RPM Redlining On Value

| About: RPM International (RPM)
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Specialty chemical company RPM International (NYSE:RPM) is a curious company for GARP investors. The company has a strong record of sales and free cash flow, but the company's book value growth and returns on invested capital have not been so remarkable. RPM also has a strong collection of brands and a good history of adding value to its acquisitions, but valuations have been marching higher for a few years while most value-creation metrics haven't kept pace.

I might not rush to sell RPM International if I owned shares today, but buying it at these prices is another story. I do believe that the company can leverage a recovering residential remodeling/repair market as well as growth in infrastructure spending and international markets, but it's very hard to find a metric whereby these shares look like a bargain for value-oriented investors.

Basically On Target In The Fiscal Second Quarter

RPM International's revenue came in a little light this quarter, but not to a significant degree. The large Industrial segment saw organic growth of just over 2%, while the Consumer business grew at an organic rate of more than 9%.

That sizable discrepancy has a few causes. First, non-residential construction and infrastructure spending remain weak and new construction is about 40% of the Industrial segment. Moreover, while about 70% of RPM's business historically comes from maintenance and repair, the results from industrial distributors like Grainger (NYSE:GWW) suggest to me that businesses have tightened up on their maintenance spending. Also, the Consumer business is really starting to step up, as homeowners are spending more on their homes and new Rust-Oleum products like NeverWet (water repellent treatments) and Restore (wood restoration) start contributing.

On the margin side, gross margin improved about a point, and adjusted operating income increased 16% as the operating margin more or less kept pace. On a segment basis, the Industrial segment saw 8% operating income growth, while the Consumer business was up 33%.

Waiting On The ABI … Just Like Everybody Else

A wide range of companies are waiting for non-residential construction to improve, and there are tentative signs that the market is getting better. As RPM has leading share in areas like institutional roofing materials, sealants, floor coatings, concrete/masonry additives, and specialty coatings with attributes like corrosion resistance and fireproofing, they stand to benefit as construction activity improves.

RPM also has some operations outside of commercial construction that I don't think necessarily always get their due. The company has roughly 30% share in the specialty highway/bridge market for products like steel coatings, concrete additives, traffic deck coatings, and roadway striping, where it competes with companies like 3M (NYSE:MMM) and Dow Chemical (DOW). I believe RPM also has some growth opportunities in the offshore energy market, where the company's fiberglass grating products can replace metal gratings.

Emerging Markets Still A Work In Progress

RPM generates about 70% of its revenue from North America and 20% from developed Europe. That tells you that faster-growing emerging markets like Brazil and China are not yet major contributors to RPM's revenue mix.

The company is working on changing this. RPM's investment in India's Kemrock hasn't worked out, and the company has fully written down that investment, but the acquisition of Brazil's Viapol tells me that they're not giving up. Viapol cost the company about $85 million and brought with it asphalt membranes, waterproofing products, concrete additives, epoxy flooring systems, and paints that should fit in well with RPM's Euclid Chemical group (part of Building Solutions). Just as important, though, I believe that Viapol can give the company a beachhead in Brazil through which it can sell more of its products.

A Good Platform Of Semi-Autonomous Companies

RPM lets units like Rust-Oleum, DAP, Tremco, and so on operate with a fairly high degree of autonomy. That incentivizes the managers in these units to take a greater interest in their addressable markets, and RPM has a good record of developing and introducing new products under familiar brands (like Rust-Oleum or DAP) that ultimately grab significant market share. With that, acquisitions like Tremco often end up delivering far more revenue down the line than seems possible at the time the deals are announced.

There aren't a lot of really good comparables to RPM, as companies like PPG (NYSE:PPG), Sherwin Williams (NYSE:SHW), and H.B. Fuller (NYSE:FUL) only overlap on a limited basis. I actually believe that is to RPM's credit or advantage, as it seems to help keep them away from commodity markets or markets where they cannot really differentiate themselves.

Even Elevated Growth Rates Don't Point To Value

RPM grew revenue at a rate above 6% over the past decade, and I'm willing to go along with the idea that a recovery in commercial construction, infrastructure spending, and housing can all collaborate to elevate RPM's growth rate to more than 7% in the coming decade. I'm also willing to model an ongoing improvement in free cash flow margins into the high single digits, with free cash flow growth of nearly 10% a year on a CAGR basis.

The problem is that even with a lower discount rate than I'd normally give to a specialty chemicals company, a discounted cash flow model still only values these shares in the mid-$30s.

The Bottom Line

RPM International doesn't appeal on a DCF basis, and an EV/EBITDA approach doesn't work any better. RPM's forward EV/EBITDA multiple has climbed steadily from 6x to 8x to around 10x, but a 10x multiple to the average 2014 EBITDA estimate only results in a mid-$30's target. Splitting the estimates for fiscal 2014 and 2015 helps a bit, but still results in a target below $38.

There's a limit to how far I'll stretch my valuation metrics for a company like RPM, as the company's persistently single-digit returns on invested capital don't argue for more benefit of the doubt. While I completely acknowledge that many seemingly overvalued stocks continue to outperform for long stretches of time, and RPM is looking at multiple improving end markets, I can't come up with a model that gets me comfortable enough to buy for my own account.

Disclosure: I am long MMM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.