AGB 2021.1 - Sherwin-Williams (SHW)

Death, Taxes and Repaint

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Sherwin-Williams

Sherwin-Williams is the leading provider of architectural and industrial coatings globally. The company has a collection of highly recognized brands such as Sherwin-Williams, Valspar, Purdy, Dutch Boy, HGTV Home, Minwax, Krylon, Thompson’s WaterSeal, etc. These brands are available in Sherwin-Williams owned stores and at strategic retail channel partners such as Lowe’s, Menards, and Walmart. Internationally, many of its products are distributed through a small selection of company owned stores and through a network of retailers, dealers and distributors.

The market for coatings can be broken down into architectural paints which make up 40%, industrial OEM coatings at 40% and special purpose coatings the remaining 20%. There were 9.8B gallons of coatings used in 2019, which roughly puts the market at $132B. Sherwin Williams is the leader followed by PPG, Akzo Nobel, and Nippon. The top 10 suppliers represent just over 50% of the market.

Within architectural paints, repaints are most of the market at around 80% and this can be further broken down by Pro and DIY (do it yourself). The North America Pro market is roughly 63% and DIY makes up the remaining 37%. Since 2009, the Pro market has grown much quicker than the DIY market.

Typically the Pro customer accesses paints and coatings through a specialty store. Pros appreciate the better selection, service (Sherwin-Williams even delivers to the site) and the contractor discounts. Sherwin-Williams has a network of 4,500 special paint stores in North America and 300 in Latin America under “The Americas Group” to address this market. This is the company’s largest segment at $10.2B revenues in FY19. Sherwin-Williams estimates that 85%-90% of the foot traffic in their stores are professionals who care much more about quality and efficacy vs. price.

For the DIY market, Sherwin-Williams has a partnerships with multi-channel retail partners, primarily in home improvement retail under the “Consumer Brands Group”. The company offers its paints and coatings at Lowe’s, Menards and Walmart, which Credit Suisse estimates accounts for $1.2B-$1.4B revenues within the segment, or almost 50% of the total $2.7B in FY19. Home Depot is a large potential partner, but Behr (owned by Masco) and PPG are popular brands that have that partnership. Sherwin-Williams did have Ace Hardware as a partner but was displaced by Benjamin Moore in 2019.

New residential and commercial paint makes up the rest of architectural paints and for those projects Sherwin Williams has partnership with 17 of the top 20 national home builders and 16 of the top 20 largest property management firms.

The industrial OEM and special purpose coatings part of the market is more difficult to analyze. Here, there is more competition from the other coatings companies and it’s mainly a B2B market. This is Sherwin-William’s second largest segment under the “Performance Coatings Group” which did $5B in revenues in FY19, most of which is from the acquisition of Valspar in FY17. Coatings for woods, metals and plastics as well as auto and marine coatings all fall into this segment category. This category has seen slower growth and margins in this segment are lower than in the paints categories.

The company has a capital allocation framework that is centered around not holding excess cash. Now, this can be effective when credit is easy and the global economy is in an upswing. However, in 2Q and 3Q the company did hold more cash on its balance sheet than it usually does, showing that excess cash can be necessary when going through an economic crisis.

Sherwin-Williams aims to have a BBB+ target rating on its debt, at the low-end of investment grade. Its target debt/EBITDA ratio is between 2x-2.5x, inline with where it is today at 2.1x. We would like to point out that prior to the Valspar acquisition, the company maintained a 0.5x-1.0x leverage ratio. The dividend is calculated to be 30% of the prior year’s EPS and capex investments usually amount to roughly 2% of revenues. The remainder of the cash will go towards acquisitions and buybacks. 

Margins are an important factor to consider when analyzing Sherwin-Williams due to the raw materials costs required for coatings. 80-85% of COGS are raw materials with largest segments being resins/latex (43%), solvents/additives (17%), pigments and TiO2 (27%), metals/plastics (13%). 60% of these costs are oil-linked. Typically, gross margins lag changes in raw material costs by up to 6 months because the company holds about 2 months of inventory on average. Because oil prices crashed in 2020 (though they’ve subsequently rebounded somewhat), we should see better margin trends in the upcoming year. The company’s long-term target for gross margins is 45%-48%.

