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Sherwin-Williams (NYSE:SHW) reported excellent results for the quarter ending September 30, 2013 summarized as follows:

  • EPS of $2.55 increased 13.8% over the prior year
  • Sales increase 9.4% to a new record $2.85 B
  • Guidance for the rest of the year is projected at a total EPS of $7.0 to $7.3 which was a reduction from earlier in the year

These earnings were negatively affected by a one time charge of $0.13 per share related to a government tax assessment in Brazil. Earnings were also strongly impacted by unfavorable currency translations in the Latin American Coatings group which overshadowed a strong increase in volume and price sales in that segment.

Ignoring the one time charge, earnings narrowly beat the analyst estimates and the market reacted with a 4.3% share price rally on Friday (October 25th).

SHW Chart

SHW data by YCharts

For anyone not familiar with the company, see background information here.

1) Sales

Overall company sales for the 9 month period ending September 30, 2013 increased $415 Million and 5.7%.

(click to enlarge)

The Paint Stores segment saw by far the largest increase, with a total increase of $373 M and 9%. This increase was driven by two important factors including a 7.4% increase in same store sales over the same time in the prior year, and the opening of 42 additional stores.

This growth is complimented by an increase in the profit margin in this segment from 16.3$ in 2012 to 18.1% in 2013. The segment's net income increased from $680 M to $822. As the largest segment of the company, this double whammy of sales and margin growth is excellent news for the company. Coupled with management's continued commitment to expand the reach by adding new stores, there is a very bright future for this segment.

The Consumer Group sales increase 5.4% in the quarter but only increased 0.3 for the nine month period. Profit margin in the group also increased slightly from 18.1% in 2012 to 19.3%. The Global Finishes Group group also posted a small increase in sales of 1.3% and margins increased approximately 1% to 8.82%. Although these segments are not as important as the paint stores segment, the steady sales and margin increases are overall a solid positive for the company.

The Latin America Coatings Group experienced an increase in both the price and volume of paints sold for a total of approximately 6%, both of which were fully offset by unfavorable currency translations as the U.S. dollar strengthened against the operating currencies. The profit margin decreased significantly due to the above mentioned Brazilian tax assessment of $31.6M over the 9 months. Currency translations are inevitable and difficult to predict, however without the impact of those and the tax assessment, this segment would have reported an excellent quarter as well.

In aggregate, the results across the segments are very promising and show a significant improvement in the current year over the prior year. With an improvement in both sales and margin, SHW was able to generate much stronger earnings and is pointing towards a stronger future.

Comex Acquisition

Although the complete acquisition was blocked earlier in the year, SHW seems to be fairly confident that a review of the decision will pass successfully. A vote of 3-2 in July by the Federal Competition Commission of Mexico blocked the $2.3 B acquisition for 3500 stores across North America.

SHW instead completed the acquisition of COMEX's U.S. and Canadian operations in September for total proceeds of $165 M including $90 M in cash and $75 in assumed liabilities. This acquisition adds 314 company operated stores in the U.S. and Canada and eight manufacturing sites.

SHW also extended the date of the Stock Purchase Agreement to March 31, 2014 for the remaining Comex operations in Mexico and declared that it remains fully committed to making the acquisition. SHW's balance sheet holds over a billion in cash and has a new working capital of $1.36 B in preparation for the acquisition.

This first piece of the acquisition will serve as a good test indicator before the acquisition of the remainder of COMEX. In the next quarter, investors will be able to assess if the acquisition delivers bang for buck in terms of sales increases and similar margins on sales from the new stores. Any announcement regarding the status of the acquisition in the coming months will be a big catalyst as hopes of it going through are likely priced into the stock.

Valuation

SHW is classified in the Chemical commodity industry. Although it doesn't actually compete directly with many of these companies, the related business models provide a good base for a valuation comparison. Against these competitors, SHW's valuation stands out quite significantly.

I also find SHW compares well to home improvement stocks given that it is largely driven by architectural paint sales and therefore strongly related to the home improvement industry. Compared to Lowe's (NYSE:LOW) and Home Depot (NYSE:HD), SHW also stands out with a much higher valuation.

Overall, SHW's valuations are quite high and indicate a good deal of the projected growth in the company has already been priced in.

The company offers a 1.0% yield on the shares with a quarterly dividend of $0.50 and continues to repurchase shares through its buy-back program. In the first nine months of the year, the company repurchased 2.8 M shares and has remaining authorization to repurchase another 13.65 M. Combined with the dividend, return to shareholders for the year is approximately between $600 and $650 M including dividends and an estimate of the cost of shares repurchased.

Conclusion:

The main reasons for which SHW trades at (and deserves) a premium can be summarized as follows:

1) Sales volume and profit margins increased significantly during the first nine months of the year. Net of the one-time charges and the net impact of the currency translation, this was an excellent quarter and the start of an excellent year for the company.

3) Although the bulk of the planned COMEX acquisition was blocked by the Federal Competition Commission of Mexico, the company remains hopeful that the deal can be reversed and has completed in the current year an acquisition of all of COMEX's U.S. and Canadian retail locations. A deal for the rest of COMEX would significantly improve the value of the company as long as it will be able to command similar prices and margins on its products as its current stores.

In my opinion a higher valuation on earnings is justified by the growth potential. Yet given the current valuation, the current share price particularly including the spike following the earnings results seems to factor in a good deal of this growth.

I would recommend buying shares of SHW, but only as an income investment with less emphasis on capital appreciation. SHW has a fantastic business model and continues to be able to command strong sales and margins, resulting in a bright future for its earnings. With the market's current optimism on the shares, I think the company would be hard pressed to surprise again in the near future, but will nevertheless provide a decent return based on its strong results.

Source: Q3 earnings report release

Source: Sherwin-Williams: What Could Possibly Justify The Premium For This Paint Supplier?