RPM International: Cost Cutting Leading To Wonderful Cash Flow Growth
Summary
- RPM International is a Dividend Champion with 47 consecutive years of dividend growth. Shares currently yield 1.64%.
- RPM International is a leader in the specialty chemicals market with a diverse customer base from construction, manufacturing, industrial and consumer segments.
- RPM International has been active in bolt-on acquisitions of other niche products.
- The MAP to Growth Initiative to reduce costs and redundancies has led to explosive growth in cash flows that can be funneled back to shareholders or used for further acquisitions.
RPM International (NYSE:RPM) is a leader in the specialty chemicals market with a diverse customer base from construction, manufacturing, industrial and consumer segments. RPM fared well during the turmoil of 2020, thanks in large part to its consumer segment, with revenues off 1% from FY 2019's results.
RPM is in the process of executing their MAP to Growth initiative which focuses on reducing costs. Considering the number of acquisitions that RPM has undertaken this last decade alone, approaching 70, there should be a lot of low hanging fruit for cost control measures for material sourcing, supply chain and logistics.
Dividend History
The dividend growth investing strategy is the strategy that I undertook when I first began investing nearly a decade ago. The strategy is simple in concept: identify strong businesses with a history of paying and growing their dividends that you believe will be able to continue to do so more forward and of course buying them as reasonable valuations.
Image by author; data source RPM International Investor Relations
RPM International's dividend growth streak dates back to 1975 and is an impressive 47 years long. That's an impressive streak considering the various economic and geopolitical catastrophes. RPM's dividend growth hasn't always been blazing fast, but it has come every year.
Dating back to 1998 RPM's year over year dividend growth has ranged from 1.0% to 9.2% with an average of 5.4% and a median of 5.2%.
Over that same period there's been 19 rolling 5-year periods with RPM's annualized dividend growth ranging from 3.2% to 7.8% with an average of 5.7% and a median of 5.9%.
There's been 14 rolling 10-year periods since 1998 with RPM's annualized dividend growth ranging from 5.3% to 6.1% with an average and median of 5.6%.
The rolling 1-, 3-, 5- and 10-year period annualized dividend growth rates from RPM since 1998 can be found in the following table.
| Year | Annual Dividend | 1 Year | 3 Year | 5 Year | 10 Year |
| 1998 | $0.454 | ||||
| 1999 | $0.475 | 4.74% | |||
| 2000 | $0.493 | 3.68% | |||
| 2001 | $0.500 | 1.52% | 3.31% | ||
| 2002 | $0.505 | 1.00% | 2.06% | ||
| 2003 | $0.530 | 4.95% | 2.48% | 3.17% | |
| 2004 | $0.570 | 7.55% | 4.46% | 3.71% | |
| 2005 | $0.610 | 7.02% | 6.50% | 4.37% | |
| 2006 | $0.655 | 7.38% | 7.31% | 5.55% | |
| 2007 | $0.715 | 9.16% | 7.85% | 7.20% | |
| 2008 | $0.770 | 7.69% | 8.07% | 7.76% | 5.44% |
| 2009 | $0.805 | 4.55% | 7.12% | 7.15% | 5.42% |
| 2010 | $0.825 | 2.48% | 4.89% | 6.22% | 5.29% |
| 2011 | $0.845 | 2.42% | 3.15% | 5.23% | 5.39% |
| 2012 | $0.870 | 2.96% | 2.62% | 4.00% | 5.59% |
| 2013 | $0.915 | 5.17% | 3.51% | 3.51% | 5.61% |
| 2014 | $0.980 | 7.10% | 5.06% | 4.01% | 5.57% |
| 2015 | $1.055 | 7.65% | 6.64% | 5.04% | 5.63% |
| 2016 | $1.125 | 6.64% | 7.13% | 5.89% | 5.56% |
| 2017 | $1.220 | 8.44% | 7.57% | 7.00% | 5.49% |
| 2018 | $1.310 | 7.38% | 7.48% | 7.44% | 5.46% |
| 2019 | $1.410 | 7.63% | 7.82% | 7.55% | 5.77% |
| 2020 | $1.460 | 3.55% | 6.17% | 6.71% | 5.87% |
| 2021 | $1.520 | 4.11% | 5.08% | 6.20% | 6.05% |
Table by author; data source RPM International Investor Relations
The payout ratio can be used to determine the safety of the dividend payment in relation to net income or free cash flow. All else being equal the lower the payout ratio the better since there's more room for the business to ebb and flow while still being able to support the dividend.
