2023-08-01 11:53:15 ET
Summary
- SHW reported higher-than-expected earnings and sales in 2Q23.
- Paint Stores Group (PSG) and Consumer Brands Group (CBG) saw sales growth, while Performance Coatings Group (PCG) sales remained flat.
- Despite positive performance, the current valuation of SHW is too high compared to peers.
Summary
This post is to provide my thoughts on The Sherwin-Williams Co. ( SHW ) business and stock. I am recommending a hold rating after reviewing the 2Q23 earnings and current valuation. The key reason for recommending a hold rating is that I believe the valuation is too high at the current level. When compared to peers, which SHW has historically traded at a minor discount to, it is now trading at a premium. Given that SHW is expected to grow in line with peers, I don’t see this premium as sustainable. Performance-wise, it is a mix of positives and negatives, which I expect to get cleaner over the coming quarters as divestitures complete, the step-up in expenses is over, and the cost price decreases. Until then, I think it is better to wait this one out.
Investment thesis
SHW reported $3.29 EPS and $1.305 billion in EBITDA, both of which are higher than consensus estimates at $2.70 and $1.11 billion. Sales were up 6% year over year, largely due to an increase in architectural volume, higher pricing, and a small contribution from acquisitions, which were partially offset by a decrease in low single digit industrial volume. Gross margin expansion also helped with SHW beating consensus estimates. The company's gross margin increased by 430 bps vs last year due to favorable price adjustments, falling raw material costs, and other cost cutting measures.
PSG (Paint Stores Group) sales rose by 10% on volume and price increases in the low to mid-single digits. It's worth noting that despite fewer housing starts , the New Residential segment was stable, a sign that SHW may be gaining ground in the sector. In addition, due to the high volume, SHW's segment margin increased by 280bps to 24%. Good news is that management is committed to long-term growth and, as evidenced by the 16% increase in SG&A in 2Q, plans to maintain its investment in stores and sales reps. As PSG's revenue increases and margins expand due to higher volumes and lower input costs, I anticipate rising operating profits. That said, the initial increase in profits might be offset by the increase in headcount (sales rep) as they are not mature yet.
The CBG (Consumer Brands Group) saw a 5% increase in sales due primarily to price increases in the low to mid-single digits. I believe the 5% headline growth does not show the underlying strength of SHW in its core markets. According to management, Latin America and Europe saw strong double growth, but growth was offset by double digit decrease in China architectural business. First of all, previously, SHW said they planned to sell off their China Architectural Paint division, and they expect to be completely done by 3Q23. Growth is much higher than the headline 5% if we exclude the China business. Once the divestiture is finalized, I anticipate this division's underlying growth strength to become more apparent, enabling investors to better analyze this segment.
Lastly, despite a high-single-digit decline in volume, PCG (Performance Coatings Group) sales were flat, thanks to price increases and an acquisition's contribution. The results of 2Q23 lead me to believe that demand in the European and Asian final markets will remain unstable, while demand in the North American market will remain sluggish. Backlogs in the auto refinishing industry should continue to grow as demand remains high, while packaging businesses should continue to struggle due to customers' shift in purchasing tendency to buy only when they need it (from the previous preference of stocking up in advance).
Valuation
I believe the fair value for SHW based on my model is $230. My model assumptions are that topline growth will recover to historical mid-single digit growth through FY25. Margins will improve accordingly as incremental volume and lower prices help. My assumptions are in line with consensus.
Peers include: Asian Paints, Nippon Paint (NPCPF), RPM International (RPM), Axalta Coating Systems (AXTA), PPG Industries (PPG), Akzo Nobel (AKZOF), and Kansai Paint (KSANF). The median NTM PE multiple peers are trading at is 19.5, and the expected 1Y growth rate is 4%. Historically, SHW has traded at a -10% discount to this group over the past 5 years.
Given my outlook for SHW growth, which is in line with peers, I struggle to see how SHW can sustain its current valuation of high 20s NTM PE. As such, I am recommending a hold rating, as I don’t see sufficient margin of safety at this valuation.
Own calculation
Conclusion
SHW has an uncertain near-term outlook and currently trades at a valuation premium compared to its peers. Despite positive aspects in its performance, I struggle to find sustainable reasons to the valuation premium. Considering these factors, I recommend a hold rating on SHW due to the lack of sufficient margin of safety at its current valuation level. Investors may want to wait for a more favorable entry point before considering any investment.
For further details see:
Sherwin-Williams: Uncertain Near-Term Outlook And Valuation Premium To Peers