2023-04-28 17:21:36 ET
Summary
- SHW's 1Q23 results exceeded market expectations, with an adjusted EPS of $2.04 and $878 million in EBITDA.
- SHW's gross margin is slated for growth, but there are potential downsides such as a decline in demand due to weak housing starts and a recession.
- There is a possibility for positive guidance revision from management which would be welcomed by investors.
The Sherwin-Williams Company: Margin set to continue expanding
Summary
The Sherwin-Williams Company's (SHW) 1Q23 results exceeded market expectations, with an adjusted EPS of $2.04 and $878 million in EBITDA, which was a significant beat compared to the consensus estimate of $799 million.
SHW's gross margin is slated for growth, but there are potential downsides such as a decline in demand due to weak housing starts and a recession.
SHW reiterated its EPS guidance range for FY23 of $7.95 to $8.65, which is reasonable, but a positive revision from management would be welcomed by investors.
Thesis
The Sherwin-Williams Company produces, markets, and deals in paints, coatings, and related products. The company's clientele span numerous sectors and international borders. In general, I have a bullish outlook on the future of the SHW industry. In my opinion, SHW's strategic move to penetrate the domestic paint contractor market is a smart one, as it will help the company capitalize on its strong franchise and grow over the long term. One of the most intriguing aspects of the SHW industry is its pricing power, which clearly indicates its strength. During the covid period, the company was able to raise prices despite rising costs of key inputs. With a 30% increase in EPS expected over the next two years, the stock is not overpriced by any means. This, together with share repurchases and a dividend yield in the low single digits, would result in a total return of more than 30% (at the current multiple). However, management did issue a warning about 2H23 performance, saying that they anticipate a difficult demand environment, which I believe is to reflect a more cautious stance (especially with the news of weak housing starts). Overall, I would give this a buy rating given the resilience of the business.
1Q23 results
SHW's adjusted EPS of $2.04 for 1Q23 exceeded market expectations and represented a significant increase from 1Q22 results. SHW also reported $878 million in EBITDA, which was a significant increase from last year and a significant beat compared to the consensus estimate of $799 million. Price increases and some inorganic factors contributed to the excellent results. Were it not for a slight drop in volume and foreign exchange headwinds, the growth would have been stronger. The company's gross margins also improved, but the sharp rise in SG&A costs neutralized this positive. Given that volume is roughly the same as it was a year ago, the growth in gross margins can be attributed to a shift in the price/cost mix. Consensus EPS growth expectations have been bolstered by management's comments that they are on track to continue expanding gross margin to their targeted range of 45 to 48%. As for operating expenses, I must admit that I did not find the emphasis on employee costs to be as alarming as it was made out to be. Management did the right thing by giving its Stores network employees two raises to keep them from leaving. SHW, in contrast to many other businesses, is prepared to pay to keep talented employees. Eventually, this should pay off in the form of lower hiring and retraining costs as employees become more invested in their work at SHW.
Margin
After hearing from management that gross margin is slated for growth, my outlook on EBIT margin expansion has brightened. I see two potential downsides to increasing margins. As interest rates rise and dampen new-home activity , the demand for SHW products is likely to decrease in 2023, which poses a number of problems for the company. The second factor is a recession, which essentially puts a big dent to demand across the board. These are macro risks over which management has little to no sway; however, the decline in the price of raw materials suggests that the FY23 estimate can be at least partially de-risked. Employee cost headwind may also begin to abate if the labor market softens, which would be good news for EBIT margin.
Guidance
SHW reiterated its EPS guidance range of $7.95 to $8.65 for FY23. Although the guide appears lower than the expected consensus estimate of $8.63, I want to point out that during the previous call, management made it clear that they would not be revising the full year EPS guidance. If current consensus estimates are any indication, investors are pricing in a 4% improvement in outlook from the current midpoint of guidance. Based on SHW's past performance of reported EPS versus consensus, which has an average surprise of 5.5%, I find a 4% increase to be reasonable. However, if management issued revised guidance with a higher midpoint, I think the stock price would respond positively.
Conclusion
With 30% increase in EPS expected over the next two years, the stock is not overpriced, and a total return of more than 30% can be expected when combined with capital returns. Although management anticipates a difficult demand environment in 2H23, the company's 1Q23 results exceeded expectations, and gross margin is slated for growth, which derisks FY23 consensus numbers. The company's reiterated EPS guidance range for FY23 is reasonable, and if management were to issue revised guidance with a higher midpoint, the stock price would respond positively. All in all, I give this a buy rating after reviewing the 1Q23 results.
For further details see:
The Sherwin-Williams Company: Margins Set To Continue Expanding