RPM International: No Room For Error

Summary

• RPM International is richly valued, giving it no room for any slowdown in growth.
• Gross margins have taken a hit over the past two years.
• DCF and valuation metrics indicate that the stock is overvalued.
• Consider selling covered calls on RPM International to generate income.

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RPM International Inc. (NYSE:RPM) is overvalued at current prices. It is seeing robust growth but cannot afford any missteps at its current valuation. Investors holding RPM stock can consider selling covered calls to generate income. Dividend seekers should wait for a higher dividend yield before buying. It may be best to wait for a pullback before buying this stock.

Can good revenue growth continue?

RPM International operates under four business segments, Construction Products, Consumer Group, Performance Coating, and Specialty products. An increase in interest rates may have brought residential and commercial construction to a standstill, yet the company's Construction Products Group experienced record sales and profitability. The company anticipates this demand strength to continue due to the spending brought on by the Federal Government infrastructure bills passed in the past year. Inflation forced the company to increase prices by 9.8% in 2022 across its products.

Since 2013, the company has seen good average revenue growth of 6.58%. 2020 was an outlier when it had a negative revenue growth of 1.04%. In the past, the company used acquisitions (Exhibit 1) as a core part of its growth strategy but may have to pause it due to the rise in interest rates. Its revenue growth rate most likely got a boost from its acquisitions over the past decade. It remains an open question whether the company can show organic sales growth.

Exhibit 1:

RPM International FY 2022 Acquisitions (RPM International 2022 Summary Annual Report)

The company's gross margins averaged 40.4% over the past decade (Exhibit 2). However, since 2018, gross margins have averaged 38.09%, a 200 basis point drop from the average over the past decade. The company's average gross margin was 42.8% between 2013 and 2017. In the past two years, the company's quarterly gross margins have consistently averaged below 40% (Exhibit 3). However, it is implementing a plan called the Margin Acceleration Plan, or MAP, to improve its gross margins to 42% by 2025 (Exhibit 4). Much work remains to be done on the cost front to bolster its margins and cash flows.

Exhibit 2:

RPM Average & Standard Deviation Revenue Growth, Gross, Operating, Net Income, & Free Cash Flow Margins [2013 -2022] (Seeking Alpha, Author Calculations)

Exhibit 3:

RPM Quarterly Gross, Operating, Net Income Margin (%) [Feb 2020 - Aug 2022] (Seeking Alpha, Author Calculations)

Exhibit 4:

RPM International Margin Acceleration Plan to Increase Profit Margins (RPM International FY 2022 Summary Annual Report)

High inventory erodes operating cash flow

Many companies have struggled to attain optimal inventory levels during these turbulent times. High inflation and uncertainty in demand may have caused the company's inventory to increase. RPM International now carries about 111 days' worth of sales in inventory (Exhibit 5). This increase in stock has eroded RPM's operating cash flow.

Exhibit 5:

RPM International Days Sales in Inventory (Seeking Alpha, Author Calculations)

In the trailing twelve months, the company saw an inventory increase of $384.2 million, which reduced the cash from operation to $126 million. This high inventory level may put further pressure on its margin in the coming quarters, especially if there is a slowdown in demand. Companies in various sectors have increased prices in the past year and have yet to see much demand erosion. In other words, price elasticity has been much lower than anticipated, but that could change with buyers becoming more price sensitive.

DCF model indicates the company is overvalued

A discounted cash flow ("DCF") model indicates that the shares are overvalued at their current price (Exhibit 6). This model assumes a revenue growth rate of 6.5% until 2027 and a long-term growth rate of 3% to arrive at a terminal value. Considering that the company can achieve its margin improvement goals, an 8% free cash flow margin is used in this model. The discount rate is 10%. Given these inputs, the equity value per share is around $50. The stock is currently trading at $97.45.

Exhibit 6:

RPM International Discounted Cash Flow Model (Seeking Alpha, Author Assumptions & Calculations)

The valuation metrics also indicate that the stock is overvalued. For instance, RPM International is trading at a trailing GAAP P/E of 24x and a forward GAAP P/E of 22x. Seeking Alpha gives the company a growth grade of B with an expected forward revenue growth of 7%. The company may grow at 7% for a few years, but assuming a long-term growth rate of 3% is reasonable.

