2 Reasons This Stock’s Strength Could be Short-lived

Neha is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Sherwin-Williams(NYSE: SHW) stock has been on a tear this year. As of this writing, the stock has gained a solid 17% year-to-date. A great first-quarter scorecard some days back sent the stock soaring to a 52-week high.

Positive housing data has been a huge factor behind Sherwin’s wild run, but now that Sherwin’s stock has gained a massive 54% over the past one year, it may be time to stop and think. Is it time to take some profits home, or has Sherwin just embarked on a fresh bull run?

In top form

While analyzing a stock that hits a 52-week high, I usually go back and weigh the company’s operational performance and financials to see whether the stock’s run was justified. Sherwin’s sales in its first quarter improved by just about 1%, but the company did a great job in translating those little incremental sales to profits by maintaining a tight grip over costs. Sherwin’s net income climbed 16% year-on-year.

This isn't the first time that Sherwin’s management has displayed its efficiency in cost control. In fact, Sherwin sports the best gross margins in the industry. Take a look.

<img alt="" src="http://media.ycharts.com/charts/86466ae6f90f72dfaf7062d4028f7a4a.png" />

SHW Gross Profit Margin Quarterly data by YCharts

Last year was one of the toughest years in terms of cost pressures, yet Sherwin maintained its gross margin above the 40% mark. Prices of key input, titanium dioxide pigment (TiO2) peaked in 2012. It was only in the second half when excess supply in the industry forced top TiO2 producers like DuPont (NYSE: DD) to rethink and halt their strategy of increasing pigment prices. As a result, DuPont’s revenue from its pigment business (performance chemicals) slumped 15% in 2012, dragging its overall net income down by 20% year-on-year. Sherwin capped off 2012 on a strong note with a 43% jump in net profits, which was also a record.

While some TiO2 producers have announced fresh TiO2 price hikes, DuPont feels its inventory level in the industry is still too high to justify price increases. DuPont isn’t expecting the TiO2 market to pick up before the second half of the year, which is good news for Sherwin. Sherwin’s consistent gross margin expansion is a big deal and investors can remain hopeful as input costs remain stable.

Internally strong

Sherwin’s balance sheet looks equally strong. The paint maker has been free cash flow positive for the past five years – an excellent sign of internal strength. Sherwin scores brownie points for generating higher FCF than net profits last year – It generated $731 million of FCF for $631 million of net income. Further, healthy growth in operating profit and a good interest coverage ratio of 22 times means Sherwin needn't worry about its debt obligations. This is critical because Sherwin will assume more debt once it completes the acquisition of Mexico-based paint and coatings company, Comex.

Sherwin expects to close the Comex deal in the second quarter. This deal has been another driving factor behind Sherwin’s stock price in recent months. Comex is Mexico’s largest paint maker and should thus give Sherwin a solid foothold in the market. The markets have rightly given Sherwin’s shares a green thumbs up on the deal. But I feel the good news is already factored in its current share price, especially because peers are making big moves that could slam brakes on Sherwin’s growth.

PPG Industries (NYSE: PPG) deal to buy out Akzo Nobel’s architectural coatings business for $1 billion was the most talked about deal in the paints industry in recent times. With this acquisition, PPG overcomes Sherwin as the largest coatings company in the world while increasing presence in Sherwin’s most important market, North America. PPG is also restructuring operations to emerge a leaner and stronger company.

RPM International (NYSE: RPM) acquired nine companies in the past two years that are doing a great job at boosting its top and bottom lines. RPM is not only adding new product lines such as nail enamels, but is also spreading its wings into markets like Brazil through takeovers. From 7% of revenue in 2010, RPM is targeting 16% of revenue from developing economies by 2015.

Valspar (NYSE: VAL) not only has a critical customer in Lowe’s but also enjoys a strong presence in markets like Australia, Latin America, and China. Its sales in China grew at a compounded average rate of 25% in the past six years. Encouraged, Valspar recently opened a new research and development center in China. These markets could play a big role in Valspar’s growth in the future.

Clearly, competition is heating up and Sherwin needs to buck up to stay in the lead. As I mentioned, the Comex deal already seems to be discounted in its share prices. Here’s how Sherwin’s valuation stacks against peers.

<table> <thead> <tr><th>Company</th><th>Trailing P/E</th><th>Forward P/E</th><th>Dividend yield</th></tr> </thead> <tbody> <tr> <td>Sherwin-Williams</td> <td>30.1</td> <td>19.1</td> <td>0.9</td> </tr> <tr> <td><span>Valspar</span></td> <td>20.2</td> <td>14.1</td> <td>1.5</td> </tr> <tr> <td>PPG Industries</td> <td>23.9</td> <td>15.5</td> <td>1.6</td> </tr> <tr> <td>RPM International</td> <td>35.8</td> <td>14.9</td> <td>2.9</td> </tr> </tbody> </table>

Source: Yahoo! Finance, Morningstar

Sherwin doesn't paint a very pretty picture here. It is among the priciest stocks with both Valspar and PPG enjoying lower trailing P/Es. Though the drop in forward P/Es indicates good upside potential for Sherwin’s stock in the near future, that holds good for peers as well. More important, Sherwin’s dividend yield is the lowest in the industry and far behind RPM’s handsome 2.9% yield. All these companies are top dividend payers. PPG and RPM have increased their dividends for 42 and 39 consecutive years, respectively. Valspar has increased its dividend for 35 straight years. Sherwin has done so for 34 consecutive years.

Foolish takeaway

A bounce back in housing has a lot to do with Sherwin’s future growth, but the company’s retail stores are still not churning out as much sales as they should. I’ll feel better once its Comex acquisition starts showing results. Booking some profits on the stock looks like a good idea for now. Meanwhile, PPG looks like a good growth story and RPM should satiate dividend lovers’ appetites. 

Neha Chamaria has no position in any stocks mentioned. The Motley Fool recommends 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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