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Why is it a good business?

Sherwin-Williams’ competitive advantage comes from its collection of brands and quality of its coatings. With years of R&D spent on improving its products and growing many highly recognized brands, Sherwin-Williams is able to charge a premium vs. many other brands. The company then leverages that advantage by having leading market share of specialty stores that caters to the professional, who isn’t as price as sensitive as a DIY consumer. It’s been stated that 80%-90% of the cost of a professional paint job is labor, so having higher quality paint that can minimize the cost of labor results in better ROI for the professional.

As mentioned before, the Pro market has outgrown the DIY market by a wide margin since 2009, when the breakdown was close to 52% vs 48%. Sherwin-Williams has benefited the most from this mix shift towards Pro due to its large advantage in the number of specialty stores. The DIY market in terms of gallons has stayed relatively flat, but the Pro market has grown by almost 60%, resulting in a 63% vs 37% split Pro to DIY. Generally as home prices have risen, more consumers are willing to pay a professional for their repainting needs. Older homeowners tend to opt for professional help as well.

Whether it was by accident or by design, Sherwin-Williams has better exposure to healthier end markets. Compared to the other large coatings companies, Sherwin-Williams is most exposed to architectural paint at 61% of revenues, whereas PPG is highly exposed to auto at 30% vs. just 5% for Sherwin-Williams and 15% to general industrial vs. just 6% for Sherwin-Williams.

With respect to costs of raw materials, the company can pass some of that cost down to the consumer in the form of price increases. The company announces the price increases at the beginning of the year and slowly implements them throughout each year. From FY17-FY20 the company was able to increases prices between 2%-2.5% annually, while raw materials increased 4% in FY17 and FY18 but declined in FY19 by 1.5%.

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Returns on capital?

The growth plan for Sherwin-Williams is relatively simple. Grow the professional stores business via investments in capex and continue to expand its lead in product innovation and quality from the consumer brands business via investments in R&D. Sherwin-Williams spends about 2% of its revenues on capex each year and 0.5% of its revenues on R&D, which usually results in a reinvestment rate around 20%. This results in store growth of about 100 per year, expanding on the company’s lead vs. the competition. Add in some smaller tuck-in acquisitions and the reinvestment rate goes up to 25%-30%.

In March of 2016, the company deviated from its slow and steady cadence of growth investments by acquiring Valspar for $11B (cash spent net of divestitures was $8.9B). This acquisition took over a year to close, due to the regulatory reviews and resulting divestitures that were necessary. Valspar didn’t come at cheap price by any measure. Sherwin-Williams paid 17x TTM EBITDA, or a 6% implied pretax return. Assumed synergies at the time of the announcement was $320M, which was later increased to $385M and then $415M. Even with the increased synergies the math comes out to roughly 10x TTM EBITDA, which still implies a 10% pre-tax return on capital.

But Sherwin-Williams didn’t just acquire Valspar for the increase in revenues and earnings. The deal increased Sherwin-Williams’ exposure in industrial coating and gave the company a larger presence in key international geographies such as Europe and Asia Pacific. Sherwin-Williams also diversified away from architectural paints by a little, but as we know has been one of the bright spots in 2020. Sherwin William’s goal is to reach 20% segment operating margins in both architectural and industrial coatings. The company is there in architectural but has some ways to go in industrial, but added scale should help somewhat.

The concern from the market is that Sherwin-Williams diversified into a worse business while paying a hefty premium. But we must remember that the added international reach gives Sherwin-Williams the option to meaningfully expand into paints internationally if that were the company’s strategy.

The big increase in capital spend in FY17 (when the Valspar deal closed) has diluted total company returns, but has made up for it by increasing the reinvestment rate to over 200%, which was funded by debt. Going forward, we should expect the reinvestment rate to come back down but returns should rebound as well. We estimate that Sherwin-Williams returns between 30%-40% on its invested capital.

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Reinvestment potential?

Within North America, there are 12,000 special paint stores. Sherwin Williams currently has just shy of 4,500 stores, or 38% market share, and is the market share leader by a factor of more than 4x vs the #2 player, PPG. The company expects that there will be more industry consolidation, especially of the smaller operators with just a handful of stores. Either Sherwin-Williams will open new stores, which will result in the eventual closure of these independent stores (the company estimates up to 1,000), or Sherwin-Williams may elect to purchase these stores. The expectation is to grow 1.5x-2x the rate of the market.

