This Stock Deserves a Kick in the Pants

By Neha Chamaria - August 28, 2012 | Tickers: DD, PPG, RPM, SHW, VAL | 0 Comments

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Positive housing data in the past few months has sent several stocks in a tizzy; and it’s not just the homebuilder stocks that are doing the dance. Companies into any kind of housing-related businesses have seen their stocks soar.

One such stock hitting its 52-week high is Sherwin-Williams (NYSE: SHW). Does the paint maker deserve such high valuation? Seems so. Is there room for more run up? Seems not.

I’ll give you 3 reasons why Sherwin’s high price seems warranted.

Top at the top
Sherwin’s started 2012 on a strong note, with sales rising 12% during the first six months of the year. More importantly, same store sales (a key metric for retailers indicating sales from stores open for more than twelve months) rose 16.6% during the period. 2011 was equally good for Sherwin as it achieved record sales. Its one-year and three-year revenue growth rates of 12.7% and 7.4%, respectively, are better than that of peers PPG Industries (NYSE: PPG) and RPM International (NYSE: RPM).

Gross impresses
What really caught my eye when I looked at Sherwin’s past few quarters were its solid gross margins. At 43% for the past twelve months, it is commendable. In fact, the paint maker has always outdone its peers on this front, consistently maintaining gross margins above 40% for the past five years. High gross margin is an important indicator of management efficiency. Take a look at the graph below, and you’ll know why Sherwin stands out.

SHW Gross Profit Margin data by YCharts

Returning to whom it matters
In a pretty similar fashion, Sherwin has generated the best value to shareholders among peers over the past five years. 

SHW Return on Equity data by YCharts

What impresses me is this: usually, high leverage (debt) pushes up the return on equity, which isn’t as meaningful as a high ROE due to better net profits would have been. In this case, one would then be quick to assume that Sherwin’s debt might also be the highest among peers. But that’s not the case. Although its total-debt-to-equity ratio is pretty high at 88%, all three peers sport higher ratios. Both Valspar and PPG have total-debt-to-equity ratio above 100%.

Sherwin has also remained free cash flow positive for the past five years (its FCF for trailing twelve months stands at $675 million), and its operating income has grown in high single digits since  2009. Steady operating margin and manageable interest expenses have resulted in a good interest coverage ratio of 22 times, indicating there’s enough cushion to service debt obligations.

Apart from good ROE, Sherwin has been a top-class dividend payer. This is the 34^th consecutive year when Sherwin has raised dividends, and it is also buying back shares.  Balancing use of cash, the company plans to open 60-65 net (new stores less closures) stores this year, apart from growing in markets like Latin America.

So is everything perfect with Sherwin Williams? Not exactly. There are concerns, and they are big.

Hole in the pocket
The biggest pain for paint makers has been soaring input costs, and they continue to be just that – a pain. Key raw material titanium dioxide prices have risen steeply over a year as producers kept pushing up prices. Sherwin, like others, in turn passed the buck to consumers.

Though prices did take a breather recently because of a slowdown in demand, stability might be far. As demand picks up, TiO2 producers can raise prices again. The world’s biggest TiO2 producer DuPont (NYSE: DD) expects demand to remain strong and volumes to grow in the forthcoming quarters. If it has remained somewhat silent over the possibility of further price hikes, it isn’t ruling them out completely either. And for how long Sherwin can pass on costs is questionable. Only a strong bounce back in sales volumes can do the trick.

Shallow bottom
If Sherwin’s gross margins were exciting, the same cannot be said for its bottom line growth. Net profit margin was 5.6% for the past twelve months. In 2011, earnings per share slipped 4.5% from the year-ago period. One reason could be high selling, general and administration expenses – they stood at 33% of sales for the past twelve months. High tax rate further dented profits – it was 40% for 2011. While a growing top line is good, it is equally important for a company to be able to convert those incremental sales into income, whether it is through cost control or effective tax planning.

There’s a silver lining though -- Sherwin’s net income surged 33% in the first six months from the comparable period last year. More importantly, the company’s full-year EPS guidance of $6.2 to $6.4 is way above the $4.14 per share it earned in 2011. But if we take a look at Sherwin’s share valuations, the bullishness already seems factored in. And this, I feel, is the biggest case against betting on Sherwin right now.

Source: Yahoo! Finance. NM= not meaningful due to negative earnings

As you can see, Sherwin is too pricey right now, no matter which multiple you look at. There really doesn’t seem to be any big growth trigger one can look forward to, except a recovering housing market, of course. Home prices are rising, housing starts have picked up, and people are tendering cash for a roof. As more houses sell, so will paint cans. Sherwin can win big because it enjoys nearly a third of the U.S. paint market share.

But there won’t be housing boom so soon. It will be slow, and thus shouldn’t be the only reason to bet on Sherwin. At least not until share prices breathe a little easy. 

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