Sherwin Williams (SHW)
Watching Paint Dry?
There are a variety of qualitative and quantitative ways to assess whether a business has a strong moat, and the strength of the barriers to entry surrounding its business. Sherwin Williams only spends 1.5%-2% of its yearly revenue on capital expenditures. Despite this minimal investment, there’s still a lack of competitors in the industry, Sherwin Williams has cemented itself as the number one (and nearly only) player in the paint sector in North America.
A bullish pattern for the company is the percent of SG&A relative to sales over time, since 2016, every year the company has decreased it’s SG&A as a percentage of sales. The company controls it’s expenses and runs a tight ship, the revenue growth would all be for not if expenses were dramatically accelerating, counteracting the topline success. This is a small thing you won’t read from many others, but these are the subtle insights into the strength of management.
On the Q3 company conference call, “If you talk with our contractors, they look at the backlog ahead, and they feel it's a terrific opportunity for them to continue to grow. The LIRA, if you look at the forecasting they have, is for double-digit growth for the remainder of 2022 going into 2023. I would agree that there's some projections that remodeling may slowdown mid-2023, but I'll also remind you that painting represents a terrific project to have high impact at a relatively low cost, and while rates are moving, house price appreciation has also moved as has the aging of housing. The aging stock home price or values – I'm sorry. Let me redo this. The aging home continues to require more remodeling, more updates, people aging in place, and we see that. You see it in the NAHB, which has slowed just a bit but still well above 50, and while existing home sales have slowed against strong comps, it's largely because of lack of inventory. And when people have a tendency to stay in home, they'll continue to invest in those homes.”
“And so throughout the period, the 2008-2010 period all the way to now, we've been working strategically on how do we better position the company. And when you look at residential repaint, it's a much larger percentage of our business now. And that's because, when we went through the last one, new residential, while we've been successful and we've been growing in our success there, we wanted to offset this and diversify our business a little bit more so we've been hard at work driving more and more residential repaint, and now it's a larger percentage of our business, and we think it's going to allow us to weather storms much better than we have in the past.”
Did you notice how shares didn’t decline during the financial crisis? The firm’s shares were relatively flat, despite the company’s sales dropping 11% during 2007-2009. Sherwin Williams expanded gross margin by 100 bps during the worst housing crisis since the great depression. Kudos!
Everyone knows paint and coatings are a mature industry, it’s no secret, and it’s definitely not sexy. It’s like watching paint dry… Nevertheless, people need paint, and they won’t stop needing paint. It won’t become obsolete. When will we stop using paint? I can’t see any scenario where a new innovative product will disrupt the paint industry. Society has painted colours on the outside of buildings for stilllystic purposes for centuries and society will continue to do so. We don’t need to worry about AI and ChatGPT taking over this industry.
SHW has raised prices significantly over the past few years, in September alone, the firm raised prices 10%. 10%!!!!! And consumers didn’t slowdown, they value Sherwin Williams products, it’s a quality item. Supply chain issues impacted some of the input materials, but for the most part products were widely available to consumers. When the company is able to continuously raise prices and still have customers return due to the value proposition, it demonstrates the resilience of the business. When the input items decrease in cost, while the price hikes paint don’t revert, it expands gross margins. High quality situation! Sherwin Williams is a great business, which is why the stock is so expensive. If the company is able to continue growing revenue in the mid teens that’s very bullish for shares in the long term.
Also, let’s not forget the return of capital policy at the company. The company is a dividend aristocrat and has raised its payout every year for the past 43 years. Compounding dividends is a beautiful thing. In 2010, the company paid out $0.48/share in dividends, in 2022, the dividend was $2.40/share. Despite the shares appearing to have a low yield in the current year, the growth of the payout allowed the company to reinvest into its business while returning capital shareholders. P.S. if the current dividend was applied to the stock price in 2010, the dividend yield would be over 10% on the cost basis. Never mind, the company retiring a third of its share count since 2009. As an investor, you didn’t have to make single trade, yet you own a significantly higher portion of this business.
I have watched this company for quite some time, admiring the business that the management team has built to sustain for long term success. However, the short-term headwinds are quite strong. SHW’s Q4 earnings report was disappointing, primarily in regards to the forward guidance. According to the CEO, “Against this backdrop, we expect 2023 first quarter consolidated net sales growth to be flat to up a mid-single digit percentage compared to the first quarter of 2022. For the full year 2023, relying on indicators we see at this time, we expect consolidated net sales to be down a mid-single digit percentage to flat compared to 2022. With annual sales at this level, we are introducing diluted net income per share guidance in the range of $6.79 to $7.59 per share, including acquisition-related amortization expense of $0.81 per share and restructuring expense of $0.25 to $0.35 per share. Full year 2023 adjusted diluted net income per share is expected to be in the range of $7.95 to $8.65 per share compared to $8.73 per share in 2022.”
