Description

COMPANY DESCRIPTION:

SHW is the industry leading retailer of architectural paint. The Paint Stores Group segment (~75% of earnings power) consists of ~4,100 company-operated specialty paint stores that primarily sell SHW branded architectural paint to pro contractors in the US, but also DIY consumer focused finishes, and protective and marine coatings. The Consumer segment (~15%) services the DIY market; 63% of revenue is intersegment transfer to SHW owned paint stores, with the balance sold at retailers such as LOW. Global Finishes (industrial end-markets) and Latin America paint stores represent the remaining 10% of earnings power. On March 21st, SHW announced its intention to acquire VAL for $11.3bn including $1.9bn of assumed net debt, or ~11x post-synergy EBITDA. VAL’s business mix is ~60% industrial and 40% architectural. Management intends to fund the acquisition with 4% paper and is targeting a 1Q17 deal close.

INVESTMENT THESIS:

1. Opportunity to own a great business at 14x 2018 cash EPS

SHW earns 35%+ ROIC vs. low- to mid-teens for its peers, primarily because Paint Stores Group (“PSG”, ~75% of earnings power) is a great business:

1. Scale – Paint is a scale business. SHW is the low-cost domestic producer and imports are not competitive because paint is dense. SHW captures ~40% of the US architectural paint market and ~65%-70% of the US pro architectural paint market. SHW’s ~4,100 owned and operated stores are more than 4x the footprint of the second largest player and nearly 3x all of its competitors combined. At SHW’s scale, unit economics for new stores are incredible (after-tax cash-on-cash returns of 70% by Year 4). SHW can only deploy ~$35-$50mm/year to new stores given their internal policy to staff new locations with store managers with 5+ years of experience.   

2. Pricing power – SHW enjoys controlled distribution through its own stores to a price insensitive customer base (pro contractors), which allows the Company to exercise pricing power. Paint represents only 10% of the cost for pro paint jobs (90% labor) and contractors prefer to work with the brand they know and trust. Many contractors believe that SHW’s paint quality allows them to complete a job faster and avoid the costly repaints associated with botched jobs.

    

3. Structural share gain – Pro contractors are gaining share from DIY. Contractors represented 59% of the US architectural paint market in 2014 vs. 40% in 1980. This structural trend tends to temporarily reverse during recessions but is a ~100bps tailwind during periods of normalized unemployment. SHW is adding ~100 stores per year, ~4x the pace of all of its competitors combined. Management is targeting a store-count of at least 5,000 US stores by 2025.

4. Strong management team  --  The new CEO (since Jan 1, 2016) is a 30+ year company veteran. He was previously COO and is widely credited with the successful execution of PSG’s controlled distribution strategy. The CFO is highly regarded in the industry and a strong capital allocator. The Company has repurchased 35% of the float in the last 10 years while simultaneously acquiring tuck-ins, increasing the dividend each year, and increasing the store-count by ~1,300. The Chairman, who remains actively involved in the business, owns ~$300mm of stock. The CEO and CFO collectively own more than $80mm of stock.

2. SHW can sustain high-single-digit PSG revenue growth through 2018 due to US housing tailwinds; consensus numbers are way too low.

My 2016-2018 SHW stand-alone estimates likely prove conservative despite being materially higher than consensus; demand checks and leading macro indicators are improving while gross margins are more durable than the market expects.  

My proprietary housing and R&R leading indicator model is highly correlated (r2 = 0.93) to SHW’s PSG SSS over the past 40+ quarters. All of these leading indicators remain below mid-cycle and well below prior peaks, leaving ample room for growth. My math suggests the current US housing and R&R backdrop can sustain 8-10% SHW PSG revenue growth.

The bear case is that SHW is over-earning on peak gross margins that will eventually revert to the mean. I think this misconception is one of the key reasons why this opportunity exists. SHW can pass through raw material costs to its customers over time; gross margins increased ~260bps from 2008-2014 despite a ~35% increase in raw material costs during that timeframe. However, gross margins do compress during periods of extreme raw material cost inflation (e.g., $140 oil was a 12-month double in 2008; TiO2 prices doubled in 2011-2012). SHW’s ASP increases lag those of raw material costs because SHW doesn’t want to jam its pro customers in the middle of a paint season, when they already have jobs quoted/contracted. Historically, when raw input costs increased but increased no more than 15%, quarterly gross margins still expanded YoY ~70% of the time. Gross margins almost never decline during periods of falling raw costs, further suggesting that retail prices are very sticky-down (i.e., SHW gets to keep the gross margin when raw mats decline).  

