibited strong gross margin in Q3 FY23 due to price increases and moderation of raw material costs.
- The new residential housing market continues to impact their top-line growth.
- The stock price is considered overvalued, and a 'Hold' rating is recommended with a fair value of $240 per share.
Since I initiated coverage , Sherwin-Williams's ( SHW ) stock price has increased by 14%. I highlighted their challenges in the new residential housing market, along with their pricing power and cost management initiatives. They exhibited a robust gross margin in Q3 FY23, attributed to price increases and the moderation of raw material costs. I believe that the ongoing influence of the new residential housing market may persist in affecting their top-line growth. I consider the current stock price to be overvalued, and I maintain a 'Hold' rating, establishing a fair value of $240 per share.
Quarterly Result and Outlook
During Q3 FY23 , Sherwin-Williams achieved a 1.1% increase in net sales and a notable 13.1% growth in adjusted EPS. However, the comparable sales of their Paint stores showed a 3% year-over-year growth, indicating a continued deceleration attributed to the sluggish new residential market. The positive margin trend was primarily fueled by price increases and the moderation of raw material costs.
Sherwin-Williams Quarterly Results
For the full-year guidance, Sherwin-Williams has raised their expectations, anticipating diluted net income per share to fall within the range of $9.21 to $9.41. This marks a revision from their earlier guidance of $8.46 to $8.86 per share. Additionally, they anticipate a low-single-digit increase in full-year revenue.
Sherwin-Williams Q3 FY23 Earnings
Their cash flow growth is quite impressive, with $2.60 billion in net operating cash during the first nine months of FY23, reflecting a remarkable 103% year-over-year increase. This growth is attributed to both profit growth and reduced working capital. Year-to-date, they have returned $1.41 billion through dividends and share buybacks.
Overall, I find their quarterly results to be quite remarkable, especially given the challenging new residential market environment. They achieved robust margin expansion and demonstrated strong growth in free cash flow. Furthermore, their capital allocation strategy appears to be consistently sound.
New Residential Market
During Q3 FY23, new residential sales experienced a mid-single-digit decline, with volume down by a high-single-digit percentage compared to the previous year. During the earnings call, the management noted that the new residential sector is expected to face challenges in the near term, primarily due to prior softness in single-family starts. To navigate the weak market environment, the company has to depend on share gains and new account wins. It is worth noting that the new residential market is estimated to constitute 12% of the total paint volume in the U.S.
I believe their expectation for new residential sales is quite reasonable. The chart below illustrates the year-over-year growth in U.S. new housing starts. While the November number is notably strong, housing start growth has been relatively weak, primarily due to the high-interest rates environment. Nevertheless, I anticipate a gradual recovery in the housing market in 2024. A potential rate cut in 2024 seems plausible given the softness in the economy and concerns about inflation. Additionally, the housing starts growth is beginning to face weaker comparable numbers from November. Therefore, from a mathematical standpoint, there should be some improvement in year-over-year growth in the coming months. Having said that, the housing market recovery would be gradual, and the persisting weakness may continue to pose challenges for Sherwin-Williams.
Pricing and Moderation of Raw Material Costs
In Q3 FY23, Sherwin-Williams experienced a notable 490 basis points expansion in gross margin, propelled by price increases and the moderation of raw material costs. During the earnings call, it was highlighted that prices rose in the low-single-digit range in the third quarter, a slight decrease from the mid-single-digit percentage in the second quarter. A similar low single-digit impact on the fourth quarter is anticipated. Concurrently, the company is observing a moderation in raw material costs. The combination of elevated prices and decreased material costs is expected to significantly contribute to their gross margin.
They anticipate a high-single-digit decrease in raw material costs for the full year in FY23, while other costs, including wages, are projected to increase in the mid-to-high single-digit range. Additionally, alongside pricing strategies and raw material management, they are actively overseeing their general and administrative (G&A) expenses. For instance, their SG&A as a percentage of total revenue has decreased from 28.7% in FY18 to 27.2% in FY22. Consequently, their effective cost management and gross margin expansion are quite noteworthy.
Valuation Update
The assumptions for FY23 align with the company's guidance. I maintain a forecast of 5% for normalized revenue growth and anticipate a 1% contribution from acquisitions, consistent with their historical average in a typical economic environment. The projected margin expansion is expected to be influenced by factors such as pricing strategies, raw material cost management, and initiatives targeting G&A expenses. Based on my calculations, the company has the potential to achieve an annual 50 basis points margin expansion.
The model uses a 10% discount rate, a 4% terminal growth rate, and a 20% tax rate. The estimated fair value is $240 per share.
Conclusion
I believe Sherwin-Williams stands to gain from the pricing increase and moderation of raw material costs. However, the new residential housing market may pose near-term challenges to their top-line growth. In light of the perceived overvaluation of the stock, I maintain a 'Hold' rating, establishing a fair value of $240 per share.
For further details see:
Sherwin-Williams: Pricing And Moderation Of Raw Material Costs