This wouldn’t be a big factor if the shares anticipated this decline, and traded at a reasonable multiple. However, the shares trade at 28x (2023 estimates) multiple, given the higher end of the company’s expectations. In 2022, the firm grew revenue in the low double digits, justifying the firm’s valuation premium. However, the slowdown in business should compress the firm’s valuation premium. You’d think, right? Makes sense? The shares are essentially FLAT since the earning report. Flat! How does that make sense? This is when Mr. Market plays tricks with your head. If I knew the results ahead of time, I would have put on a significant short position. Given the results, I’d assume the stock would’ve decreased significantly. I got a nice slice of humble pie from the stock market, I’m wrong and disappointed this didn’t create a buying opportunity.
On the conference call, management said everything you’d want if you were an owner:
“We expect to outperform the market, just as we have in the past. At the same time, we're not operating with our heads in the sand. We currently see a very challenging demand environment in 2023, and visibility beyond our first half is limited”.
“So, you can kind of ask what to expect. John mentioned this earlier. The rate increases will pressure our builders, and we will grow share. But we were not going to be immune to the impact of these rates. We're going to respond to these changes, and I would expect that our builders would do the same. They might adjust floor plans. Many are looking at standardization, but no one will respond like Sherwin-Williams. We're going to take this expertise. We're going to aggressively go to builders that may have relationships with some of our competition. And we're going to demonstrate these capabilities in a way that will allow us to grow share”.
“I think there is no impact on the shelf restriction on Consumer, but I think there's a huge amount of market share gain opportunities within our industrial businesses and that's all of them. As John talked about, we do not have 100% market share in any of our businesses, segments or regions, and that's the way we're going into 2023. We're marching aggressively. So, there are terrific opportunities that we're going to be pursuing and we often talk about the coiled spring. As this business comes back and we grow share, grow customers and it returns, it's going to spring.”
No downturn goes without opportunities. Management has the proper mindset. They aren’t sitting around feeling sorry for themselves. Hopefully, if the market pulls back and/or if there’s a continue slowdown in housing, it will give a good entry point into the shares. If you are able to get the stock at sub 20x earnings that would be a STEAL. However, I doubt it’ll get to that point due to buyers coming in to the market. If you can buy the shares at 22x-23x earnings, with the company growing revenue in the mid teens that’s an attractive PEG ratio with a incredibly resilient business that doesn’t have a significant premium relative to the firms historical growth.
I began writing/researching this blog before the recent quarter, this is what I said, “Despite shares appearing expensive at nearly 28x 2023 estimates, I view the shares as attractive in a pullback. SHW has a huge moat in its North American operations, which has few competitors, as Sherwin Williams possesses a significant portion of the North American market share(Benjamin Moore and PPG Industries, the only existent competitors, have a fraction of the share) . Globally, SHW is growing through M&A, expanding their offerings beyond the U.S. and Canada. Internationally, its margins are significantly lower compared to its North American business, the company is expanding, gaining share, and investing for the long term, foregoing margins in the short term. SHW has completed more than 40 acquisitions since 2020, it’ll take some time to accrue the synergizes, they don’t happen overnight. The company is growing for the long term.”
The majority of this statement is still relevant and true, but the sentiment surrounding the company has turned quite negative. Yes, the company is growing share internationally, yes, the company has a strong moat, yes, the company is investing for the long term. You can expect this company to execute, as the company raises prices, continues its global expansion, and returns capital to shareholders.
However, I don’t see any major upside catalyst in the short term, due to the decline in housing. It’s hard to say when this pressure will abate. Housing has ripped and roared for a decade-plus since the great recession. The rise in interest rates will impact housing, and hence impact Sherwin Williams business in the short term. How long will this last? I don’t know. Nevertheless I’d be more than willing to buy the shares if they traded at a more reasonable multiple. Don’t get me wrong, I know I won’t be able to buy the stock at 10x earnings. But isn’t sub 20x reasonable? I can’t foresee any upside catalyst at the current moment and feel you can wait to purchase the shares either at a more attractive valuation in the future. There are other opportunities I see the market. I’d add to existing holdings in my portfolio before starting a position in SHW at the current price. I’d rather purchase many other names that I don’t currently hold before buying Sherwin Williams. There are better places to put your money. I’ll be patient, continue to watch the company and pounce on the opportunity, when it presents itself.