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Summary

  • The company’s shares have surged upward in the last several years to all time highs and insiders continue to sell large amounts of shares.
  • Much of SHW’s sales are derived from the slow-growing North American market where many purchasing decisions are based on discounting rather than brand loyalty.
  • The company benefits from the recovery in the U.S. housing market, but also suffers when the housing market turns downward.
  • Litigation costs will continue for SHW as public nuisance allegations regarding lead paint sales from years earlier are likely to continue to be brought against the company.

Sherwin-Williams (NYSE:SHW) is a well-run company that is executing its objectives well. The company has a strong and proven track record of posting solid earnings, strong revenue growth and dividend increases. The share price has sharply increased over the last several years, but now the current share price is near all-time highs and insiders are selling significant amounts of shares. Let us look briefly at the company and their recent earnings announcement.

Background

Sherwin-Williams develops, manufactures, distributes and sells paints, coatings and related products to professional, industrial, commercial and retail customers primarily in North and South America with additional operations in select areas around the world. The company is divided into four divisions: paint stores, consumer, global finishes and Latin America coatings. The paint stores division, representing 59 percent of 2013 sales, offers Sherwin-Williams branded architectural and industrial paints, stains and related products. The consumer division, representing 13 percent of 2013 sales, develops, manufactures and distributes architectural paints, stains and more. The global finishes division, representing 20 percent of 2013 sales, develops, licenses, manufactures, distributes and sells paints, stains, coatings, varnishes, industrial products and more for the automotive, aviation, fleet and heavy truck markets. The Latin America coatings segment, representing 8 percent of 2013 sales, develops, licenses, manufactures, distributes and sells a wide range of architectural paints, industrial coatings and related products throughout Latin America.

Second Quarter Earnings

SHW earnings rose about 19.5 percent to $2.94 per share from the 2013 second quarter. Net sales for the quarter were $3.04 billion. Increased paint sales volume at SHW's paint stores division and the favorable impact of acquisitions led to higher sales in the quarter. The paint stores division recorded net sales of $1.88 billion in the quarter, up 17.2 percent from the 2013 second quarter. The gain in this division resulted from increased architectural paint sales volume across all end market segments and acquisition. The consumer division recorded net sales that increased 10.1 percent to $433.4 million due to acquisitions and higher volume sales to most of the company's retail customers. The global finished division recorded net sales that rose 6.1 percent to $544.6 million in the quarter due to higher selling prices, and higher paint sales volumes. The Latin America coatings division recorded net sales that fell 8.9 percent to $181.2 million as higher selling prices were offset by unfavorable currency translation, which reduced sales by 11.3 percent, and lowered paint sales volume.

During the earnings conference call, the Chairman and CEO of SHW summarized the positive and negative factors the company faced in the quarter as follows:

Our confidence in the domestic building and remodeling markets continues to grow and we expect non-residential to play an increasingly important role in driving future paint and coating demand.

Many of the industrial segments also appear to be gaining momentum. These positives will be offset to some degree by persistent challenging conditions in Latin America. Based on this outlook, we expect third quarter consolidated net sales to increase in the range of 9% to 14% compared to the third quarter 2015.

With sales at that level, we expect diluted net income for common shares for third quarter to be in the range of $3.15 to $3.25 per share compared to last year's $2.55 per share. For the full year 2014 we expect consolidated net sales to increase 8% to 13% compared to last year.

SHW raised their earnings guidance for 2014 to a range of $8.50 to $8.70 per share from $8.12 to $8.32 per share expected previously. The shares surged to a 52-week and all-time high the day after the earnings announcement.

Competitors

The U.S. coatings market is divided into two major markets, the architectural coatings market and the industrial and commercial coatings market. Architectural coatings include interior and exterior paints stains and varnishes, etc. Industrial and commercial coating includes auto and other industrial coatings. SHW participates in both markets, but predominantly in the architectural market, and has different competitors in each.

In the architectural coatings market, SHW is the largest producer in this market and significantly outsells its closest competitors Imperial Chemical Industries (owned by Akzo Nobel (OTCQX:AKZOY)), Benjamin Moore and Masco (NYSE:MAS). SHW is a smaller participant in the industrial and commercial coatings market, which is dominated by the large chemical corporations Akzo Nobel, Dupont (NYSE:DD) and PPG Industries (NYSE:PPG).

The two largest U.S. paint makers have different strategies to prevent the slow-growing U.S. market from adversely affecting their financial results. SHW's customers, for example, make purchasing decisions based on discounting rather than brand loyalty. In addition, those paint makers face slow long-term sales growth in North America and Europe, a slump in Latin America and large Asian market where neither has been able to establish a significant presence.

PPG has made acquisitions to become a global coatings business and is competing with AKZOY for the top position in the global market. About 50 percent of PPG's sales are from outside of the U.S. and Canada. SHW, the third largest global coatings company has a market share of about 5 percent and focuses on the Americas, where it runs its own stores, and has made fewer acquisitions. SHW's strategy of selling paint primarily through their own stores gives them greater control over pricing and direct contact with customers. SHW indicates their business is benefiting from the recovery of the U.S. housing market and a greater willingness of Americans to remodel and repaint. In June 2014, PPG announced their plan to acquire a Mexican paint maker, Consorcio Comex SA, for $2.3 billion. The purchase would make PPG the world's biggest coatings maker by sales, surpassing Akzo. In 2013, Mexican regulators blocked SHW from buying the same company, stating that such deal would have reduced competition, but PPG believes their deal will succeed as they, unlike SHW, have a small amount of paint sales in Mexico.

Risks

The industry is cyclical and affected by costs for basic commodities, especially oil and gas. Price movements impact dependent industries such as resins, plastics, synthetic fibers, paints, coatings and more. The industry is also dependent on the health of the housing industry as well. In addition, in the coatings market, there was a lawsuit in Rhode Island against SHW and other companies where the companies were found liable for creating a public nuisance by selling lead paint decades earlier. Punitive damages were not awarded, but clean-up costs were estimated at $2.4 billion. The decision was later overturned. Commentators believe that the overturning of the lower court decision diminishes the risk of negative rulings in other states. Litigation costs, however, will continue for SHW as additional public nuisance allegations are likely to be brought against the company.

Analysts' views and our view

Many analysts have neutral/hold ratings on SHW shares with price targets ranging from $218 to $240.

Our view is that SHW is an excellent, well-run company that is currently overpriced. The company's shares have had an extraordinary run over the last five or so years. The 2015 earnings estimate is $10.70. The forward price to earnings ratio based on such estimate is 19.15, which is above the company's historical average of 15. We would like to see the share price pull back to $182 to $192 (which is a forward price to earnings ratio of 17 to 18) before any investor even considers starting a position in SHW shares. That said, future estimates are just that, estimates. Even the slightest stumble by SHW or the U.S. economy at this point will bring SHW shares back to their historical price to earnings ratio and the shares would likely drop 30 to 40 percent from their highs.

We once owned SHW shares and sold them in late 2012. We thought we could buy the shares back at a lower price but the shares never dropped significantly after we sold our shares. We believe it is too dangerous to buy the stock now as the shares are at an all-time high, insiders are selling millions of dollars of shares and the shares are priced to perfection.

Source: Sherwin-Williams: A Great Company With An Overpriced Stock