Description

Think of an industry with a stable and predictable offering, paint has to be top of the list. 

While selling paint is generally an ordinary business, generating modest returns, Sherwin Williams is anything but ordinary. It is an extremely profitable and well managed franchise.

The business is divided in three major segments:

Americas Group: this segment includes the 4,500 stores in the US, Canada & LatAm, where they sell paint primarily to pro painters.

Consumer Brands Group: segment sells paint in retailers outside their store network, primarily to DIY clients. In the US, company relies on Lowe´s.

Performance Coatings Group: segment sells coatings for industrial use including auto, aerospace and packaging globally.

This writeup will focus on the Americas Group, given 75% of total profits come from this segment, it is also the crown jewel.

Why is US Architectural paint at SHW such a great business?

SHW dominates the US market with more than 50% market share and 70% share in Pro. The industry structure is favorable, given the concentration in a small number of rational players. The 3 largest competitors are PPG & Masco with 15% market share each and then Benjamin Moore at 5%. None of these have the vertical integration and capacity to offer a similar service. For example, Masco relies solely on Home Depot, BM on independent distributors and PPG a mix of independent, big box and their own stores. None of these have the capacities of SHW.

Sherwin is vertically integrated and controls local monopolies. The company manufactures and stores the product close to the customer, which provides some barriers to entry as the required investment and complexity is high, they own branches near the end customer with focused sales reps. Control distribution in a way that many times the paint is delivered to the job site though their truck network, increasing customer productivity.

Sherwin has significant scale as the largest paint producer globally. This helps them with R&D investments and marketing. The company has more than 2,000 employees focused on research and a number of patents.

There are also some favorable dynamics, by which close to 85% of the cost of a paint job is labor. For this reason, price is not the primary consideration in the mind of the professional painter and SHW has overtime pushed pricing in exchange for a valuable service. There are other important considerations such as product assortment, help in selecting product, high quality paint, local delivery where the job is being done, etc. Sherwin is committed to improving the profitability of their customer, enabling them do their job faster and better.

Sherwin has built a strong brand amongst its customers and the general public, after years of providing a quality product and service. It is ranked as the #1 brand by professional painters.

Why now?

Over the last few months, the stock has declined +30%. The market correctly expects that the housing slowdown will hurt Sherwin in the short term, and the stock has been hammered together with anything related to the sector. While there is some correlation to home starts, close to 80% of volumes can be considered repainting existing surfaces. So business should remain healthy even in a slowdown.

In a recent announcement, the company reduced guidance citing inflation´s impact on margins and lower demand internationally. They also suspended buybacks until year end to reduce leverage from 3.3x to their target under 2.5x.

There are many unkowns and headwinds, but this decline represents an opportunity to own one of the most durable moats that I am aware of. While the stock is not statistically cheap at 27x guided 2022 earnings, I believe it is actually quite reasonably priced as Sherwin is underearning.

While many of the housing names got a huge tailwind during covid, as customers embarked on DIY projects and invested in their homes, Sherwin did not get a large boost. 2 main reasons, most of their business is Pro and people preferred DIY instead of bringing a stranger to their homes while they were present. Additionally, they ran out of inventory due to lack of supply in some of their inputs and some internal mistakes. 

Earnings are depressed due to the significant input inflation, which has not been offset with pricing given the latter works with a lag. For this reason, 2022 gross margins are expected to be close to 41% which is the lowest figure in years. I expect gross margins should trend up from here and get close to 47% by 2024. Management has even guided to 45-48% gross margins in a normalized environment. In 2016, during the latest commodity price decline gross margins reached 50% while sales grew.

The good thing is that top line will have significantly expanded due to the pricing they have pushed and some modest volume.

I expect revenues to hit close to $27bn in 2024 and the 47% gross margin makes earnings expand significantly to $3.5bn or $13.50 eps.

Historically, US architectual paint gallons have grown at 2%, no reason to expect a large deviation going forward. On top of that we might get 3% pricing and some share gains as pro gains vs DIY. This gives us something like 5% top line growth medium term. A company that grows 5% with some incremental margin potential, high returns and a defensible position might garner a high multiple of earnings. My guess is as earnings expand from a depressed base, there will be no multiple contraction from current 27x. Lets put a target of $365 in 2 years or 55% total expected return. While there are higher return opportunities out there, this might be one of the most predictable and simple.

Catalyst

improved profitability once pricing exceeds input inflation