$SHW | Sherwin Williams - Security Analysis

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Key Statistics

EV/EBIT = 27.78x

ROE = 45.49%

FCF Yield = 4.56%

Dividend Yield = .73%

Debt/Equity = 240%

The Company

I decided to take a look at Sherwin Williams (SHW) after combing a list of dividend aristocrats. I looked at the impressive returns on capital and saw all the signs of an incredible company.

Some quick stats: average ROE for the last 10 years is 40%, 10-year average ROIC is 22%, FCF has grown at a 10% CAGR for the last 10 years, and revenues have grown at a 10% CAGR for the last decade. The average gross profit margin for the last decade is 45%. Thanks to a combination of growth and buybacks, EPS has grown at a nearly 16% rate over the last 10 years.

Sherwin Williams manufactures paint and paint products and it can trace its history all the way back to 1866. They currently operate 4,758 specialty paint stores throughout the US, Canada, Latin America, and the Caribbean. Products include paints, coatings, industrial products, floor covering, along with painting equipment.

Revenues are mainly derived from three divisions: consumer brands, the Americas group, and performance coatings. Consumer brands are what you’d think of when you think of SHW as a brand – products that they sell through retailers like Lowe’s or Ace. Performance coatings are mainly geared towards industrial customers, such as automotive companies or floor manufacturers. They have a wide variety of brands beyond Sherwin Williams itself: Cabot, Duckback, White Lightning, Kemtone, Woodscapes. A notable brand is Valspar, which they acquired in 2016. The America’s segment – the most significant driver of the business – is the actual Sherwin Williams retail stores.

The Americas Group accounts for 56% of sales, consumer brands account for 15%, and performance coatings account for 29%.

Their claim to fame was selling ready-made mixed paint in 1875. Their brands are widely used and customers are loyal. Professionals and retail customers alike use their products and they have a strong network of retail stores.

Sherwin Williams has been able to grow rapidly over the last twenty years. The business itself has continued to grow organically over the last decade. Shareholders have been rewarded through the organic growth of the business, along with FCF-fueled buybacks and dividends.

However, the stock isn’t cheap, which I will dive into later.

Performance

Sherwin Williams has been a rapidly growing, consistent performer for a long period of time.

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The company’s fortunes are very much tied to the strength of the housing market, but it is still resilient in any downturn in housing. During the GFC, net income declined from a peak of $616 million in 2007 and fell to a low of $436 million in 2009. Net income recovered by 2012, and then it was off to the races of robust growth. In 2019, net income was $1.9 billion.

The fact SHW didn’t lose money during the GFC is a sign that the business is resilient in the face of a downturn. It is much more resilient than other kinds of housing plays, like housing builders who endure a relentless boom-bust cycle.

Additionally, thanks to its fat margins and free cash flow generation, SHW can continuously cannibalize its own shares, making per-share earnings and FCF compound at a higher rate than the underlying business.

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The performance of the business has richly rewarded shareholders over the years. The stock has advanced at a 16.98% CAGR since 1985. Since 2000, it has advanced at a 20% CAGR, turning a $10,000 investment into $495,397.

Not bad for a paint company with a stable and predictable business. No speculation on future technological/societal change was necessary.

Moat

Sherwin Williams has a strong moat that is almost certain to endure. We will always need paint, and I don’t see how it will be possibly be disrupted by new technology any time soon. I don’t think that a Silicon Valley startup is going to disrupt the paint industry.

The moat is hinted at in their margins, which clearly shows that the company has a lot of pricing power.

Much of the moat is derived from SHW’s strong relationship with contractors. When a contractor is trying to complete a job, paint prices don’t matter as much as how quickly and efficiently they can get the products. A painting contractor can go to Sherwin Williams retail outlet and quickly get everything that they can possibly need to complete a paint job. SHW also offers quick delivery, which is also an advantage. With 4,758 locations, it’s a network that is not easy to duplicate or compete with.

Financial Quality

SHW has a high debt/equity ratio (240%), but the stock has an overwhelming degree of financial quality to make up for the leveraged balance sheet. It generates so much free cash flow that it can easily withstand most financial challenges. The Altman Z-Score is solidly in the safe zone, at 4.34. Interest coverage is also robust at 11.72. The Beneish M-Score is currently -3, so there are no signs of earnings manipulation. SHW’s WACC is estimated as 6.6% and their average ROIC over the last decade is 22%, so the company is not a net destroyer of capital.

Valuation

From a valuation perspective, SHW is now near all-time highs. The market understands that this is a premium company and has bid up the shares accordingly.

On a pure shareholder yield basis, SHW is currently not delivering a high yield. The forward dividend yield is only .73% and the share count declined by 1.42% in the last year. Of course, that yield will almost certainly grow in the future. 2019 dividends were $4.52 per share – back in 2010 it was $1.44. Even with that growth taken into consideration, the dividend yield is now at an all-time low. In the depths of the financial crisis, this traded with a 3.3% yield. For most of this last decade, it traded around a 1% yield. .73% seems quite low.

