(Published by Nick McCullum on July 21)
Dividend history is one of the most straightforward and accurate measures of business quality.
Intuitively, this makes sense – a company must have a significant and durable competitive advantage in order to raise its dividend every year for decades.
Sherwin-Williams Co. (SHW, Financial) is one of the most high-quality, well-managed businesses in our stock universe.
The company has increased its annual dividend since 1979, which qualifies it to be a member of the Dividend Aristocrats – elite dividend stocks with at least 25 years of consecutive dividend increases.
The company shows no sign of slowing down. On July 20, Sherwin-Williams reported financial performance for the second quarter ending June 30. Alongside double-digit revenue growth, the company gave an update on the integration of its most recent acquisition – Valspar, a fellow manufacturer and distributor of paint and coating products.
Business overview and current events
Sherwin-Williams is North America’s largest manufacturer of paints, varnishes and industrial coatings. The company also manufacturers paint application equipment and other accessory items.
The company delivers its products through more than 4,000 retail locations. Founded in 1866, Sherwin-Williams is headquartered in Cleveland, Ohio and has a market capitalization of approximately $33 billion.
As mentioned, Sherwin-Williams recently reported its financial performance for the second quarter of fiscal 2017.
Results were generally quite strong during this reporting period.
The company’s consolidated net sales were $3.74 billion, a 16% increase from the same period a year ago. For the six-month period ending June 30, Sherwin-Williams’ revenues increased 12.1% from 2016’s figure.
Naturally, the most important aspect of this earnings release was the impact of the recently-acquired Valspar business.
Valspar was an international manufacturer of paints and coatings headquartered in Minneapolis, Minnesota. Valspar had annual revenues of approximately $4 billion and about 11,000 employees on payroll at the time of the acquisition.
Sherwin-Williams’ acquisition of Valspar had a significant impact on the company’s financial performance. The transaction created an 11.8% and 6.6% boost to quarterly and six-month sales, respectively.
The transaction also generated plenty of one-time financial charges, which temporarily depressed the pro forma company’s earnings per share.
For the full year, the Valspar transaction is expected to create $2.50 per share of acquisition-related charges. This comes after Sherwin-Williams incurred 86 cents of acquisition-related expenses in fiscal 2016. This has not been a cheap transaction so far.
The acquisition, however, remains highly accretive to per-share profits despite these expenses. Valspar operations increased EPS by 10 cents in the second quarter, and are expected to increase EPS by 40 to 60 cents and 75 to 90 cents in the third quarter and full-year of fiscal 2017, respectively. These figures are all net of acquisition-related expenses.
Investors should also note the Valspar transaction created meaningful changes to the segmented results Sherwin-Williams now reports.
In the past, Sherwin-Williams operated in four segments:
- Paint stores group
- Consumer croup
- Global finishes group
- Latin America coatings group
This is changing significantly moving forward.
Sherwin-Williams’ paint stores segment is merging with its Latin America coatings group to form the combined company’s "The Americas Group."
In the second quarter, this segment reported sales of $2.4 billion and profit of $533 million. It will be the largest segment for the new Sherwin-Williams.
Source: Sherwin-Williams Second-Quarter Earnings Presentation
Sherwin-Williams’ consumer group is merging with Valspar’s paint segment to form the consumer brands group.
In the second quarter, the consumer brands group generated sales of $537 million and profit of $97 million. Note the stark contrast in financial results between the Americas group and the consumer brands group.
Source: Sherwin-Williams Second-Quarter Earnings Presentation
Lastly, Sherwin-Williams’ global finishes segment will be merging with two of Valspar’s segments: the coatings segment and the paint segment.
The new segment, called the performance coatings group, generated $761 million of sales and $100 million of profit in the second quarter
Source: Sherwin-Williams Second-Quarter Earnings Presentation
To sum up, Sherwin-Williams now reports financial results in the following three operating segments (along with second-quarter 2017 financial performance):
- The Americas group: $2.4 billion of sales and $533 million in profit.
- The consumer brands group: $537 million of sales and $97 million of profit.
- The performance coatings group: $761 million of sales and $101 million of profit.
Also, note the difference in net margin between Sherwin-Williams' different operating segments:
- The Americas group: 22.2% net margin.
- The consumer brands group: 18.0% net margin.
