Current Price: $372 Price Target: $480
Position Size: 2% TTM Performance: -9%
SHW missed on the top and bottom line. Revenues were $4.7B (+5%) vs consensus $4.8B. Adjusted EPS was $5.68 was below the Consensus $5.74. Excluding all acquisition-related costs and purchase accounting third quarter adjusted gross margin decreased 30bps sequentially and 130bps YoY which illustrates the fact that pricing continues to lag raw material inflation in some parts of the business. Lowered upper-end of full-year EPS guidance despite lower assumed tax rate. The Americas Group operating margin improved while the Consumer & Performance Coatings margins declined YoY. The America’s group is passing on raw materials costs more quickly, and the Consumer Group margins are being negatively impacted from costs to service the new LOW’s retail program. [MORE]
Key Takeaways:
· Revenue growth slowed from 2Q because of slower growth in:
o N. American architectural business. Paint Stores Group same store sales of +5.2% missed expectations. This is a deceleration from +6.8% last quarter, but in line with Q1. Performance in this segment is key as it drives the majority of revenue and even more of their profit. They noted a slower pace of sales growth in some end markets most notably DIY. Weather was also an impact (hurricanes).
o Sequential slowdown in industrial businesses in China.
o Unfavorable currency translation.
· The slowdown in the industrial business in China was expected given PPG’s report last week, and is less impactful to SHW than the disappointing SSS in the architectural business.
· Raw material cost pressure has been “unrelenting and accelerating.”
· During the third quarter they announced an additional price increase in the range of 4% to 6% which took effect on October 1. And they have more pricing already scheduled to roll in.
· Price increases are generally keeping up with raw material cost increases with the exception of the Performance Coatings where price increases are lagging.
· Remodeling activity may moderate next year from a mid-7% growth rate to a mid-6%. So still solid growth.
· They are not seeing moderation in their residential repaint results and more than 80% of the industry is repaint.
· They aim to reduce their leverage ratio to 3x by year end.
· Full year capex should be $265m or 1.5% of revenue.
Valuation:
· Expected free cash flow of $1.7B in 2018, trading at a 4.9% yield. Dividend yield <1%.
· Given growth prospects, steady FCF margins and high ROIC the valuation is still reasonable.
· Balance sheet is fairly levered from the Valspar acquisition, but they expect to get to 3x by the end of the year.
Thesis:
· SHW is the largest supplier of architectural coatings in the US. Sherwin-Williams has the leading market share among professional painters, who value brand, quality, and store proximity far more than their consumer (do-it-yourself) counterparts.
· Their acquisition of Valspar creates a more diversified product portfolio, greater geographic reach, and is expected to be accretive to margins and EPS. The combined company is a premier global paint and coatings provider.
· SHW is a high-quality materials company leveraged to the U.S. housing market. Current macro and business factors are supportive of demand:
o High/growing U.S. home equity values. Home equity supportive of renovations.
o Improving household formation rates off trough levels (aging millennials).
o Baby boomers increasingly preferring to hire professionals vs. DIY.
o Solid job gains and low mortgage rates support homeownership.
o Residential repainting makes up two thirds of paint volume. Homeowners view repainting as a low-cost, high-return way of increasing the value of their home, especially before putting it on the market.
$SHW.US
[tag SHW]
Sarah Kanwal
Equity Analyst, Director
Direct: 617.226.0022
Fax: 617.523.8118
Crestwood Advisors
One Liberty Square, Suite 500
Boston, MA 02109
www.crestwoodadvisors.com