The company's return on invested capital (ROIC) is estimated at 11% (Exhibit 8). This ROIC is better than its estimated weight average cost of capital (WACC) of 8.5% (Exhibit 7). The WACC estimate assumes a 10-year US Treasury yield of 3.87% and a beta of the stock of 0.98. The beta shows that RPM International should move in line with the market. However, the past year has been aberrant due to COVID-related disruptions, the reopening of the global economy, and stimulus-driven demand. In the low-interest rate environment of the past decade, 11% ROIC may be the cause for cheer. But, it is a low return in today's rate environment where the risk-free 2-year US Treasury yields 4.42%.

Exhibit 7:

RPM International Weighted Average Cost of Capital (Seeking Alpha, Author Assumptions & Calculations)

Exhibit 8:

RPM International After-tax Return on Invested Capital ((ROIC)) (Seeking Alpha, Author Assumptions & Calculations)

Its capital turnover ratio is 1.37 (Exhibit 8), which is not impressive and needs improvement. Over the years, the premium paid for its various acquisitions has increased the goodwill on its balance sheet. The goodwill has reduced its capital turnover ratio. But, the company would have struggled to grow fast without the acquisitions. In this scenario, its capital turnover ratio may have been low due to low revenues. The ROIC model assumes a tax rate of 21%, but the company's effective tax rate may be lower, and that could add a few basis points to the ROIC. The company's cost of debt is bound to go up in the coming years, assuming this high-interest rate environment prevails. The company produces a return greater than its WACC, but investors should watch this metric closely to assess how the returns change in these volatile times. Any company not producing returns above its cost of capital is destroying wealth.

Monthly return analysis

Typically, an investor should expect the stock to move in line with the market, given its beta of 0.98. But RPM International has bucked the trend this year, falling just 2.4% compared to the 19.7% decline in the Vanguard S&P 500 Index ETF (VOO). The company has averaged a monthly return of 1.7% (Exhibit 9) compared to the 0.93% (Exhibit 10) for the Vanguard S&P 500 Index ETF. The company has much higher third-quartile monthly returns of 7.4% compared to the Vanguard S&P 500 Index ETF return of 5.74%.

Exhibit 9:

RPM International Monthly Returns [Jun 2019 - Dec 2022] (Data Provided by IEX Cloud, Author Calculations)

Exhibit 10:

Vanguard S&P 500 Index ETF Monthly Returns [Jun 2019 - Dec 2022] (Data Provided by IEX Cloud, Author Calculations)

A good candidate for covered calls

Investors can consider selling covered calls, given that RPM International Inc. is overvalued. That is, assuming the investor has sizeable gains on stock. The company will announce its earnings on January 5, 2023. Wall Street analysts have revised the earnings upwards in the past three months. The stock could get a boost if the company releases good earnings and sees strong demand going into 2023. However, the company has made unremarkable moves the day after its earnings release (Exhibit 11) but typically sees double-digit gains or losses in the month they were released (Exhibit 12). An investor can wait for the earnings release before selling a covered call to minimize the risk of the shares being called away. The Feb 17 $100 strike price calls last traded at $2.80. The premium would amount to a good yield of 2.8% (Exhibit 13).

Exhibit 11:

RPM International 1-Day Return After Earnings Release (Data Provided by IEX Cloud, Author Calculations)

Exhibit 12:

RPM International Month-end Return After Earnings Release (Data Provided by IEX Cloud, Author Calculations)

Exhibit 13:

RPM International Call & Put Prices Feb 17, 2023 Expiry (E*Trade)

Low dividend yield

The company offers a low dividend yield of 1.7%, which is not attractive in today's environment, where the U.S. 2-year Treasury yields more than this yield. The company has grown its dividend by an average annual rate of 5.8%. The company's payout ratio is a conservative 39%. The company has a debt-to-EBITDA ratio of 2.98, which is slightly high for the current rate environment. A debt-to-EBITDA ratio closer to 2 would be more appropriate. The company has enough liquidity to cover its short-term obligations, given its current ratio of 1.5. This stock is not for investors seeking dividend income at its current dividend yield, even with good dividend growth.

RPM International Inc. is a good company in the materials sector. However, it is overvalued based on discounted cash flow model and various valuation metrics. Investors can consider selling covered calls to generate income and use this strategy to book gains if the call is assigned. Income seekers should avoid RPM stock given its low dividend yield. It is best to consider RPM International Inc. stock after a pullback.

Disclosure: I/we have a beneficial long position in the shares of VOO either through stock ownership, options, or other derivatives. 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.