Description

Thesis

RPM is a self-help story in an above average quality business.  While the company already put out a 16% FY2021 EBIT margin target at its November 2018 investor day, the market is giving the company little to no credit for its cost cutting plan.  We believe the market seems to be falsely interpreted raw material cost inflation headwinds (which should reverse), below the line charges (which should reverse) and poor communication (which the company appears to be improving upon) over the past few months as misexecution, and is ignoring the steps the company has already taken to improve its margin profile that should start to yield results over the next few quarters. 

Business Overview

·         For the past 50 years, RPM has basically been a holding company of coatings (paints, sealants, adhesives, etc.) businesses, run by the Sullivan family

o   The company was founded by Frank C. Sullivan, who passed on the reigns to his son, Thomas C. Sullivan, who was then succeeded by his son, Frank C. Sullivan (the grandson of the founder) in 2002

§  Two other family members that we know of currently work at the company: (i) Thomas C. Sullivan, Jr. (son of the former CEO and brother of Frank C. Sullivan, the current CEO) serves at VP of Business Development, and (ii) Frank “Sully” Sullivan (the son of Frank C. Sullivan, the current CEO) serves as Business Development Manager for RPM Performance Coatings

o   Former employees have indicated that despite not having (anywhere close to) voting control, the Sullivan family has historically called the shots because the board had been carefully chosen over many years

§  Frank C. Sullivan (current CEO) only owns ~1.35mm shares of stock (~1% of the company or, ~$80mm of value); it is unclear how much other family members own, but suspected to be minimal

o   The Sullivan family has always believed in decentralization, and they apparently surrounded themselves with board members and executives that bought into that corporate philosophy

§  While decentralization resulted in many inefficiencies, the emphasis on decentralization likely helped the company acquire many small/medium-sized businesses over the years

·         The company is divided into three reporting segments

o   The Industrial segment comprises ~55% of total revenues and includes maintenance and protection products for roofing and waterproofing systems, flooring, industrial coatings, passive fire protection, corrosion control, high-performance sealing and bonding solutions, infrastructure rehabilitation and repair and other construction chemicals

o   The Consumer segment comprises ~30% of total revenues and includes rust-preventative, special purpose and decorative paints, caulks, sealants, primers, nail enamels, cement, cleaners, floor sealers and wood care coatings and other branded consumer products

o   The Specialty segment comprises ~15% of total revenues and includes industrial cleaners, restoration services equipment, colorants, exterior finishes, edible coatings and other specialty OEM coatings

o   In total, RPM has ~85 business units within these three segments

·         RPM’s historical growth algorithm was to grow revenues organically at ~2% and through M&A at ~4%, for ~6% annual revenue growth; margins haven’t moved much over the past decade, so adj. EBIT has grown in-line with revenues; a modest amount of leverage has resulted in HSD adj. EPS growth

o   Up until fairly recently, an asbestos liability provided a drag to FCF (the company made its last asbestos trust payment in 2017) and all remaining FCF was used to pay a steadily rising dividend (the company has increased its dividend slightly every single year since the 70’s, and the dividend currently yields ~2%) and acquisitions to drive the ~4% inorganic top-line growth

o   RPM had a reputation of being the white knight in the industry – it was able to acquire small and medium sized coatings businesses for 1-2x cheaper than market valuations because it then allowed those business units to continue to be run independently

§  RPM rarely integrated acquired businesses with existing businesses and typically kept all employees, manufacturing facilities, etc. 

o   While this unique business model made some sense in the past, the company apparently grew too big for it to persist and needed to pivot towards a new strategy – that’s where Elliott came in

·         We believe that RPM is a higher quality business than perceived

o   Historically, RPM has grown revenues roughly in-line with its closest coatings comps (all of which are perceived to be fairly high quality businesses), although with modestly less cyclicality

§  While RPM’s organic growth CAGR has performed roughly in-line with SHW/PPG/AXTA/VAL over the past decade (and during the difficult 2007-2011 period), RPM has actually shown the most resilience throughout the cycle; in fact, in CY2009 RPM’s organic growth only declined 6%, which was modestly better than the peer group, which saw organic growth declines of 10-14%. 