Image by author; data source RPM International SEC filings
RPM's payout ratio has fluctuated pretty significantly from year to year suggesting that RPM's business is cyclical. The 10-year average payout ratio based on net income is 63% with the 5-year average at 61%. The average free cash flow payout ratios are 59% and 65%, respectively.
Quantitative Quality
When implementing the dividend growth strategy the strengths of the business are what truly matter and will allow the dividend payments to continue growing in the future.
Image by author; data source RPM International SEC filings
RPM's revenue growth over the last decade surprised me quite a bit showing year over year dividend growth every year except for FY 2020 which saw a 1.0% decline. RPM grew revenues 63% in total or ~5.6% annualized over the last decade. Gross profits climbed 49% in total or 4.6% annualized over that same period.
Operating profits lagged slightly behind revenue growth climbing 58% in total or 5.2% annualized. Meanwhile operating cash flow showed excellent growth rising 131% or 9.7% annualized. Free cash flow didn't keep pace with growth in operating cash flow, but still far outpaced revenue growth. Free cash flow great 103% in total over the last decade or 8.2% annualized.
Image by author; data source RPM International SEC filings
RPM's gross margins have declined slightly over the last decade especially so in FY 2020. The 10-year average gross profit margin is 41.6% with the 5-year average at 41.3%.
Over that same period free cash flow margins have been improving although they are still very tight margins. The 10- and 5-year average free cash flow margin for RPM is 5.6%. I generally want to see free cash flow margins greater than 10% which RPM is far from hitting.
My preferred profitability metric is the free cash flow return on invested capital, "FCF ROIC". The FCF ROIC represents the annual cash return of potentially distributable free cash flow that the business generates in relation the capital currently invested in the business. My expectation is that high quality businesses will show at least stable, and preferably rising, FCF ROICs over time as they are able to flex the strength of their business.
Image by author; data source RPM International SEC filings
RPM has generated adequate FCF ROICs spanning between 4.0% and 11.8% although there is definitely a heavy dose of variability in those results. The 1-year average FCF ROIC for RPM is 8.3% with the 5-year average coming in at 8.2%.
To understand how RPM has used its free cash flow I calculate three variations of the metric, defined below:
- Free Cash Flow, FCF: Operating cash flow less capital expenditures
- Free Cash Flow after Dividend, FCFaD: FCF less total cash dividend payments
- Free Cash Flow after Dividend and Buybacks, FCFaDB: FCFaD less net cash spent on share repurchases
Ideally I'd like to see strong FCF and FCFaD over time. I place less of an emphasis on buybacks, but if management does pursue repurchases as a means to return additional excess cash flow I want to make sure they aren't doing so in an excessive manner, i.e. more total cash outflows compared to total cash inflows. I'm not concerned about the numbers in any specific year; rather I focus on the trend over time.
Image by author; data source RPM International SEC filings
As we saw earlier, RPM has been FCF positive every year of the last decade. In total RPM has generated $2.6 B in FCF. With that FCF management has returned $1.4 B to shareholders via rising dividend payments. That puts the 10-year cumulative FCFaD at $1.1 B. RPM has been FCFaD positive in every year except for FY 2019.
Management has spent a total of $0.5 B on net share repurchases over the last decade which puts the cumulative FCFaDB at a healthy $0.7 B.
Share repurchases haven't typically been utilized by RPM management to return excess cash flow to shareholders. Save for FY 2019 and FY 2020 net cash spent on buybacks had not been in any meaningful amount.
