Will Sherwin-Williams Paint My Portfolio Green or Red? (SHW)

[Update 04/07/2015: The SeekingAlpha editon has been published!]

Quick Background:

Sherwin-Williams (SHW) is probably one of the easiest companies to understand that I’ve analyzed thus far: it makes and sells paints. The company was founded in 1866 by Henry Sherwin and Edward Williams, and is currently based in Cleveland, Ohio, USA. SHW is #278 on the Fortune 500 list, and is a Dividend Aristocrat.

The company consists of four major segments. The “Paint Stores Group” operates outlets that sell Sherwin-Williams-branded paints, coatings, and various accessories. The “Latin American Coatings Group” focuses on the manufacture, distribution, and sale of SHW products in Latin America. The “Consumer Group” actually makes the paints and coatings that SHW-branded and third-party stores sell. Finally, the “Global Finishes Group” makes and sells “OEM product finishes, protective and marine coatings, and automotive finishes” internationally.

As can be expected in a somewhat commoditized industry, SHW has quite a few competitors. Valspar (VAL) is only one-quarter the market cap of SHW, but a well-known alternative. PPG Industries (PPG) is a bit more diversified, but still has several divisions dedicated to paints, coatings, and enamels. Benjamin Moore, a competitor since 1883, was purchased by Berkshire Hathaway (BRK.B) back in 2000, and is therefore only indirectly publicly traded. Interestingly, all of these companies (besides BRK.B) are Dividend Champions, with 37, 37, and 43 straight years of dividend increases respectively.

For more basic information, check out the company’s website and the 2014 annual report.

Fun fact: An investment of $10,000 in December 2000 would be worth $114,121.53 today, all dividends reinvested. This yields a annual rate of return of 18.6%, which crushes the S&P 500’s return of 4.2% during this time frame (Source: FAST Graphs)

Sparknotes Analysis:

Since SHW is a simple company to understand, it shouldn’t be any trouble to subject it to our normal screening criteria:

• Pays a dividend: Yes
• Has 5+ years of dividend increases: Yes (37 years)
• Has not frozen dividend for over 8 quarters: Yes
• Has a Chowder number of 10 or more: Yes (10.1)
  • For Dividend Champions, I look for a Chowder number of 10 or more
• Has am EPS payout ratio of less than 70%: Yes (30.45%)
• Pays a dividend monthly or quarterly: Yes (Quarterly; March, May, September, December)

• Has an S&P Quality Ranking of ‘A-‘ or better: Yes (A)
• Has generally increasing earnings over the past 10+ years: Yes
• Is fairly valued/undervalued according to the Normal P/E ratio (blue line): No
• Is fairly valued/undervalued according to the Intrinsic P/E ratio (orange line): No

Other Bonus Ratings:

• S&P Capital IQ: 2-star Sell
  • Scale is 1-5, 1 being ‘strong sell’, 5 being ‘strong buy’
• Thompson Reuters StockReport: 8 (optimized score of 8)
  • Scale is 1-10, 10 being best, 1 being worst
  • Optimized scores weight insider trading and price momentum heavier than other criteria
• Value Line: 1 for safety; 3 for timeliness
  • Scale is 1-5, 1 being best, 5 being worst

Financial Overview:

SHW has a rather paltry dividend yield of 0.94%, paying out $0.67 per share quarterly, $2.68 annually. The dividend is safe, as the company sports only a 30.45% payout ratio. The company had 2014 diluted earnings per share of $8.45, well covering the dividend payment. The $7.02 per share in 2014 free cash flow (2014 FCF of $665.7 million divided by 95.07 million shares outstanding) confirms that judgment. Debt is not an issue either. The company has $1.805 billion in debt, which yields a debt/equity ratio of 1.8. While shocking, especially considering the peer group’s average debt/equity ratio of 0.7, the interest coverage ratio is 20.6x. This implies that the debt, while high, is well under control. Finally, the company is a bona-fide share cannibal, going from 108.79 million shares outstanding in June 2010 to 94.89 million shares today. While I can’t pretend to be thrilled at the valuations these shares were purchased at, I do like the fact that management likes to reward shareholders in ways beyond simple dividend payments. The company hasn’t split since a 2:1 split in 1997.