o   Most investors also don’t appear to appreciate that ~70% of RPM’s business is repair and maintenance

The Setup

·         On June 28^th, 2018, RPM announced that it had reached a “cooperation agreement” with Elliott Management to “improve operating and financial performance and enhance shareholder value”

o   As part of the “cooperation agreement”, Elliott added 2 board members, the board formed an “Operating Improvement Committee” to put out a margin improvement plan by November at an investor day, and the company hired a consulting firm, AlixPartners, to evaluate operating improvement opportunities

§  The 2 new board members included (i) the CFO of NRG Energy, who “helped lead NRG’s transformation plan starting in early 2017” (Elliott announced a similar “cooperation agreement” with NRG in February of 2017 and the stock proceeded to double over the subsequent 15 months as the company executed on its plan), and (ii) the former COO and board member of Valspar (VAL), which was sold to SHW in 2017

·         A case study on NRG shows a lot of analogies to the RPM setup and our discussions with former VAL employees have provided what we view as solid reference checks on the former COO of VAL

·         In the first 6 months after the “cooperation agreement”, the company started to make a number of changes

o   The long-time COO, Ron Rice, who had been in that role since 2006 and was only 55, decided to take an “early retirement” just a week after the “cooperation agreement”

o   On July 19^th, when the company reported FQ4, it noted that it had just cut a total of 183 positions, consolidated 3 manufacturing facilities, and shuttered an underperforming business, which will provide a total of $25mm in annual cost savings

o   On August 8^th, the Director of IR took an “early retirement”

o   On August 17^th, the company announced that it had removed its “poison pill”

o   On August 28^th, the company released its annual report and noted that two other senior executives, the President of the Performance Coatings Group and the President of the Rust-Oleum Group would “retire”

o   On October 3^rd, when the company reported FQ1, it noted that it had cut an incremental 150 positions (for 333 in aggregate over 2 quarters), consolidated 4 manufacturing facilities, and redeemed a convertible bond

o   At the November 2018 Investor Day, the company officially put out its FY2021 targets and provided a sufficient level of detail on how they’re going to get there (see below for detail) 

·         FY 2021 Targets

o   3% annual organic growth from FY2018 – FY2021

o   $290 in total savings

§  $75mm from consolidating 31 manufacturing facilities and improving manufacturing efficiencies

§  $145mm from consolidating materials and logistics procurement

§  $70mm from SG&A efficiencies, including the position cuts mentioned above and consolidating accounting and IT support services

o   $1.0bn in annualized FY2021 Adj. EBIT, which represents a 16.0% margin, up from 10.6% in FY2018 (note that we believe margins in FY2018 were depressed from raw material cost inflation)

§  $1.158bn in annualized FY2021 Adj. EBITDA, which represents an 18.5% margin, up from 12.9% in FY2018

§  $4.90 - $5.30 in annualized FY2021 Adj. EPS, which represents a 20% CAGR from FY2018 Adj. EPS

o   $230mm in working capital improvements

o   $1bn in share repurchases over 3 years and $150mm - $200mm in M&A per year

·         Thoughts on the targets

o   We spoke with tons of former employees and competitors prior to the Investor Day, did a bottoms-up analysis and a top-down analysis, and independently got to very similar headline Adj. EBIT and Adj. EPS targets.  Those targets were built from generally the same manufacturing, procurement and SG&A cost cutting build assumptions.  However, since the official targets are out, I’ll just comment on those targets.

o   In our opinion, the company provided a sufficient level of detail on each of the large buckets – manufacturing, procurement and SG&A.  I won’t provide that detail here, but see the Investor Day presentation for all the backup. 

o   The obvious pushback is that these targets are great, but how is a management team that has practiced deconsolidation for decades going to suddenly be able to execute on efficiencies gained through consolidation?  We think you need to look at the other players involved to answer this question.  Management has told us that John Ballbach, the former COO of VAL and a current board member (whom we’ve received very positive checks on), is very involved, and we’ve heard very good things about several of the senior executives in charge of executing on the plan, including Gordy Hyde (in charge of the manufacturing bucket) and Tim Kisner (in charge of the procurement bucket).  In addition, we think that the degree of difficulty inherent in executing on these three initiatives is fairly low. 

