1 Looming Concern That Could Hit This Stock Hard

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Mr. Market sure has a good sense of humor! How else do you explain the sharp 8% drop in shares of paint retailer Sherwin-Williams ) after it reported record third-quarter sales and net profits even as most companies flounder with their numbers? Well, Sherwin failed to meet Street estimates on the top line, and just scraped through at the bottom.

Were analysts expecting a bit too much from Sherwin? Could be, as it belongs to the category of companies riding high on a housing rebound. Or maybe it was Mr. Market’s way of telling Sherwin: I was just waiting for an opportunity to dump you after you became too pricey!

Sherwin’s shares were in fact trading at what-I-feel were pretty unsustainable levels for its valuation. Although a good set of numbers has revived my interest in the company, I won’t give the crown to Sherwin yet. That’s because even if a key issue paint companies face has recently shown signs of thawing, it’s far from over yet. And this is what I feel could mar Sherwin’s growth.

Encouraging Signals

After DuPont (NYSE: DD) reported feverish demand for titanium dioxide pigment (TiO2) during its recent third-quarter earnings release, many thought that could mean sluggish sales from Sherwin as well. TiO2, of which DuPont is the world’s largest producer, is a key input for paint companies. But that was not to be, as Sherwin’s third-quarter revenue rose around 5% from the year-ago period to hit a record quarterly high of $2.6 billion. More importantly, same-store sales (sales from stores open for twelve months and more) rose around 9% during the quarter.

What’s noteworthy is that it wasn’t just prices that boosted revenue volumes were up too, which essentially means customers are now more willing to let loose their pockets to perk up their homes. RPM International (NYSE: RPM) too reported a 6.5% rise in its last-quarter sales, with nearly 3% of it coming from higher volumes as opposed to prices which accounted for only 2% growth in sales. Likewise, third-quarter sales in PPG Industries’ ) industrial coatings business improved 5% from the year-ago quarter backed by stronger volumes. Though the company’s total revenue remained flat, it was because of currency headwinds that offset higher volumes and prices.

Why it Could Work

Rising volumes is indeed an encouraging sign (which is also the reason why Sherwin caught my attention again). If Sherwin continues to successfully implement higher prices while volumes improve, and input costs remain subdued as they are currently, that would be a double advantage. Prices of titanium dioxide (TiO2) pigment -- a key input for paints flew through the roof last year as producers passed on the buck to paint makers. The world’s largest TiO2 producer DuPont enjoyed solid revenue growth quarter-after-quarter through 2011 primarily because of high TiO2 prices it charged, which even boosted its twelve-months top line growth rate till December last year to an impressive 20%. Meanwhile, paint companies felt the heat.

It was only earlier this year when the pigment market started slowing down, and the last time DuPont hiked TiO2 prices was in March. Naturally, it was a big relief for companies like Sherwin, which got reflected as better numbers over the past couple of quarters. But this is where the problem crops up.

Short-lived Joy?

TiO2 producers are ready to jump at the slightest opportunity to push up prices again to offset their own costs which continue to rise; and this must remain as constant fear in the minds of paint makers. This probably explains why none of the paint companies were willing to comment on whether they see further softness in TiO2 prices as the year progresses. DuPont feels the TiO2 market should bottom out in the next six to eight months as housing in the U.S. and infrastructure spending in China warm up. Once TiO2 inventory levels in the industry start receding (they already are) and demand catches up, pigment producers might start the pricing game all over again. And then, Sherwin could be one of the worst-affected.

Where it Lags

Sherwin’s problems multiply because its paint stores group and consumer group account for more than 70% of total sales. Comparatively, Valspar (NYSE: VAL) gets around 40% sales from its paints segment. Paints business is impacted the most by TiO2 prices, so you know why Sherwin is at risk. Also, three of Sherwin’s four business divisions deal in consumer products, which means their fate largely hangs on consumer spending and housing conditions.

In contrast, products of both PPG and RPM have wider applications in industries. As I mentioned earlier, PPG’s industrial coatings segment was the best performer in its last quarter, and RPM’s industrial segment sales contributed 67% to total sales in its last quarter. RPM is also gradually expanding its industrial base through acquisitions. The difference is here to see if Valspar’s and Sherwin’s last-quarter sales increased 1% and 5%, respectively, from the year-ago period, RPM’s sales rose around 7%. 

Lazy Boy!

These companies clearly know how closely their fates are tied to the white pigment. Little wonder then that they are trying out various ways to curb costs. PPG aims to end the year with overall 4% to 6% lower TiO2 usage, and is even weighing options like manufacturing TiO2 in the longer run. Similarly, Valspar is eliminating TiO2 this year by ‘mid-single-digit’ percentage, and switching gradually to cheaper sulphate-based TiO2 (most of which is coming from China). Sherwin, in turn, has revealed no such plans yet, and admitted it will be a ‘later adopter’ of such practices.

Foolish Takeaway

The housing sector still has a long way to go as recovery has been painfully slow. Meanwhile, if TiO2 prices start acting tough again, Sherwin could feel the pressure to maintain margins. It needs to get proactive about three things chalk out plans to control costs (as increasing selling prices might not work every time), include more industrial products in its growth plans, and expand its geographic reach as well as product base to take full advantage of a housing rebound. I’d then be more willing to pay a premium for its shares.

Sherwin-Williams had a great run but buying the stock for high premiums could leave investors watching their investments slathered in red. Are there stocks that can help keep your portfolio nice and clean? Absolutely! Check out The Motley Fool's new free report, "Secure Your Future With 9 Rock-Solid Dividend Stocks," for some great investing ideas. To get your copy of this free report, click here.

Neha Chamaria has no positions in the stocks mentioned above. The Motley Fool owns shares of Sherwin-Williams. Motley Fool newsletter services recommend Sherwin-Williams. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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