Image by author; data source RPM International SEC filings
RPM's share count has risen over the last decade due in part to the number of acquisitions that management has undertaken. RPM has spent a net $1.8 B on acquisitions over the last decade that were financed by both equity and debt issuance. The share count has climbed 1.5% over the last decade or ~0.2% annualized. Share repurchases have been quite aggressive in both FY 2019 and FY 2020 reducing the share count by 2.1% and 3.2%, respectively.
When investing in the equity of a business I want to make sure that the downside business risk is mitigated. I do that examining the balance sheet to make sure it's not over-leveraged.
Image by author; data source RPM International SEC filings
RPM's debt-to-capitalization ratio has been steadily climbing over the last decade. At the end of FY 2011 the debt-to-capitalization ratio stood at 45% and by the end of FY 2020 it was up to 67%. The 10-year average debt-to-capitalization ratio is 55% with the 5-year average at 60%. Given the persistently low interest rates over the last decade that's not necessarily a bad thing, but it's something I would keep an eye on should the interest rate environment change in the future.
I keep a closer eye on the debt levels relative to a variety of profits and cash flow metrics as a better gauge for the riskiness of the debt load. The debt ratios allow me to see how quickly the balance sheet could be de-leveraged assuming the business isn't significantly impaired.
Image by author; data source RPM International SEC filings
I like to look at the net debt versus EBITDA, operating income, and free cash flow. RPM's debt ratios have been climbing over the last decade as the debt load and debt-to-capitalization ratio have risen. The 10-year average net debt ratios or 2.5x, 2.9x and 5.9x, respectively, with 5-year averages of 3.2x, 3.7x and 7.6x.
RPM doesn't appear to be over-leveraged although the debt levels are higher than I'd like to see for a business that has shown large fluctuations in profitability from year to year.
Valuation
Before investing in a business I need to be comfortable with my perception of the quality and the valuation has to make sense. The valuation methods that I use are the minimum acceptable rate of return, "MARR", analysis, dividend yield theory and a reverse discounted cash flow analysis.
The MARR analysis requires you to estimate the future earnings and dividends that a business will produce, apply a reasonable expected terminal multiple and then determine what the expected return will be. If the expected return is greater than your hurdle rate, you can feel free to invest; if not, then you wait for better valuation prospects and look for other opportunities.
Analysts expect RPM to report FY 2021 EPS of $4.23 and FY 2022 EPS of $4.64. Analysts also expect RPM to show annual EPS growth of 12.7% across the next 5 years. I then estimated that RPM would be able to grow EPS at 4.0% annually for the following 5 years. Dividends are assumed to target a 35% payout ratio.
For the expected terminal multiple, I like to see how market participants have historically valued RPM. The following YCharts shows that RPM has typically been valued between ~12x and ~24x TTM EPS over the last decade. For the MARR analysis I'll examine terminal multiples ranging from 10x to 25x.
The following table shows the potential internal rates of return that an investment in RPM could generate provided the assumptions laid out above are reasonably close to how the future plays out. Returns assume dividends are taken in cash and assume a purchase price of $92.43, Thursday's closing price.
| IRR | ||
| P/E Level | 5 Year | 10 Year |
| 25 | 16.4% | 11.3% |
| 20 | 11.3% | 9.0% |
| 17.5 | 8.2% | 7.6% |
| 15 | 5.0% | 6.2% |
| 12.5 | 1.2% | 4.4% |
| 10 | -3.2% | 2.3% |
Alternatively, I like to re-work the MARR analysis to determine what price I could pay in order to generate the returns that I desire from my investments. My standard hurdle rate is a 10% IRR and for RPM I'll also examine 8% and 12% IRRs.