I spent a lot of time on the raw mats (propylene, TiO2) and I think the chances of another sudden spike in the near-medium term are fairly low. I expect TiO2 prices to remain relatively flat in 2016 and move gradually higher in 2017/2018. Raw mats may spike at some point in the future but long-run gross margins are sustainable as long as input costs don’t show hockey stick growth in perpetuity. A 10% increase in TiO2 prices requires ~2% of ASP increase to offset. SHW has not raised prices in the last 28 months, the longest stretch of time in recent history, which provides some buffer for potential raw material cost increases in 2017. The Company’s production facilities are also currently running at low-80s utilization vs. management’s target of 88%-94%, so operating leverage on non-raws should provide another buffer against gross margin compression.  

If you want to mathematically prove the above claims, you can run a multi-variate regression on scale/operating leverage (revenue, number of stores), raw material basket prices, and seasonality. Those four factors explain nearly 90% of the variation in quarterly gross margins over the last decade+. The majority of that variation is explained by changes in revenue and number of stores (i.e., scale/operating leverage), rather than raw mats prices.

3. VAL synergies are likely understated

Management guided to $280mm of realized cost synergies and $320mm run-rate in 2018. Architectural coatings are SHW’s crown jewel and the company enjoys 20% segment margins there vs. VAL at 10%. Conversely, VAL is a market leader in industrial coatings and the company enjoys 20% margins there vs. SHW at 10%.  My work suggests that management’s stated synergy number is in-line with industry precedent, based solely on raw material purchasing and SG&A cost savings of bringing VAL’s architectural margins in-line with those at SHW and SHW’s industrial margins in-line with those at VAL. I do not believe that management has aggressively underwritten the substantial opportunity in utilizing VAL’s in-house resin technology. Former executives I spoke to believe that in-housing resin could yield substantial savings with limited capital investment. Furthermore, SHW has not promised any revenue synergies despite the fact that management has for years explained that the key limiting factor for growth in their industrial coatings business has been their lack of scale in key international markets, which is exactly what they are getting with VAL. I don’t underwrite any revenue synergies, but my conversations with former executives and precedent industry acquisitions suggest that they are highly likely.

KEY RISKS:

Raw Material Costs

Discussed in (ii) above.

Deal Risk

Regulators may push for the divestiture of a portion of VAL’s US architectural business, which may pressure my synergy assumptions. The outcome hinges on how regulators define the market. SHW can walk away if regulators mandate the divestiture of more than $1.5bn of revenue and the purchase price would decrease from $113/share to $105/share if SHW must divest more than $650mm. VAL’s current trading price of $107/share suggests that the market expects minimal divestitures.

SHW will lever up to 4.3x net debt to finance the deal, which requires debt markets to remain open through 2016. The Company is a strong credit and the majority of the debt will be funded through a term loan and is thus not contingent on the health of the junk bond market. Management believes the company can de-lever to 2.0x by 2019.

HD/LOW competition

Home Depot acquired Interline, a distributor to property managers, for $1.6bn in June 2015. HD believes that it can utilize the acquisition to sell more paint to pro contractors. SHW/VAL do not sell to HD (Masco is the sole supplier). SHW/VAL represent ~80% of LOW’s paint sales (PPG is the third supplier); management’s statements imply that they do not expect material dis-synergies at LOW.

Oil and Gas exposure

The Protective & Marine (P&M) segment represents 13-15% of PSG revenue and has significant exposure to Oil & Gas (protective paint for tankers, wells, pipes, etc.). I estimate that P&M declined ~20% in 2015, with declines worsening through the year. I model continued weakness in these segments but more aggressive declines can pressure SSS metrics.

VALUATION:

My year-end 2017 target price of $420 is based on 20x 2018 cash EPS of ~$21, 40%+ up in 18 months.

SHW traded at a 15% premium to the SPX from the early- to late- 1990s but at a 18% discount to the S&P for the next decade as the company was dragged through class action suits in several states for damages related to the past manufacture and sale of lead paint. Estimates of SHW’s liability ranged from $1bn-$2.5bn (depending on how much insurance coverage was assumed), which is a substantial amount for a company with a mid-single-digit billion market cap at the time. The litigation overhang started to lift around 2009-2010 after a string of SHW legal victories and the Company has traded at a 36% premium to the SPX over the last five years. My target price assumes an 18% premium to the current market multiple. A discount to SHW’s current multiple is warranted; the acquired VAL business is good but not as high-quality as the core Paint Stores business.

A premium to SHW’s 1990s multiple is justified because of the success of the Paint Stores Group strategy and industry consolidation. In 2006, 55% of US architectural coatings were sold by 21 companies. By 2010, four companies held 71% market share. Pro-forma for the VAL acquisition, three companies will now account for 85% of North American Architectural coatings.

Catalyst

- Material beat and raises in the next several quarters.

- Deal closing in 1Q17 and inclusion of cash EPS accretion to 2017/2018 numbers.