Playing The Sherwin Williams-Valspar Deal

| About: The Sherwin-Williams (SHW)
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As S&P has remained flat during the last one and a half year and earnings are expected to remain flat this year, deal arbitrage is the ideal spot of investing.

The deal of Sherwin-Williams/Valspar currently offers a 7.6% yield in less than one year.

The financing of the deal has already been secured. In addition, there is minimal business overlap between the two companies so the deal will almost certainly receive the anti-trust approval.

As the ongoing bull market has just celebrated its 7th anniversary, investors are afraid that the best days of this rally are behind us and an imminent bear market is just around the corner. The imminent hikes of interest rates by Fed only add to these worries. Therefore, many investors have increased the cash portion of their portfolios while they also wonder how they can achieve satisfactory returns with minimal risk from now on. To these investors, I strongly recommend purchasing Valspar (VAL), which currently offers a 7.6% yield in less than one year.

As I have mentioned in the past, deal arbitrage can be highly profitable and is an ideal spot of investing under the current market conditions. During a period of stagnating earnings growth, in which S&P (NYSEARCA:SPY) has remained essentially flat for one and a half year and a downtrend is more likely than a further rally, investors should pinpoint deals that have a very favorable risk/reward profile. In this way, they will enjoy excellent returns even if the market plunges. Of course, when one invests in a deal arbitrage, one should first make sure that the deal will materialize. Otherwise, the good profits from the deals that materialize will eventually be offset by a great loss from a deal that is cancelled.

Sherwin-Williams (NYSE:SHW) recently announced that it will acquire Valspar for $113 per share in an all-cash deal. The deal is expected to close the latest in the first quarter of 2017. As per the terms of the deal, in the unlikely event that divestitures greater than $650 M are required by the anti-trust authority, the price of the deal will fall to $105 per share. Moreover, the two companies will have the right to cancel the deal if the required divestitures exceed $1.5 B.

The only factors that can break the deal, just like every deal, are the rejection of the deal by the shareholders of one of the two companies, lack of financing resources for the payment of the deal, and rejection by the anti-trust authority due to competitive issues arising from the deal. As Valspar is being acquired at a 41% premium over its 30-day average price and a 30% premium over its all-time high, it is certain that its shareholders will approve of the deal without any reservations.

It is also worth noting that the deal will enable Sherwin-Williams to expand internationally, particularly in China, where Valspar generates 15% of its total revenue. Another benefit for Sherwin-Williams is the strength of Valspar in coatings for food and beverage packaging and for steel coils, two areas in which the former wants to expand. Moreover, the management of Sherwin-Williams estimates the synergies from the deal to amount to $280 M per year by 2017 and the boost to the earnings per share to be nearly $4.00 by 2018. Therefore, the shareholders of Sherwin-Williams are not likely to oppose to the deal either.

In reference to the financing of the deal, while the deal has a total value of $11.3 B, Sherwin-Williams has already secured a fully committed bridge loan from Citigroup for $9.3 B. Moreover, the company has a strong balance sheet, with a net debt of $3.5 B, which is only 3 times the expected earnings of this year. In addition, the company is minimizing its share repurchases from this year so it will be in an excellent position to rapidly deleverage after the deal is complete. All in all, the financing of the deal is secure and hence investors should not worry about this factor.

The only issue that remains is the approval from the anti-trust authority. However, the two companies use different architectural channels in the U.S. while they do not have any overlap in the industrial coating business. Therefore, the anti-trust authority will almost certainly approve of the deal without any reservations. Investors were initially cautious on this issue due to the provision of the deal for a lower deal price ($105 per share) in the event that the regulatory authority required divestments higher than $650 M. However, as the managements of the two companies repeatedly emphasized in the conference call, they introduced this provision only to secure the certainty of the deal. The two companies have hired some experts in the anti-trust field, who expect zero divestments to be required by the authorities. To make a long story short, both managements strongly believe that the regulators will not require any divestments at all but they incorporated this term in the deal only to make sure that the deal will materialize. That's why the stock of Valspar rallied on the day of the conference call.

All in all, the deal will almost certainly materialize and investors can make a great profit from it. Given that Valspar will pay a quarterly dividend $0.33 in the next 3 quarters, investors who purchase Valspar at the current price, will earn 7.6% in less than a year. Given the current status of the market, with essentially flat earnings and more interest rate hikes in the near future, the above yield is excellent, particularly given the extremely low risk of the trade.

Disclosure: I am/we are long VAL.

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.