Our consistent theme in regard to Sherwin-Williams (NYSE:SHW) has been in recent years "great company with overpriced shares." Our opinion has not changed even though the company's shares have been weaker in recent months while the overall market has stayed near all-time highs. We think the company's shares are still expensive and have further to fall especially if the overall market sells off strongly in the near term, which we expect as well. We have noted in the past that SHW's shares, a sort of stodgy paint company in our mind, were trading in a manner similar to a momentum stock in recent years. Even more troubling to us is that the company's shares continue to trade at a premium to their historical average price to earnings ratio. We have noted previously that we believe that SHW's announced acquisition of Valspar Corporation (VAL), a company that develops, manufactures, and distributes a range of coatings and paints, is an admission that the company's organic revenue and earnings growth is slowing and no longer able to support the company's expensive share price. We noted that such acquisition was risky and was a warning sign that SHW's shares were headed for a fall, which is happening as we write this article.
In early 2016, SHW announced its acquisition of VAL for about $11.3 billion. At the time the company indicated that the acquisition would enhance its position as a premier global paints and coatings provider and accelerates it growth strategy by expanding its global platform. The company also expected the combine companies would achieve $280 million of estimated annual synergies in the areas of sourcing, SG&A and process and efficiency savings within two years and long-term annual synergies of $320 million. The company also indicated that the acquisition would be immediately accretive excluding one-time costs and meaningfully enhance its cash flow generation profile. The company continues to expect the acquisition to in 2017 despite the U.S. Federal Trade Commission having issued a second request for additional information and documentary material in connection with the VAL acquisition. Although SHW and VAL remain steadfast that the acquisition will close, we are not so sure given how many large-scale mergers have been blocked in recent years.
There is no doubt in our mind that SHW's acquisition of VAL is heavily motivated by the company's attempt to compensate for slowing underlying organic revenue and earnings growth. With this in mind, we believe any attempt by the U.S. FTC to block SHW from acquiring VAL would cause SHW's shares to slide closer to their 52-week lows as organic revenue and earnings growth would not be able to support the company's historically high price to earnings ratio. We should note that SHW and VAL acknowledge the possibility of antitrust concerns with regard to the acquisition. We cannot say whether the merger will close or not, but we can point out that the current U.S. FTC has blocked many announced mergers, especially between major competitors attempting to consolidate. With the uncertainty as to whether such acquisition will close, the integration risks of the acquisition if it goes through and SHW's historically expensive shares, we reiterate that investors continue to avoid the company's shares at this juncture.
Second quarter 2016 earnings
In late July 2016, SHW announced reported earnings of $3.99 per share, an increase from $3.70 in the year-ago quarter due to improved operating results of its paint stores and global finishes divisions. Adverse currency effects decreased earnings by 2 cents per share. The company recorded net sales of $3.219 billion, a 2.8 percent increase from the year-ago quarter due to increased paint sales volumes in its paint stores division that were partially offset by adverse currency effects.
SHW's paint stores division recorded net sales of $2.11 billion, a 6.2 percent increase from the year-ago quarter due to increased architectural paint sales volume across all end markets. Net sales for the company's consumer division decreased 2.6 percent to $477.5 million due to the initial shipments of HGTV HOME products. Profits for the division decreased due to lower sales and increased SG&A spending that was partially offset by improved operating efficiencies. Net sales from the company's global finishes division decreased 1.3 percent to $499.2 million due to adverse currency effects. Profits for the division improved due to a decrease in costs of raw materials and cost-controls that were partially offset by adverse currency effects. The company's Latin America coatings division net sales decreased 11.2 percent to $133.3 million due to adverse currency effects and lower volumes that were partially offset by higher selling prices. Profits for the division decreased due to increasing raw material costs and adverse currency effects.
SHW expects 2016 net sales to increase by a low-single digit percentage from 2015. The company increased its earnings estimate for 2016 to $11.65 to $11.85 per share, an increase from $11.16 in 2015.
SHW's success in recent years is a result of its growth strategy of increasing store opening rate and extending its leading position as a supplier to construction and painting contractors. Such strategy, in combination with trends such as the construction and remodeling market recovery, enabled the company to substantially grow its earnings. SHW's strategy underlying its acquisition of VAL, however, is to diversify cash flows geographically and by product segment. In addition, SHW benefits from such acquisition through cost synergies including cost savings from selling, general, and administrative costs, raw materials sourcing, research and development, and manufacturing/distribution. The acquisition of VAL would also expand SHW's international exposure since it is currently a mainly U.S.-market focused company. While the acquisition of VAL can have positive results for SHW over the long term, we believe there are too many execution risks with respect to such acquisition to invest in SHW shares now. Aside from execution risks, as noted above, there are risks that the U.S. government may not approve the acquisition.
With SHW's shares trading at a historically expensive price to earnings ratio, such shares are at risk of falling further given the following: 1) a weakened global economy; 2) a lackluster recovery in the U.S. economy that may turn downward; 3) integration risks involving the VAL acquisition whereby SHW does not fully realize expected synergies; and 4) the U.S. government blocking the VAL acquisition due to antitrust concerns thereby exposing SHW's likely slowing growth without such acquisition. SHW's earnings estimate for 2016 is $12.64 and its earnings estimate for 2017 is $14.05, with estimates for each year falling in recent months. The forward price to earnings ratio based on the 2017 estimate is about 19.15, which exceeds the company's historical average of 15. A potential investor should wait for a share price pull back to at least $238.85 to $252.90 (which is a forward price to earnings ratio of 17 to 18 based on 2017 earnings estimates) before initiating a position in SHW shares. Although the company continues to excel, the risk for a new investor to invest in the company's shares now is too high.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.