The long-term plan for Sherwin-Williams is to open ~100 stores per year to reach 6,000 stores (half of the market) in the medium term. The gating factor is hiring of professionals and sales people to fill these stores and the required distribution network along with expanding in underpenetrated geographies. There is also the potential of Sherwin Williams acquiring one of the smaller national players, but many are owned by larger corporate parents like Benjamin Moore (owned by Berkshire Hathaway) and Dunn-Edwards (owned by Nippon Paint).

The company has also mentioned that it would consider doing a large acquisition in the industrial focused space to complement the Valspar assets. Remember that industrial and auto are the two largest end-markets for coatings after architectural. The company would lever up to a debt/EBITDA ratio of 4x-5x for the right asset. As of the F20Q3 quarter, Sherwin-Williams had $7.7B in net debt with a debt/EBITDA ratio of 2.1x. The company could lever up to 5x by taking on another $10.4B in debt prior to adding on the EBITDA from the target.

With 30%-40% returns on capital (except for the recent Valspar acquisition) and a reinvestment rate between 25%-30%, we estimate that Sherwin-Williams increases its intrinsic value between 9%-11% annually. The Valspar acquisition did result in significant capital spend at a lower than average return, but the capital spent was so much larger than what the company usually spends on capex, that the increased reinvestment rate made up the difference. Now, we must recognize that this came at a price, which is the increase in debt, but it can be argued that Sherwin-Williams was overcapitalized prior to the acquisition.

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What else is important?

Covid impact

Sherwin-Williams was fortunate to be one of the companies that navigated well through the lockdown measures related to Covid-19. First, the lockdown resulted in more homeowners electing to improve their home, which included DIY paint jobs. Second, the company was able to take advantage of having two sets of customers (Pro and DIY), so volumes lost to Pro customers were made up for by the DIY customers. The shift to DIY resulted in a margin boost because DIY tend to be smaller projects, which require smaller containers that have higher margins, and there were fewer contractor discounts given.

Sherwin-Williams recognized that it would be best to invest through the downturn and the company didn’t trim any personnel in the specialty stores. Although professional projects were getting cancelled or delayed at the start of the lockdowns in March, paint jobs came back starting in 2Q with exterior work resuming first and then interior work improving nicely in 3Q. Residential has come back quicker than commercial due to the timing of paint jobs after a project start. Commercial painting starts 12-18 months after the start of a project, while residential painting starts 3-4 months after the start.

Though there was little activity in 2Q, the company continued to open stores throughout the year and now the company expects to open 55 stores in 2020. Similar to other large location/retail based businesses, the market is assuming that the share gains vs. smaller competition will accelerate coming out of the Covid related lockdowns.

Environmental Lawsuits

In 2019, Sherwin-Williams settled a lawsuit as one of three defendants in California related to advertising in lead-based paints many years ago. This legal battle lasted almost 20 years. The result is for Sherwin-Williams to pay a fine of $101.7M spread over 7 years. This was a reduced judgement from the courts original $1.15B and $409M (divided by 3) following an appeal. Sherwin-Williams will pay the fines until September of 2025.

When dealing with chemical or energy companies, litigation is always a risk, but the fines are usually not crippling unless the negligence is egregious. It’s just something to monitor.

Optionality

M&A is the biggest area of optionality for the company. Shoring up the performance coatings segment would allow the company to improve margins. Either by increasing the number of specialty stores in certain international markets or by densifying distribution across certain regions could help the company improve margins. The company has had a tough time keeping many of the international retail locations post the close of the Valspar acquisition. Sherwin-Williams recognized later on that the returns were just not there even if they improved the stores, so the company elected to close many of them down.

The other upside option would be a partnership with Home Depot as one of their paints and coatings suppliers. Right now Home Depot has 5 distinct suppliers with PPG and Behr (Masco) being the two largest. This would improve Sherwin-Williams position within DIY but it may be dilutive to margins. Sherwin-William’s partnership with Ace Hardware was low margins (the company stated that margins improved post the devolvement of the partnership) and Ace is a much smaller player than Home Depot.

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