On an EV/EBIT basis, SHW currently trades at 27x. This is a tremendous premium to its history. As recently as 2016, SHW could be purchased at 13x. For most of the decade of the 2000s, it traded below 10x EV/EBIT.

On a price/sales basis, SHW is radically more expensive than at any point in the last 20 years. It is currently 3.75x sales. This is an all-time high. Throughout the 2000s, it traded around 1x sales and often below that. During the 2010s, it typically traded around 2x sales. Since 2019, it took off, now reaching the current extremely high levels.

On an FCF/price basis, SHW now trades with a free cash flow yield of 4.7%. On this front, it is more reasonable. Considering that FCF compounded at a 9.9% pace over the last decade, buying a company yielding 4.7% that can compound at a nearly 10% rate isn’t completely absurd, particularly with near-zero interest rates.

With all of these metrics take into consideration, Sherwin Williams doesn’t trade at an absurdly high price, but it’s not a bargain price, either. If the market were to value SHW at levels as recently as 2016, the stock could easily suffer a 50% drawdown.

What would cause that sort of drawdown? I could think of a number of possibilities. It could be a nasty recession. Rates could go up. The most likely shock would be a recession or downturn in the housing market, which is now red hot and a key reason SHW trades at such high multiples.

Sherwin Williams has also benefited in recent years from a decline in the prices of raw materials, which increased operating margins from 9.6% in 2010 to 13.5% in 2020. If that commodity deflation goes the other way, those margins can be compressed, and that could be a catalyst for shares to decline.

While I have no idea what the future holds, I do know is that bad news can happen. At current prices, SHW investors can suffer significant multiple compression.

Of course, this is the kind of business where an investor with a long term perspective (10 or 20-years) will probably make out just fine if they can hold.

However, I am a value investor, and I want to buy this with a margin of safety. With patience, I think that I will one day be able to pick up SHW at a more compelling price. It is 100% the sort of business that I would like to own.

Checklist

  • Can the stock deliver a 10% CAGR for the next decade?

SHW is an expensive stock and multiple appreciation is unlikely. I think compression is more likely than expansion.

With that said, even if the current EV/EBIT multiple is cut in half, it could still deliver a 10% CAGR. If the business can continue growing at a 10% rate and maintain its moat (and returns on capital), the stock could still deliver a 10% CAGR through organic growth & buybacks.

Pass.

  • Has the business delivered consistent results over a long period of time?

Sherwin Williams has been a consistent performer over a long period of time, regularly growing earnings and cash flows. Shareholders have been richly rewarded with a 20% CAGR over the last 20 years.

Pass.

  • Does return on equity consistently exceed 10% without the use of heavy leverage?

The average return on equity over the last 20 years is 37.6%. It stays consistently high. During the GFC, it was able to maintain a 28% ROE.

Pass.

  • Is management sketchy?

Management is transparent and honest with no signs of being shifty promoters or grifters. They focus on growing the business and aren’t the sort of people obsessed with short-sellers. The CEO, John Morikis, strikes me as a competent leader.

Pass.

  • Is the company financially healthy?

Debt/equity is high, but that is not a problem for SHW. The Altman Z-Score is 4.34. Interest coverage is 11.72. The Beneish M-Score is currently -3. SHW’s WACC is estimated as 6.6% and their average ROIC over the last decade is 22%.

Pass.

  • Has the company consistently generated returns for shareholders? Is the industry in secular decline?

SHW has consistently generated strong returns for shareholders. It has delivered a 20% CAGR since 2000. The paint industry is not in secular decline and is unlikely to be disrupted.

Pass.

  • Has the company survived previous recessions?

During the GFC, SHW did not suffer any losses. Earnings and cash flow declined, but it was not a situation where they were brought to the brink of ruin or their future was in jeopardy.

Pass.

  • Does the company have a moat?

Sherwin Williams has a strong moat. A key source of their moat is their network of stores and tight relationships with contractors. Their brands are also well known and their customers are sticky. It is highly unlikely that this company will be disrupted.

Pass.

  • Is the stock cheap on an absolute and relative basis?

SHW is an expensive stock. It trades are a significant premium to its history and is certainly not cheap on an absolute basis. By several metrics, it is at all-time highs in terms of its valuation. Multiple compression is highly likely, especially if commodity prices increase or if the housing market faces another downturn.

Fail.

  • If I was forced to hold the stock for 10 years, would I be terrified?

I would not be terrified to hold this stock for 10 years. I think it’s highly likely that an investor makes out just fine if the business continues its organic growth and maintains its moat.

However, at the current valuation, I wouldn’t be comfortable buying at these levels.

It’s worth noting that SHW went into the last housing downturn at an 11x EV/EBIT multiple and still suffered a 30% drawdown. If we faced another recession, SHW has much further to fall from a 27x multiple. A housing downturn seems unlikely in the midst of an economic recovery, but the future is unpredictable and I’d rather own the stock at a more compelling price. As recently as 2016, this stock could have been picked up at a 15x multiple.

SHW is most certainly a wonderful company, but it is currently not selling at a wonderful price. I am passing on this stock but will be watching closely. It is on my wish list if it ever trades at a bargain price.

Fail.

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