Sherwin-Williams: Delivering Earnings Growth Through The Cycles (NYSE:SHW)


Facing an investment landscape fraught with uncertainties, I think owning Sherwin-Williams (SHW) makes a lot of sense. The company has grown EPS, successfully implemented price increases, and gained market share through a pandemic – no small feat.

Looking ahead, I think SHW is poised to continue on its growth path on the back of long-term US architectural paint growth trends, and therefore, double-digit medium-term EPS growth looks well within reach. Valuations appear elevated at first glance, but balanced against the company’s ability to grow earnings organically through the cycles, along with the potential for inorganic growth and buybacks, I am bullish on SHW’s compounding potential.

Growing Through a Pandemic

One of the key selling points for SHW is its breadth, which has allowed it to capture demand wherever it occurs. For instance, the shift away from pro-applied has been largely offset by a shift to DIY, and the shift away from interior paint has been offset by a shift to exterior, enabling SHW’s earnings resilience. Similarly, while non-architectural markets such as auto repaint have weakened, other end-markets such as can coatings have strengthened.

As a result, pricing has remained steady through COVID-19 despite some raw materials seeing price declines along with oil. Beyond pricing, management also deserves credit for quickly adapting during COVID-19 to facilitate online/contactless purchases and curbside pickup/deliveries, all of which have helped keep business going and driven cash flow generation through the downturn. In sum, SHW appears well-positioned to grow as long as overall painting activity sustains.

A Brighter Near-Term Outlook

SHW did not provide a quarterly EPS guide per usual, but management did update FQ3 sales guidance to +3-5% Y/Y. For the full-year, sales are now projected to be flat to up slightly Y/Y, which translates to an adjusted EPS range of $23.50 to $24.00 (up from $21.75 to $23.25), excluding acquisition-related costs. As FQ4 is generally a seasonal low, however, most of the earnings upside should come in FQ3, which is a positive for the near-term outlook.

Source: Sherwin-Williams Financial Community Presentation Slides

By segment, TAG sales are guided to be up low-single-digits %, Consumer Brands at up low to mid-teens %, and Performance Coatings at down low to mid-single digits %. Nonetheless, the overall mix remains favorable, with stronger exterior balanced against interior paint weakness. Similarly, operating cost control initiatives are tracking better than planned, which should contribute to added operating leverage in the upcoming quarters.

While the positive FQ3 pre-announcement was likely anticipated by investors, I think the magnitude of the revisions (amid a pandemic, no less) likely surprised to the upside. The earnings strength not only underlines the resilience of SHW’s business model, but also its ability to grow through the cycles.

Outlining the Mid-Cycle Scenario

On another positive note, long-term gross margins are now targeted at 45-48%. Assuming SHW achieves the upper-end of this range, EBITDA margins could reach a very impressive c. 25% (up from the current c. 17%) in the coming years. In addition to organic growth, SHW also stands to benefit from continued e-commerce adoption, with digital offerings driving a higher price/mix run-rate, along with improved operating leverage from longer-term cost discipline.

While there is currently no explicit timeline on Consumer Brands and Performance Coatings margins reaching 20+%, Consumer Brands segmental margins are already thereabouts due to strong fiscal 2020 DIY volumes (partially helped by COVID-19-influenced operating conditions). Assuming DIY volumes continue to grow long term, I think the thesis is well on track across both segments, even as price/cost tailwinds normalize.

Capital Allocation Could Add to EPS Growth

Additionally, the company also plans on using M&A to drive growth in industrial and push sustainable Performance Coatings margins higher. The rationale being that the addition of pieces to the Industrial portfolio will improve market consolidation and, in turn, drive economies of scale across the business. Interestingly, the company appears to have honed in on Europe and Asia as its key focus for strategic M&A, although no specifics have been disclosed thus far.

Another way SHW could supplement EPS growth is through aggressive buybacks, either through cash or by leveraging the balance sheet above the current 2.0x-2.5x target. Considering the company’s cash generative business, I think there is plenty of room to raise leverage above 2.5x for M&A or buybacks, but only for the right opportunity or at the right price.

Source: Sherwin-Williams Financial Community Presentation Slides

Potential Oil Price Beneficiary

As c. 80-85% of COGS are raw materials, with the largest portion of variable spend going toward resin/latex, which is tied to oil/ olefin prices, SHW is a potential play on the prospects of a structurally lower oil price backdrop. While SHW margins could also be hurt if oil prices rise, SHW’s pricing power (especially in architectural coatings) shields it from most of the impact.

For instance, SHW successfully raised prices in its stores by 3-4% at the start of the year, of which the company has realized c. 2%. Historical precedent from prior years also suggests SHW is able to maintain pricing through oil price inflation (peaked in late 2014) and a TiO2 super cycle (peaked in 2012). A look back at its gross margin profile from 2012-2015 supports this view.

ChartData by YCharts

Looking ahead, SHW expects raw materials to be down mid-single digits % in fiscal 2020 despite hurricane supply chain disruptions. On TiO2, prices remain stable in North America and down sequentially in Asia.

Delivering Earnings Growth Through the Cycles

In conclusion, I think SHW’s outperformance through the pandemic has validated its status as an industry-leading paint company capable of delivering steady earnings growth momentum through the cycles. Coming out of Investor Day, SHW’s updated margin targets indicate it should continue to compound EPS at double-digit growth rates organically, with additional upside likely from strategic M&A or buybacks. Shares currently trade at c. 29x full-year EPS, which I think is a reasonable price to pay for SHW’s quality and growth potential.

ChartData by YCharts

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.

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