The Sherwin-Williams Co. (SHW, Financial) announced in March that it was acquiring The Valspar Corp. (VAL, Financial). The deal is expected to close in the first quarter of 2017 with a total value of $11.3 billion, providing Valspar shareholders $113 per share in cash. The current stock price is $102.62 and that 10% premium offers a strong margin of safety in what I feel is an overheated market.
Under the terms of the agreement, in the unlikely event that divestitures are required totaling more than $650 million of Valspar's 2015 revenues, the transaction price would be adjusted to $105 in cash per Valspar share. This would lower the total yield but still make this trade worthwhile.
Valspar is a chemical company that makes coatings and paint products for both consumer products and commerical applications. It traces its roots back over 200 years. Maybe you’ve heard of its products? Home Depot (HD, Financial) and Lowe's (LOW, Financial) both run national commercials highlighting the brand. The company is the sixth largest in the industry with a current market capitalization of $8.18 billion.
From a financial standpoint, it’s done a great job all the way around. Gross margins are up 22% in the last decade to over 36%. Net income has grown from $175 million to $352 million, a 100% rise. The company has bought back 22 million shares, helping to increase EPS from $1.71 to $4.35 and boosting dividends to $1.29 this past year. Perhaps more importantly, Valspar’s capital spending is less than a quarter of its net income and its return on equity is a solid 36%.
Aside from the consumer facing paint, the company has a strong competitive advantage because switching costs are pretty high across its packaging segment, where coatings must go through rigorous approval processes with government agencies as well as the package maker (e.g., Ball [BLL]) and brand owner (e.g., Coca-Cola [KO]). This product mix places Valspar in a good position long term, a big reason Sherwin-Williams is buying it.
Whether the company merges with Sherwin-Williams or not, Valspar shareholders are still in a good position long term. Thus, the arbitrage trade provides a great margin of safety and the potential for solid short term gains in the 30% annualized range.
There are two ways to trade this: cash or margin. Buying on cash means you spend $10,000 for 100 shares and look to earn $1,000.
In normal times when the market isn’t hyped up on lower tax possibilities from a president-elect, I would opt for leveraging my current positions and trade the stock on margin – especially since Valspar has a strong underlying business. If you take this route, the net return would still be around 10%, but your ROI on the trade could reach as high as 2,000%.
Here’s how. On margin, buying Valspar would mean paying a 2% annual interest rate, which over a three-month holding period would be about $50 on a 100 share investment.
- 100 shares @ $103 = $10,300
- $10,300 @ 2% = $206
- $206 ÷ 4 = $51.5
If the deal closes at the agreed upon price of $113, the investor would pocket the $1,000 minus interest paid. Even if the deal drags on into the second quarter of 2017, investors on margin still may see a 10x profit trading this way. And, if the deal falls through, which is unlikely, the baseline for the price drop short-term is around $90. If that happens, investors could be forced to take a loss or ante up and buy the position in cash. It’s never advisable to hold stocks long-term on margin.
So, expect the Valspar by Sherwin-Williams deal to be completed in early 2017. Realize that due to high market concentration in the paint market, some divestitures may be required by the FTC, but as long as they stay under $650 million, the target price will be reached.
NOTE: I’ve written about this before as the financial engineering that Warren Buffett (Trades, Portfolio) used to product market beating returns for over 40 years.
Disclosure: I do not own any of the stocks mentioned in this article.
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