·         The FQ2 report

o   The company reported a fairly weak FQ2 in early January and guided to lower than expected Adj. EPS for FQ3; the stock sold off on that report, and has since continued to underperform the market YTD; we perceived a couple major culprits to the weak results

§  Raw material cost inflation continued to be a headwind; while raw material cost inflation was an issue for all of CY2018, most of the raw materials they purchase (propylene, ethylene, silicones, epoxy resins, asphalt, etc.) started to see some relief in CQ4 2018; however, it takes ~90 days for this to flow through the income statement given that they use FIFO accounting, so we won’t see the benefit of this until late FQ3

§  The company experienced modest equity losses during FQ2 (ended November 30^th, 2018) in its $130mm captive insurance portfolio (of which $93mm was in equities) and a new accounting standard requires that the company record unrealized gains and losses on equity securities in earnings (Berkshire Hathaway experienced a similar issue this past quarter, although to a much larger degree).  This resulted in lower FQ2 earnings and the company guided to further headwinds in FQ3 as a result of the market selloff in December.

·         Obviously, this has now more than fully reversed, so this should now provide a tailwind for FQ3 instead of the guided headwind.   

o   The more frustrating issue than the weak results/guidance was, in our opinion, very poorly communicated.  The company should have known about both the raw material cost inflation headwinds and the accounting standard change when it held its Investor Day in late November, but it failed to provide any short-term caution on FQ2 or FQ3 at the time.  The company does not currently have a formal IR person (although they are in the process of looking for one) and management does not seem to be very savvy about managing investor expectations.  We do believe that they’ve learned their lesson though and that communication will improve from here. 

·         Valuation and path to getting paid

o   We’re estimating $5.19 in FY2021 Adj. EPS; applying a 17x P/E multiple to that (which is ~1x below the company’s 5-year historical average of 18x and consistent with the comps and the company’s current forward P/E multiple) and adding dividends results in a target price of $90 over 1.5 years (when the company reports FY2019), 58% upside, or a 45% IRR. 

o   In order for the stock to start pricing in that level of earnings, we think the market is going to need to see 2-3 quarters of solid results.  We think that starts in FQ4 2019 (or possibly when they report FQ3 in early April and provide guidance for FQ4), when the benefits of the recent restructuring initiatives will start to flow through the numbers.  By then, raw material headwinds are also likely to start becoming tailwinds. 

·         Risks

o   Execution, as discussed above

o   While this business is less cyclical than most industrial businesses (and even its coatings peers), it does sell into construction, housing, industrial and consumer end-markets, so there is definitely some cyclicality

o   Raw material cost inflation can create short-term gross margin headwinds

§  The company purchases a number of commodities, some of which are petroleum based

§  While the company is typically able to recover cost inflation with a lag, significant moves can cause the company to miss quarterly expectations

Disclosure:

We and our affiliates are long RPM International Inc (NYSE: RPM) and may buy additional shares or sell some or all of our securities, at any time. We have no obligation to inform anybody of any changes in our views of RPM. This is not a recommendation to buy or sell securities. Our research should not be taken for certainty. Please conduct your own research and reach your own conclusion.

Catalyst

o   We’re estimating $5.19 in FY2021 Adj. EPS; applying a 17x P/E multiple to that (which is ~1x below the company’s 5-year historical average of 18x and consistent with the comps and the company’s current forward P/E multiple) and adding dividends results in a target price of $90 over 1.5 years (when the company reports FY2019), 58% upside, or a 45% IRR. 

o   In order for the stock to start pricing in that level of earnings, we think the market is going to need to see 2-3 quarters of solid results.  We think that starts in FQ4 2019 (or possibly when they report FQ3 in early April and provide guidance for FQ4), when the benefits of the recent restructuring initiatives will start to flow through the numbers.  By then, raw material headwinds are also likely to start becoming tailwinds.