- The performance coatings Group: 13.2% net margin.
Based on the large size and company-leading profitability of the Americas group, I would not be surprised if Sherwin-Williams focuses most of its resources on growing this segment from this point onwards.
Competitive advantage and recession performance
Sherwin-Williams is far from being the most recession-resistant Dividend Aristocrat.
The company’s sales are highly reliant on a healthy real estate market, which tends to crash during economic downturns.
With that said, the company does enjoy a compelling scale- and brand-based competitive advantage.
Customers are highly likely to purchase paint from Sherwin-Williams simply because it is the first brand that comes to mind when they begin shopping. In addition, the company's large size means it can generate economies of scale and pass the savings onto its customers, creating enduring brand loyalty.
These advantages can be seen in Sherwin-Williams’ historical recession performance. Despite being reliant on the real estate market, the company managed to maintain profitability during the massive 2007-2009 housing crash:
- 2007 adjusted EPS: $4.70
- 2008 adjusted EPS: $4.00 (14.9% decrease)
- 2009 adjusted EPS: $3.78 (5.5% decrease)
- 2010 adjusted EPS: $4.21 (11.4% increase)
- 2011 adjusted EPS: $4.14 (1.7% decrease)
- 2012 adjusted EPS: $6.02 (45.4% increase – new record)
Sherwin-Williams’ high-quality business model and its historical recession performance indicate a downturn in the housing market would be the best time to accumulate this stock for long-term investors.
Valuation and expected total returns
The transformative characteristics of the Valspar acquisition mean it is difficult to assess Sherwin-Williams’ valuation using 2016’s earnings.
Instead, we can look to the company’s 2017 guidance to assess its current valuation multiple.
In the company’s second-quarter earnings release, Sherwin-Williams increased its full-year adjusted EPS guidance to $12.30 to $12.70, with a 75 cents to 95 cents benefit from the Valspar transaction net of a $2.50 per share impairment charge for acquisition-related costs.
Sherwin-Williams is currently trading at a stock price of $350.78. Using the middle of the new 2017 EPS guidance – $12.50 – gives a forward price-earnings (P/E) ratio of 28.1.
The following diagram compares Sherwin-Williams’ current valuation to its long-term historical average.
Source: Value Line
Sherwin-Williams current P/E ratio of 28 is significantly above its long-term average of 17.4.
So why are investors paying such a premium for this stock today?
It is partially due to the current low interest rate environment. Low interest rates tend to inflate the valuation of stocks – particularly dividend stocks – as investors sell fixed-income instruments and look to other asset classes for the possibility of stronger risk-adjusted returns.
Another factor is the reassessment of Sherwin-Williams’ intrinsic value by the financial markets.
The company did not begin to sport a premium valuation overnight; instead, its valuation steadily increased over the years as investors began to realize the true quality of the Sherwin-Williams enterprise.
Looking again at the valuation chart, this trend can be seen beginning in roughly 2009.
Source: Value Line
The reappraisal of Sherwin-Williams’ "normal" valuation by the financial markets was likely driven by the company’s impressive historical earnings growth.
Amazingly, Sherwin-Williams managed to compound its adjusted EPS at an annual rate of 14% per year between 2001 and 2016. All said, this grew the company’s bottom line from $1.68 to $11.99.
Source: Value Line
I believe Sherwin-Williams’ current valuation is not justified, however. The company is unlikely to deliver 14% growth per year moving forward. Even if it did, a P/E of 28 significantly discounts future shareholder returns.
Thus, I believe investors should wait for a better buying opportunity for Sherwin-Williams’ common stock. A recession would present a prime opportunity to pick up shares of this high-quality business on the cheap.
Final thoughts
Sherwin-Williams is well known among the investment community because of its long track record of rapid earnings growth and steady dividend increases.
The company’s stock appears overbought right now, however. A 28 P/E ratio is excessive for even the most high-quality business.
Moreover, Sherwin-Williams’ historical financial performance suggests recessions are a fantastic opportunity to accumulate its common stock. It is highly likely there will be better chances to buy the stock in the future.
Investors should avoid this stock for now, but it remains a strong hold for existing investors, particularly those with a low-cost basis on current holdings.
Disclosure: I am not long any of the stocks mentioned in this article.