SHW currently has an astoundingly high P/E ratio of 32.3. Morningstar states the company’s one-year forward P/E ratio is a more reasonable 22.3. I expect this compression to be a combination of the company continuing its solid earnings growth and of the company’s share price coming down to earth. As shown by FAST Graphs, SHW stock is very overvalued, so it logically follows that if the share price reverts to the historical P/E ratio of around 13-17, the price will decrease somewhat. VAL’s P/E ratio is 17.8, and PPG’s is 28.5, indicating that SHW is expensively valued even among its peer group. Margins are relatively in-line with the peer group. Gross margins and operating margins are above average (46.40% vs 32.66%, and 11.68% vs 10.95%). Net profit margins are slightly below average (7.78% vs 8.40%). This makes sense, due to SHW’s focus on company-owned and -operated retail stores, which naturally will put some downward pressure on profit.

If we project the historical compound annual growth rate into the future, we can make some predictions on how SHW and its competitors will perform going forward. By 2020, we can assume that SHW will grow its earnings by 11.1%. However, the rate of return will be -4.52%. This implies that although earnings will be growing at a healthy rate, that won’t be enough to compensate for the extreme overvaluation we see in the FAST Graphs snapshot above. This implies that an investment in SHW at the current price will lose money by then. With an estimated earnings growth rate of 11.4%, VAL is expected to have a rate of return of 61.08%. PPG, on the other hand, is expected to grow earnings at the comparatively low rate of 5.1%. This, combined with PPG’s valuation, implies a rate of return of -3.76%. When all three peers are compared, VAL appears to be the best bet going forward. Both PPG and SHW suffer from overvaluation, and PPG also suffers from slower earnings growth.

Risk Factors:

Besides the given overvaluation, some other major risks inherent in a company like SHW are as follows:

• Cyclicality: Paints and coverings are generally cyclical, coinciding with construction and manufacturing booms. When the economy is doing well, people feel more free to spend money on things like house renovations and remodeling, and new luxuries such as new cars and boats. While SHW benefits from boom times, consumers curtail unnecessary spending during recessions. This could hurt SHW’s sales, and if the company does not have enough cash available, the dividend could be in danger of being maintained or cut.
• Input costs: The company needs many varied chemicals to produce paint and coatings, such as titanium dioxide, propylene, petroleum derivatives, and natural gas. Any spikes in each component increases input costs and lowers profit margins. While I don’t see this being a major issue, especially with the current prices for oil and natural gas, spikes in other materials could be an issue.
• Environmental costs: as a chemical company, SHW has to abide by many varied laws and regulations concerning how it makes, sells, and disposes of its products. Considering many of their products are used in the home, the threat is magnified. If the company produces an exceptionally toxic batch of paint, recalls and legal costs could be exorbitant. With the company’s already-high debt load, such costs could hinder their ability to grow and reward shareholders.

Final conclusion:

The company passes all my criteria, except for valuation. SHW doesn’t seem like a bad company, with reasonable margins and a penchant for rewarding investors with rising dividends and share buybacks. Independent of share price, I would be interested in owning the company. But currently, the company is extremely overvalued, almost by a factor of two. I’m normally all for layering into a stock in order to lower your cost basis. It seems at this point, thought, that an investment in SHW is a guaranteed loss over the medium term as the company reverts to fair value. The company hasn’t approached that point since 2011. Before then, we see that the price followed earnings closely. If we project that SHW’s share price will eventually revert to the norm (meaning a ~15 P/E ratio), we achieve a fair value range between $134.39 and $187.40. SHW is currently trading at $284.35. Once SHW hits $190.00, the high end of an appropriate valuation range, I will start considering initiating a position. Until then, I will avoid buying.

What do you think? Does SHW make the cut for your portfolio? Also, how can I improve future analyses?

Disclosure: None

All data is accurate as of market close, 4/5/2015. My stock analysis archive page has been updated accordingly. Please read my disclaimer here before choosing to invest. Company logo image source is available here. Data source is FAST Graphs, David Fish’s US Dividend Champions List, or company materials, unless otherwise indicated.

Tags: dividend-stock-analysis, Sherwin-WIlliams Company, SHW