| Purchase Price Targets | ||||||
| 10% Return Target | 8% Return Target | 12% Return Target | ||||
| P/E Level | 5 Year | 10 Year | 5 Year | 10 Year | 5 Year | 10 Year |
| 25 | $120 | $103 | $131 | $122 | $111 | $88 |
| 20 | $98 | $86 | $106 | $101 | $90 | $73 |
| 17.5 | $86 | $77 | $94 | $90 | $80 | $66 |
| 15 | $75 | $68 | $81 | $80 | $69 | $58 |
| 12.5 | $64 | $59 | $69 | $69 | $59 | $51 |
| 10 | $53 | $50 | $57 | $58 | $49 | $43 |
Dividend yield theory is a valuation method built on the premise of reversion to the mean and that a dividend paying enterprise will trade around a normalized dividend yield. For RPM I'll use the 5-year average dividend yield as a proxy for the fair value of the business.
Image by author; data source RPM International Investor Relations and Yahoo Finance
Currently shares of RPM offer a forward dividend yield of 1.47% compared to the 5-year average forward yield of 2.18%.
A reverse discounted cash flow analysis can be used to decipher what the current market valuation implies about the expectations for the cash flow of a business. I use a simplified DCF model built on revenue growth, a tax rate of 23% and an EBIT margin of 10.3%. To discount the forecast cash flows, I'll use a WACC of 6.9% that is derived from a cost of equity estimate of 7.6% using the dividend capitalization method.
Under those assumptions, revenue growth needs to be 4.6% annually over the forecast period in order to justify the current share price. Improvement in EBIT margin or a lower tax rate would lower the revenue growth threshold.
Conclusion
RPM is a solid business with a wide array of end users that helps to cushion the blow of the inherent cyclicality. That has played out during 2020 when the global economy was brought to a standstill, yet RPM was able to show modest sales declines thanks in large part to their consumer segment that benefited greatly from the DIY trend once consumers had ample time on their hands.
RPM's margins aren't as strong as I would like and their returns on invested capital should trend higher moving forward as they continue to focus on their "MAP to Growth" which has a heavy dose of cost cutting. Management is targeting $290 M in annualized cost savings by the end of FY 2021 which will improve margins and efficiency.
RPM does utilize acquisitions as a means to grow their business; the most recent being the Ali Industries acquisition. RPM has completed nearly 70 acquisitions during the last decade alone. Those acquisitions allow RPM to deepen their relationships with retailers. With the sheer number of acquisitions being completed, it shouldn't be a surprise that management is focusing on cost cutting in their MAP to Growth plan as there is likely ample improvements to be made in materials sourcing, supply chain and logistics.
Dividend yield theory suggests a fair value range between $57 and $69. The MARR analysis based on a 10% IRR with a 15x to 20x terminal multiple suggests a fair value between $75 and $98.
The reverse DCF doesn't throw up any red flags with modest revenue growth requirements that are relatively in line with how RPM has performed over the last decade. The reverse DCF does seem to imply that RPM could be pretty cheap based on margin improvement from their MAP to Growth plan. A blended long term EBIT margin of 12.0%, which appears achievable, would boost RPMs valuation up to $110 based on the same revenue forecast derived earlier.
RPM is an intriguing business in the specialty chemicals sector that I'm quite interested in. I don't believe it's a screaming buy at current levels because you're banking on pretty aggressive growth rate assumptions for the next 5 years. That growth could easily come to pass with further execution of the MAP to Growth initiative in conjunction with an improving economy and therefore rising demand for RPM's assortment of products.
I would hope to see an increase in the pace of dividend growth with cost savings leading to higher growth, likely through additional acquisitions, as well as freeing up more cash flow. The MAP to Growth plan has shown substantial increases in cash generation with operating cash flow climbing 88% for FY 2020 compared to FY 2019 and the TTM period showing an additional 50% increase compared to FY 2020.
The low $80s would be a much more attractive price to purchase shares of RPM which the share price was at about one month ago, although I believe now is a fair price for RPM. Historically purchasing shares of RPM has been quite attractive with the TTM FCF yield greater than 5% which it's currently trading above.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in RPM over 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.
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