Is This Rally Just Getting Started?

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

Since starting the year at $90, Sherwin-Williams's (NYSE: SHW) stock price has rocketed upward nearly 60% to over $140 per share. The rally is in response to improving fundamentals in the housing market. But even with a stronghold in the U.S. market and a long runway for improvement in the years ahead, a 26x earnings multiple is enough to raise doubts as to the investment merits of the stock.

Since it was founded by Henry Sherwin and Edward Williams in 1866, Sherwin-Williams has built a powerful brand in the domestic coatings market; at $9.2 billion in sales over the last four quarters, SHW is the largest coatings manufacturer in the U.S. and third-largest worldwide.

Its four business segments provide products to customers ranging from commercial construction companies to do-it-yourself hobbyists. Well-known brands include Sherwin-Williams, Krylon, Minwax, and Thompson's WaterSeal. Aside from selling premium-quality paint, the defining characteristic of SHW is its 3,450 company-owned stores in the U.S., Canada, and the Caribbean. These stores allow the company to have direct contact with its customers, an advantage that no other U.S. competitor can match.

However, SHW currently trades at 1.54x sales. This is despite EBIT margins coming in at ~10.5% during good years. Meanwhile, competitor PPG Industries (NYSE: PPG) routinely produces EBIT margins in excess of 11% but only trades at 1.22x sales. In addition, Valspar (NYSE: VAL) trades at 1.32x sales with slightly more volatile margins than SHW and PPG.

Perhaps SHW's higher relative valuation can be explained its remarkably stable free cash flow generation. Even during the rough years right after the real estate market collapsed, SHW continued to produce a consistent amount of free cash flow relative to sales. This is a testament to its dominance in the U.S. market, showing that not even desperate competitors could cut into SHW's margins. However, PPG, which derives a much larger percentage of revenues internationally, has also shown an ability to generate consistent free cash flow margins. In addition, PPG has grown free cash flow at an annual rate of 4.35% since 2005, while SHW's free cash flow has remained flat over the same period. More alarmingly, SHW's tangible assets have grown at the same rate as EBIT, which suggests that the company's expansion is producing little, if any, incremental value.

Conclusion

SHW's business results will continue to improve as the housing market rebounds, but the stock price has run up to a level where buyers can only hope to sell to a greater fool. The price multiples may come down somewhat as fundamentals improve, but the company is already hitting record sales levels and margins have already improved since the depths of the crisis. In addition, SHW normally trades at a price to sales closer to 1x, even in years when it has a higher net margin. Insiders have been selling since the stock hit $120, another sign that the stock price has reached speculative levels. All of this suggests that the prudent investor should move on to another company to find a better bargain.

Alternatives

If you want to buy a coatings manufacturer, PPG is cheaper, and just as reliable as SHW. If you want to bet on a rebound in U.S. housing, you can get better value buying a company like Headwaters International (NYSE: HW). Headwaters is a highly-leveraged manufacturer of building products and construction materials in the midst of a turnaround. It is worth investigating if you are looking for exposure to the housing sector.

 


titans8904 has no positions in the stocks mentioned above. The Motley Fool owns shares of Sherwin-Williams. Motley Fool newsletter services recommend Headwaters and 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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